Business Owners Tax Planning

Self-Employment Taxes for Partners and LLC Members

BY Spectrum Wealth Management | Aug 5, 2022

Here’s a question: Does a member of a limited liability company (LLC) or a partner in a partnership have to pay self-employment taxes on the member’s or partner’s share of the entity’s income?

Incredibly, the answer is not always clear.

If you are a general partner in a general partnership:

  • you must pay self-employment tax on your entire distributive share of the ordinary income earned from the partnership’s business. General partners must also pay self-employment tax on guaranteed payments for services rendered to the partnership.

Partnerships generally are not required to pay guaranteed payments to the partners. Guaranteed payments are like employee salaries; the partnership pays them without considering the partnership’s income. They are often incorrectly called “partner salaries.”

If you’re a limited partner in a limited partnership:

  • you don’t pay self-employment tax on your share of the partnership’s profits, but you do pay self-employment tax on any guaranteed payments you receive.

For LLCs, things are a bit different. LLCs are the most popular business entity in the U.S. today, with an estimated count of 21 million. It is not always clear when LLC members (owners) pay self-employment tax.

LLCs are state law entities not recognized for federal tax purposes. In other words, they are always taxed as something else. The tax code taxes the single-member LLC as a sole proprietorship unless the owner elects taxation as a corporation, which is rare.

If you’re the owner of a single-member LLC:

  • you file a Schedule C and pay self-employment tax on your net profit. It couldn’t be simpler.

LLCs with multiple members are treated as partnerships for tax purposes unless they elect taxation as a corporation. If a multi-member LLC is taxed as a partnership, should its members be treated as general or limited partners? Let’s take a look at the proposed IRS regulations:

  • Members of member-managed LLCs cannot be treated as limited partners and must pay self-employment tax.
  • Members of manager-managed LLCs can qualify as limited partners, provided they work no more than 500 hours per year in the LLC business.
  • Members of service LLCs engaged in health, law, engineering, architecture, accounting, actuarial science, or consulting must be classified as general partners.

Fortunately, you don’t have to follow the proposed regulations. The IRS has not finalized them and says it won’t enforce regulations that have not been finalized. Instead, you should look at U.S. Tax Court rulings. The leading case says an LLC owner may be treated as a limited partner only if they are passive investors who do not actively participate in the LLC business.

As always, you should seek advice from your wealth advisor or trusted tax professional regarding income taxes, self-employment taxes, or tax rules and regulations.

Spectrum Wealth Management, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Additional information about Spectrum’s investment advisory services is found in Form ADV Part 2, which is available upon request. The information presented is for educational and illustrative purposes only and does not constitute tax, legal, or investment advice. Tax and legal counsel should be engaged before taking any action. The opinions expressed and material provided are for general information and should not be considered a solicitation for purchasing or selling any security.