Does a member of a limited liability company (LLC) or a partner in a partnership have to pay self-employment taxes on the member’s or partner’s share of the entity’s income? Believe it or not, the answer isn't always clear. Let's break it down.

General Partners

If you are a general partner in a general partnership, you must pay self-employment tax on your entire distributive share of the ordinary income earned from the partnership’s business. General partners also must pay self-employment tax on any guaranteed payments for services rendered to the partnership.

Guaranteed payments are like employee salaries; the partnership pays them without considering the partnership’s income.

Limited Partners

If you’re a limited partner in a limited partnership, you don’t pay self-employment tax on your share of the partnership’s profits. But you do pay self-employment tax on any guaranteed payments you receive.

LLCs

LLCs are state law entities not recognized for federal tax purposes. In other words, they are always taxed as something else. So the self-employment tax analysis is based on how the LLC is taxed.

Single member LLCs are taxed unless the owner elects taxation as a corporation. Thus, owners of single-member LLCs file Schedule C and pay self-employment tax on their net profit.

LLCs with multiple members are treated as partnerships for tax purposes unless they elect taxation as a corporation. If a multi-member LLC is taxed as a partnership, should its members be treated as general partners who pay self-employment tax on their share of net profits, or limited partners who do not pay self-employment tax on their net profits?

Under proposed IRS regulations:

- Members of member-managed LLCs cannot be treated as limited partners and must pay self-employment tax.

- Members of manager-managed LLCs can qualify as limited partners and therefore avoid the self-employment tax, provided they work no more than 500 hours per year in the LLC business. 

- Members of service LLCs engaged in health, law, engineering, architecture, accounting, actuarial science, or consulting must be classified as general partners. As a result, they must pay self-employment tax.

The IRS has not finalized these proposed regulations and says it won’t enforce them. However, the IRS has stated that taxpayers can rely upon them if they wish.

Alternatively, you can look at U.S. Tax Court rulings instead. The leading case says an LLC owner may be treated as a limited partner only if he is a passive investor who does not actively participate in the LLC business.

To be safe, you should keep good documentation of each partner's involvement with the company, including hours worked and managerial duties. This will strengthen your case if you choose to exempt limited partners (as defined by the proposed regulations) from self-employment tax.

If you would like more information about self-employment taxes, click here to schedule an appointment with one of Gold Standard's seasoned tax accountants.

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