Excluding SE tax on LLC as return on investment.


C

Cheryl

I recently heard a CPA said he had a case on audit and was
able to convince the IRS agent of his position. What do you
think?

Guys start a cleaning business, an LLC taxes as a P'ship. It
is successful. They hire employees that do the cleaning,
run the office, etc. All they do is sign checks, go to the
bank etc, probably putting in 10 hours a month. They pay
themselves $7200 a year that they pay SE tax on and $80,000
a year that they don't. WHen this is audited, the CPA
argues that since they don't actually do much work, then
most of the money is a return of their investment and should
not be considered taxable for SE purposes and the agent
agrees.

Do any of you try similar arguments with LLC's? Do any of
you split of the income to the partners so as to not pay
some SE tax? How is this being treated on audits or before
the courts. My understanding is that this has not been
ruled on specifically. Thanks.
 
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E

Ed Zollars, CPA

Cheryl said:
Do any of you try similar arguments with LLC's? Do any of
you split of the income to the partners so as to not pay
some SE tax? How is this being treated on audits or before
the courts. My understanding is that this has not been
ruled on specifically. Thanks.
This whole area is somewhat messed up <grin>, and frankly I
suspect that much like the frequent flyer area, this is one
where the IRS is simply afraid to enforce the law as it
actually exists, so it's virtually "anything goes" at this
point. But note I say at this point--should public opinion
change (the public gets worked up about social security
running out of funds and this gets publicized as people
"robbing" social security) it would be useful to have the
law on your side.

The law isn't real good if you actually read it <grin>.
Section 1402(a) provides in part this general rule of
inclusion of partnership income as self-employment income:

"...plus his distributive share (whether or not distributed)
of income or loss described in section 702(a)(8) from any
trade or business carried on by a partnership of which he is
a member..."

Note that the test isn't whether the *partner* carries on
the trade or business (or is even active in it), but rather
whether the *partnership* does. So the general rule is that
it is self-employment income and you have to find a
provision to *exclude* it.

Section 1402(a)(10) provides a limited exception for a
retired partner--but that isn't going to help in the case in
question since he clearly *is* performing services <grin>.
The one you'd have to hang your hat on for this purpose is
the limited partner exception of Section 1402(a)(13).

Now we hit a bit of a problem--state law has a very detailed
definition of what is a limited partner, and an LLC member
isn't that <grin>. Rather, LLCs were created at th state
level specifically because limited partnerships weren't an
effective structure for many operating businesses looking to
avoid corporate status under the IRC.

There is a bit of an out, though--the IRS "stealth tax"
proposed regulations that Congress blocked back in 1997 (and
then ignored) did have a hours of service test to determine
who was a limited partner for purposes of Section
1402(a)(13). Now the problem was they ignored the state law
definition entirely so that a state law limited partner
might not qualify for 1402(a)(13) protection--but, since you
want to ignore the state law definition, maybe that's not a
bad thing <grin>. Of course, Congress implied strongly when
blocking the regulation that the IRS had no authority to do
this and that the regulation likely would be invalid anyway.

As well, those proposed regulations have never been made
final and they were not issued as temporary regulations--so,
in theory, they aren't worth anything.

If those don't work for you, there was a prior set of
proposed regulations that were withdrawn that were even more
liberal <grin>. But, again, they really aren't worth much
today.

My own take is that, if litigated, the Tax Court would rule
that since an LLC is taxed as a partnership and it's not a
limited partnership, all income is subject to SE tax. But,
right now, the IRS isn't likely to litigate the issue.

So do I believe the CPA got the result he claims? Sure.
Frankly, I suspect he would have likely found the IRS would
have eventually caved had he taken the "whole hog" position
and not paid out any guaranteed payments. Most likely, at
this point the IRS doesn't want to risk a case. But taking
the position is, in my opinion, gambling that the bias on
this issue won't change before the statute runs out <grin>.
 

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