Sunday, March 12, 2017

The Taxation of LLC Member Distributions | Bethesda Tax Lawyer

With the deadline for filing income taxes approaching, I’d like to discuss a recent decision on whether an individual’s share of income earned through a Limited Liability Company (LLC) is subject to the self-employment tax.  Self-employed individuals generally must pay self-employment tax (SE tax, which consists of 12.4% Social Security tax plus a 2.9% Medicare tax ) as well as income tax, so it is crucially important to know whether money received in a given year counts for self-employment tax purposes.

An important prior case, Renkemeyer et al. LLP v. Commissioner (2011), addressed the question of earnings by partners in a law firm.  In that case, the Tax Court examined the operation of the partnership and determined that all of the earnings that passed through to the partners “arose from legal services they performed on behalf of the law firm” and thus were subject to the self-employment tax as surely as if each partner was doing business for himself. It was clear to the court that “the partners’ distributive shares of the law firm’s income did not arise as a return on the partners’ investment.”  Had some of the partners merely had their names on the masthead of the partnership, and drawn passive revenue from it after a substantial initial investment, the decision might have been different, but the facts as presented did not allow the court to make such a determination.  

However, in last month’s Hardy v. Commissioner (2017) decision, the Tax Court had the opportunity to distinguish Renkemeyer and clarify our understanding of when self-employment tax should apply.  Plastic surgeon Stephen Hardy had bought a $165,000 share, or 12.5%, of a surgery center organized as an LLC.  In exchange, Hardy received annual distributions from the center’s earnings and met quarterly with the other members of the LLC.  Unlike the Renkemeyer partners’ earnings, Hardy’s distributions from the surgical center were not premised on daily attendance at the center or even on the performance of a center number of surgeries on site.  He merely received the distributions, independent of any surgeries or other customer service duties he might undertake.  

After considering those facts, the Tax Court held that “Hardy’s distributive shares [were] not subject to self-employment tax because he received the income in his capacity as an investor.”  His distribution share was, of course, still subject to taxation per the rules governing LLCs, but he was not required to pay self-employment tax that can sometimes prove a significant added cost.  Obviously, some cases of earnings through LLCs will be less clear-cut than either Renkemeyer or Hardy, and the determination of whether the self-employment tax applies will depend on a careful analysis of the many factors that swayed the courts in those two cases, such as the income’s source (return on investment or services performed on behalf of the LLC) and the role of the individual within (daily management and oversight touching on all services that generate earnings, or merely receipt of passive distributions in accordance with their ownership stake in the LLC).  

For a free phone consultation regarding the self-employment tax or other tax matters, please contact the Law Office of Aaron P Richter, a Bethesda-based law firm with expertise in Tax Controversy, Business Formation, Estate Planning, and Tax Preparation.