Self-Employment Tax Strategies Are Still Available
A common quest for those who are self-employed is how to reduce, eliminate or even avoid self-employment taxes. Unfortunately, there has been much ambiguity of the self-employment tax laws for decades, but beginning with 2018 returns, self-employment tax reporting for limited liability companies will likely change. The IRS recently won several court cases that will clarify the application of self-employment tax laws to LLCs.
Historically, there hasn’t been binding guidance in place to regulate how LLCs report earnings for self-employment tax. While there was guidance provided in 1997, it wasn’t binding. As a result, there has been no consistency in the treatment of self-employment taxes and little oversight. Taxpayers have pursued their own self-interests in their interpretation of the rules, which led to a tax gap due to under reporting of SE income to the tune of about $65 billion between the years 2008 – 2010 according to an IRS study.
This has led the IRS to not only pursue those lost taxes, but impose penalties on under reported self-employment income for some LLC members. The IRS recently launched a campaign to look into under reporting of self-employment taxes of LLCs in March. In a series of court cases, the IRS challenged certain LLC members on this issue, and the court ruled in favor of the IRS in three separate cases involving both service and manufacturing businesses.
The rulings in these cases now provide the IRS with law and binding guidance, which favors their view on this issue. As a result, the IRS now has cause to challenge LLCs who continue to use the previous ambiguity in the tax law to avoid self-employment tax on their distributive shares of LLC income.
For those who want to avoid self-employment tax, there may still be a few options. Self-employment taxpayers who are member-managers in an LLC should meet with their advisors to reevaluate their reporting of self-employment income. Some options include:
- Avoid member-manager status or member-managed structures entirely.
- Consider opportunities for segregating their involvement into separate interests or separate entities.
- Determine if forming an S corp might be better to manage self-employment taxes in situations where the S corp eligibility requirements are satisfied and state law permits the business to be organized in corporate form.
Even with the new guidance, uncertainty remains in this area of the self-employment tax law. For example, the law remains unclear as to when the income of an LLC member is deemed to come from services or from capital, and if an LLC member’s service-based income affects his or her income that is a result of capital investment.
The IRS plans to litigate reported exclusions of self-employment taxes on distributive earnings to LLC member-managers. With this increased enforcement and the IRS’s recent successes, it is imperative for taxpayers and their advisers to reevaluate their reporting positions for self-employment income for member-managers in LLCs.
Email Rea & Associates to learn more about these new rules and start working toward putting a plan in place to minimize your tax bill.
By Christopher Axene, CPA (Dublin office)