Category: Choice of entity – Social Security taxes

PROTECTING YOUR CLIENTS FROM SOCIAL SECURITY TAXES—THE LLC SECRET WEAPON

By , June 15, 2010 5:07 pm

For 2010, Social Security taxes apply to individuals, including individuals who are members of LLCs, at a rate of 15.3% on the first $106,800 of their “net earnings from self-employment” (“NEFSE”), including their shares of LLC income; and 2.9% on any excess.  NEFSE means, basically, active income—i.e., income from providing services.  In the case of employees, Social Security Taxes are called “FICA” taxes (for “Federal Insurance Contribution Act”).  In the case of sole proprietors and owners of entities taxable as partnerships, they are called Self-Employment Taxes (the “SET”).

In recent years, Congress has increased the “Social Security base”—the above $106,800—a thousand or more dollars every year. 

Because of their rate and for other reasons, Social Security taxes are a big concern for many individuals who are LLC formation clients. 

The easiest way for an LLC to protect these individuals from Social Security taxes on their shares of LLC income is to make an S election—i.e., an election to be taxed under Subchapter S of the Internal Revenue Code.  And LLCs are making these elections at a rapidly increasing rate.    

But what can an LLC do if (i) it wants to protect individuals who are its members from SET on their shares of LLC income; but (ii) it also needs the benefits of federal income taxation under Internal Revenue Code Subchapter K (partnership taxation), not under Subchapter S?  This can happen if the LLC needs the remarkable flexibility of partnership taxation; or if it can’t meet onerous Subchapter S eligibility rules.

The solution for such an LLC may well be a 1997 proposed IRS regulation designated Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”). 

Even among sophisticated tax practitioners, the Prop. Reg. is little known; and many tax practitioners who are familiar with it are hesitant to use it because it is a “mere” proposed regulation, not a final one.  They don’t want to create audit risks for their LLC clients.

However, the Prop. Reg. has been on the books without amendment since January 13, 1997.  And on a number of occasions, the Internal Revenue Service has announced publicly that the Prop. Reg. constitutes its SET audit guidelines.  The IRS did so most recently at a December 2009 meeting of the Tax Section of the District of Columbia Bar Association. 

For this and other reasons, it is very unlikely that the IRS will challenge the SET liability reported by LLC members as long as their LLC complies with the Prop. Reg.

In a soon-forthcoming post in this blog, I’ll provide a brief, plain-English explanation of the Prop. Reg. for the benefit of LLC lawyers who are not tax specialists.  

However, if you want a comprehensive technical discussion of the Prop. Reg. and a critique of it, and you want this right away, click on www.llcformations.com; then on the button on the left-hand navigation bar of that website marked “LLC Library”; and then on Item 12 under the heading “John Cunningham’s Writings,” etc.

Happy reading!

LLCs AND CHOICE OF ENTITY—THE BIG PICTURE

By , June 9, 2010 11:22 am

Every LLC lawyer will agree that the most important threshold task in forming LLCs is a task often referred to as “choice of entity.”  In the months and years to come, this blog will address dozens of choice-of entity issues.

But the key fact you have to realize before you undertake any choice-of-entity analysis is that there is, technically, no such thing. Rather, choice of entity requires three types of analyses, each of which is entirely different from the others. When you’re doing choice-of-entity, you should, to the extent of your competence, do all three analyses and then, if there are any conflicts among them, reconcile these conflicts.

To explain:

  • Non-tax choice of entity. The first type of choice-of-entity analysis is non-tax choice of entity. This is the process by which lawyers choose the best type of business organization for their clients on non-tax grounds—mainly on business organization law grounds. The key types of business organizations are sole proprietorships, divisions, general partnerships, limited partnerships, corporations and LLCs. The key issues are, for most clients, (1) Does the client need a liability shield? (2) If so, which type of organization will provide the client with the best shield? (3) Does the client need the special statutory business asset protections referred to by LLC lawyers as charging order protections? (4) If so, should the client obtain these protections through a general partnership, a limited partnership or an LLC? (Most corporate statutes don’t provide charging order protections.)
  • Choosing the right federal income tax regimen for federal income tax purposes. The second is choice of federal income tax regimen for federal income tax purposes. The relevant regimens are disregarded entity taxation and Subchapters C, K and S. Key issues include: (1) Which regimen will provide the client with the lowest tax rate? (2) Which will provide the client with the greatest flexibility in deploying and redeploying business assets?
  • Choosing the right federal income tax regimen for Social Security Tax purposes. The third is choice of federal income tax regimen for Social Security Tax purposes. The relevant regimens are those listed above, but the relevant issues are entirely different from federal income tax issues. In addition, you won’t find the key authority in this field in the Internal Revenue Code or even in a final regulation—it’s a little-known but remarkably powerful IRS proposed regulation designated Prop. Reg. § 1.1402(a)-2.

Understanding these three types of analyses in detail takes a lot of study and experience; but the best place to start in understanding them is with the Big Picture. The Big Picture is in the three bullet points above.