How to avoid the self-employment tax

By JOHN CUNNINGHAM

For the Monitor

Published: 06-03-2023 4:00 PM

In my Nov. 11, 2020 ,column in this newspaper, I wrote about a powerful but little-known and little-used Internal Revenue Service proposed regulation called Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.” ). The Prop. Reg. enables individuals who are members of multi-member LLCs taxable as partnerships under IRC Subchapter K to lawfully make potentially major savings of their liability for the Self-Employment Tax (the “SET”). Most New Hampshire multi-member LLCs and their members are — and should be — subject to Subchapter K.

Given the potential value of the Prop. Reg. to New Hampshire LLC members, I want to provide today an update of my 2020 column about it.

It is true that under the governing case law, IRS regulations that are “mere” proposed regulations don’t bind the IRS. This is no doubt the reason why many tax professionals don’t advise their clients to make use of the Prop. Reg. But many of them don’t even know about the Prop. Reg.

However:

■In two widely reported public forums, the IRS has stated that the Prop. Reg. is its SET audit guideline;

■The Prop. Reg. has been on the books since its original publication in 1997; and

■The Prop. Reg. is substantively very sound — indeed, impressively so.

Thus, in my view, tax professionals who fail to advise their clients about the Prop. Reg. are making a significant mistake.

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The SET is harsh. For 2023, it imposes a 15.3% tax on the first $160,000 of the income of LLC members who do work for their LLCs and a 2.9% tax on any excess. Thus, for LLC members who earn $160,000 in 2023 from their LLC work, their 2023 SET liability will be, $24,480.

As noted, the Prop. Reg. can garner major SET 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 restructure their businesses as multi-owner LLCs. The easiest way to do this is to admit a spouse or other trusted person as a co-owner of their LLC.

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

■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 limited and general partnerships. It doesn’t apply to sole proprietorships, C corporations or S corporations. (And anyway, for most individual business owners, Subchapter S is not a good way to avoid Social Security Taxes.)

■In addition, the Prop. Reg. is inapplicable to individuals who are members of the classic “professions” – namely, accountants, actuaries, architects, attorneys, consultants, engineers and health care providers. It does apply to every other type of businessperson.

■The 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 even though, by their terms they apply only to LLC non-manager members. 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

■At least 20% of the interests in the investor class are owned by a member that meets the above three tests.

Ideally, this member will be the managing member’s spouse or another trusted person. The remaining 80% of the interests in the investor class can be owned by the managing member.

In the above situation, the managing member will owe no SET on his or her 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 can be somewhat 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. So if you and your LLC co-member want to use the Prop. Reg., you have to amend your certificate of formation.

Example: Mary Jones has a single-member LLC that sells widgets. Thus, she’s not a “professional” under the Prop. Reg. In 2023, Mary earns $160,000. Her 2023 SET, as noted, will be $24,480.

However, if she had admitted her spouse as a co-member of her LLC on 1-1-23 entitled to 20% of the profits allocated to the LLC’s investor class and Mary was a member of the LLC’s manager class but was also a member of its investor class and was entitled to also 80% of the LLC profits allocated to that class, she could have saved herself an SET liability of $20,000 or more. Too bad for Mary, her family and her business.

But it’s not too late for her to take the above actions even now. And there’s always 2024.

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