This general rule implies that members of an LLC classified as a partnership are subject to self-employment (SE) tax on their share of the LLC's income derived from a commercial or business activity. A significant number of taxpayers have argued that none of the residual benefits, after deducting guaranteed payments, or so-called distributive income, are subject to self-employment tax, even if those benefits were assigned to a management member or who was otherwise actively working. To be fair, some taxpayers have taken a more conservative stance in applying proposed regulations and limited case law to subject part or all of their distributive participation to self-employment income tax. However, taxpayers use both methods today with little consistency.
The special tax rule favorable to self-employment for limited partners was enacted long before LLCs existed. Can LLC members claim to be limited partners for self-employment tax purposes because they are not personally responsible for the LLC's debts? If the answer is yes, they could avoid self-employment tax by simply not accepting any guaranteed payments. Instead, they could simply make random distributions free of self-employment taxes to collect their share of the LLC's cash flow. While that's arguably a viable position, it's likely that the IRS won't agree to case of an audit.
This situation was never contemplated when Congress created the limited partner exception from the self-employment tax, because at that time the active participation of a partner always meant unlimited liability. For tax purposes, an LLC is considered to be the same tax entity as its owners, and all tax obligations fall on its individual members. The existence of a single-member LLC is generally not considered for federal income tax purposes, unless you choose to treat it as a corporation. Therefore, while the Castigliola decision is certainly not good news for those who want to take the position that members of an LLC can avail themselves of the exception of limited partners, the decision may need to be considered.
with skepticism. The Tax Court ruled that members should not be treated as limited partners for self-employment tax purposes because members shared control of the PLLC under state law, and limited partners lose limited liability protection under Mississippi state law if they participate in the control of the company. Lawyers' interests in the LLP had been divided into units of general management partner companies and investment firm units, and partners had treated income attributable to investment firm units as investment income from limited partnerships not subject to self-employment tax. General partners (who participate fully in the management of the company and have unlimited liability) are subject to self-employment tax on their distributive share of income.
The 2.9% portion of the self-employment tax that corresponds to Medicare applies to all of an individual taxpayer's net income. It could have far-reaching consequences, because the decision could be applied to treat distributive stock income assigned to the directors of LLC members as self-employment income solely because the members of the LLC have management authority. On the contrary, a general partner must include their share of the company's net income derived from business activities in income from self-employment. As a comfort (perhaps minor), you can deduct half the amount of your self-employment tax as a business expense, reducing your overall federal tax bill.
Every member of a multi-member LLC must pay self-employment taxes on their participation in the LLC's profits. Type S public limited companies are still a transferred tax entity, so the company's profits and losses flow to individual owners, as is the case with a limited liability company. The owners of a single-member LLC are not employees and instead must pay self-employment tax on the income they earn of the company.
