As I explained in last week’s column, the federal Social Security Tax known as the Self-Employment Tax (the SET) is harsh. For example, if you are lucky enough to earn $137,700 from your work in 2020, you may owe SET of $21,068. This will be, of course, over and above your federal income tax.

As I also explained last week, Internal Revenue Code Subchapter S can be a powerful weapon in lawfully reducing your SET, since the net income of an S corporation is not subject to FICA (the Social Security Tax that applies to corporations).

However, there is, as I also mentioned last week, a little-known but powerful additional weapon you can use to avoid the SET. It’s called Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”). And for many New Hampshire taxpayers, the Prop. Reg. can be far more effective than Subchapter S in avoiding the SET.

The Prop. Reg. can garner major Social Security Tax savings for individuals who are members of multi-member LLCs taxable as partnerships. However, it can do the same for sole proprietors or members of single-member LLCs if they can restructure their businesses as multi-owner LLCs. The easiest way to do this is to admit a spouse as a co-owner of your LLC. (In the rest of this column, all references to ”LLCs” will be to multi-member LLCs taxable as partnerships.)

Here are the basics that sole proprietors and LLC members should know about the Prop. Reg.:

— It was originally issued by the IRS in 1997 as a proposed regulation, and although, in my view, it reflects highly competent federal tax administration, the IRS has never issued it as a final regulation. This means that, in theory, you can’t rely on it in an audit. However, the IRS itself has said on at least two widely-publicized occasions that the IRS itself views it as its audit guidelines.

— Why then, hasn’t the IRS issued it in final? The reasons are sickening anti-IRS political reasons. I won’t bother you with them here.

— The Prop. Reg. applies to every type of entity that is taxable as a partnership. This means, in New Hampshire, most multi-member LLCs, limited partnerships, general partnerships, and registered general partnerships. The Prop. Reg. doesn’t apply to sole proprietorships, C corporations or S corporations.

— It is also inapplicable to members of the classic “professions” – namely, accountants, actuaries, architects, attorneys, consultants, engineers and health care providers.

— It does apply to owners of every other type of entity taxable as a partnership.

— The most basic Prop. Reg. provision provides that individuals don’t owe the SET on their shares of LLC income if (i) they have no personal liability for their LLC’s debts (and personal guarantees don’t count as personal liability); (ii) they don’t have LLC contract-signing authority; and (iii) they work fewer than 500 hours a year for their LLC.

However, there is a huge exception to the above three rules. This exception provides that even if you’re the manager of your LLC and you flunk all of these rules, you can still make substantial SET savings if:

— The operating agreement of your LLC provides for two classes of interests – a manager class and an investor class; and

— If at least 80% of the interests in the investor class are owned by a co-member who meets the above three tests. Ideally, this co-member will be your spouse or another close relative. The remaining 20% can be owned by you as manager.

In the above situation, you as member-manager will owe no SET on your share of LLC profits allocated to the investor class.

I’ll end this column with a final explanatory point, a warning and an example.

Explanatory point: If your business is presently a state-law business corporation taxable as an S corporation but you want to convert it to an LLC taxable as a partnership, it’s quite possible to accomplish this conversion, but the process is complex. I’ll describe it in a future column.

Warning: If you’re a member of a multi-member LLC in which you are largely passive but your LLC is filed with the Secretary of State as a “manager-managed” LLC, this means that you automatically have contract-signing authority, whether you want it or not. In this situation, you can’t benefit from the Prop. Reg. even if you’ve never signed an LLC contract and never will.

Example: Mary Jones has a single-member LLC that sells widgets. She has no employees and she earns $137,700 in 2020. Her 2020 SET, as noted, will be $21,068. But if she had admitted her husband as a co-member of her LLC on 1-1-20 and as an 80% co-owner of her LLC’s investor class, she could have saved herself SET of at least $15,000. Too bad for Mary, her family and her business. But there’s always 2021.

 

 

John Cunningham is a Concord, NH lawyer who is of counsel to the law firm of McLane Middleton, P.A. His practice is focused on LLCs, federal tax, estate planning and general business law. His telephone number is (603) 856-7172. His e-mail address is lawjmc@comcast.net. The link to his website is www.llc199a.com.