Category: Self-Employment Tax

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!