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Tax News: Self-Employment Tax

Winter 1995

Limited liability companies or "LLCs" have become popular as a vehicle for organizing new business ventures. LLCs can combine the limited liability benefit of a regular corporation with the flexibility and one-level of taxation benefit of partnerships. However, it has been unclear whether income allocated to individual, as opposed to corporate, members of LLCs is subject to self-employment tax.

On December 29, 1994, the Internal Revenue Service published proposed regulations in this area. Basically, if an LLC is "member-managed" and engages in a trade or business, the regulations appear to provide that all income, whether or not distributed, is subject to self-employment tax. In general, many LLCs elect member management in filing their articles of organization with the state, even though they have boards of managers and officers. This is because member-managed LLCs are more likely to be taxed as partnerships. However, using the member-managed feature to achieve this important goal of taxation as a partnership may come at the cost of self-employment tax. This includes the 2.9% Medicare tax on net earnings from self-employment on which there is no cap.

Rentals from real estate and from personal property leased with real estate are generally not included in earnings from self-employment in all cases unless the individual is a real estate dealer and the rentals arise from property held for sale to customers in the ordinary course of business

Although the regulations are not final, taxpayers should consider potential exposure to self-employment tax when deciding whether to do business as a member-managed LLC.

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