Self-Employment Tax A Big Tax that is Difficult to Avoid

Any individual engaged in a trade or business as a sole proprietor, partner in a partnership or member of a limited liability company (LLC) must pay self-employment tax (SE tax) on net earnings from self-employment.   SE tax has two components, (1) the old age, survivors and disability insurance component (OASDI), which we all know as Social Security, which is imposed on net earnings up to the Social Security wage base, and (2) the hospital insurance component we all know as Medicare, which is imposed on net earnings without any limitation.  The Social Security wage base in 2010 and 2011 is $106,800.  

If wages are received by a self-employed individual during the year, the SE tax base is reduced by the wages on which OASDI and Medicare were already paid.  Also, no SE tax is due if net self-employment income is less than $400.  Because a self-employed individual pays both the employee and employer share of OASDI and Medicare, the tax rates are 12.4% and 2.9%, respectively.  The OASDI rate for 2011 was reduced to 4.2% for employees and 10.4% for self-employed persons by the recent Tax Relief Act. To compensate the self-employed individual for paying both halves of the SE tax, one-half of the SE tax is deductible “above the line” on page 1 of Form 1040.  Although for 2011 the SE tax is reduced by 2%, the page 1 deduction will remain 7.65%. 

Net earnings from self-employment consist of the gross income derived from any trade or business less allowable deductions.  Certain forms of income, most notably rental real estate unless received as a dealer in real estate, are excluded from the definition of self-employment income.  The above noted deduction for SE tax, and until last year the deduction for self-employed health insurance, are not deductible in arriving at net earnings from self-employment.  Under The Small Business Jobs Act of 2010, self-employed health insurance is allowed deduction in computing the SE tax in 2010.

A general partner’s share of a partnership’s trade or business income, shown on line 1 of Schedule K-1, is subject to the SE tax.  A limited partner’s share of such income is exempt from this tax, except for guaranteed payments received for services rendered to the partnership. The applicability of SE tax to members of an LLC taxed as a partnership is unsettled.  A managing member who spends the majority of his time working for an LLC that derives its income from a trade or business will be subject to SE tax on his share of the LLC’s income in the same manner as a general partner of a partnership.  But what about a non-managing member who devotes all of his time to the LLC – is he treated like a general or limited partner in a partnership? 

In a 1994 private letter ruling, the IRS essentially took the position that all members of an LLC would be subject to SE tax on their share of income. Under 1997 proposed amendments to the existing self-employment tax regulations, the IRS said an LLC member would be treated like a limited partner unless he:

  1. has personal liability for the LLC’s debts,
  2. has authority to contract on behalf of the LLC under state law, or
  3. participates in the LLC’s trade or business for more than 500 hours per year.

In addition, under the proposed regulations, a member of a service business LLC (one in the fields of medicine, law, engineering, architecture, accounting, actuarial science or consulting), would not be treated as a limited partner if he provides more than a de minimis amount of time to the LLC.  The Taxpayer Relief Act of 1997 stipulated that the IRS could not issue final regulations in this area prior to July 1, 1998.  That was over 12 years ago, and final regulations have yet to be issued.  This uncertainty in the law provides some interesting planning opportunities and could tilt the balance in favor of an LLC over a partnership.

S corporation net income is notably absent from the definition of net earnings from self-employment.  Revising the law to subject this income to SE tax has been proposed several times but to date nothing has been enacted.  The same challenges of distinguishing between a shareholder that is more like a general than a limited partner would have to be met if SE tax was expanded to include S corporation net income.

The advantages of this different treatment can be significant.  Consider a two shareholder S corporation with $1 million of net income before paying its shareholders.  If formed as a general partnership, the total SE tax incurred by the two partners in 2010 would be $55,486.  As an S corporation, the shareholders should each take a “reasonable” salary for their services.  Failure to do so is a major examination issue within the IRS.  Assuming a reasonable salary for each shareholder is the Social Security maximum of $106,800, the total Social Security tax (employer/employee share) would be $32,681 – a savings of almost $23,000.  The decision to form as an S corporation versus a partnership or LLC should not be based solely on this tax savings, but it is large enough that it should not be ignored. 

The self-employment tax is often a significant portion of a taxpayer’s overall federal tax liability. A taxpayer with no taxable income due to a loss carryforward and/or itemized deductions, may still have a large SE tax liability.  The current large budget deficit and future Social Security shortfall means that the SE tax assessment on the labor force will most likely continue to rise.  A phone call to your CBIZ MHM tax professional before forming a new entity may enable you to reduce this burdensome tax. 

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