10/8/2005 From Tax Guru - Ker$tetter Letter (http://www.TaxGuru.net)
Q:
Kerry:
What I've always told my clients is that an LLC is a disregarded entity for tax purposes. Therefore, a single-member LLC is taxed as a sole proprietorship (SECA-liable), and a multiple member LLC is taxed as a partnership (SECA-liable on net profits from business).
The only way that an LLC can avoid SECA is to do an entity election change and be treated as a corporation or an S-corporation. Even there, the "reasonable salary" (with FICA) requirements of the S-corp tangle you up. On the C-corp side, you have the issue of dual-entity (LLC and individual) taxation.
As far as I know, this is mainstream tax advice. Anything I'm missing?
A:
It isn't as open and closed as you may think. For LLCs that are reported on 1065s, there has long been a dispute as to whether or not the K-1 income is subject to SE tax.
I don't have time to list the full history of this issue; but I will give a short summary. If you have the 2004 Small Business QuickFinder Handbook, there is a very good recap of the historical development of this controversy on page F-3.
Basically, there are some people who believe LLC members should be taxed the same as general partners of a regular partnership; with the net income subject to SE tax. Other folks believe that LLC members should be treated like limited partners in a normal partnership; with no SE tax on the net K-1income.
IRS issued a proposed regulation in 1997 requiring SE tax for any member who was active in the LLC business for more than 500 hours during the year. This has never been made official, which has given us the current status of having SE tax optional on LLC members.
There are currently some practitioners who are taking the approach of subjecting net income to SE tax for those members who actively participate in the business, while exempting the net income from SE tax for those members who are merely investors and not actively involved in the business's day to day operations. This approach is also voluntary and not enforceable by law.
I hope this helps you better understand the environment we currently have in regard to this issue.
Thanks for writing.
Kerry Kerstetter
