Reducing Self Employment Tax With LLC Taxed as Partnership

Reduction of employment taxes is part of asset protection planning involving limited liability companies. An LLC may elect to be treated for income tax purposes as either a partnership or a Subchapter S corporation. Advisors typically suggest taxation as an S corporation in order to minimize the amount of LLC distributive income subject to self-employment tax.

The IRS imposes a 15.3% employment tax on W-2 income. An additional 2.9% is charged over a base wage amount. The tax is imposed on various forms of income received for personal services and labor. The tax law specifically exempts from ET dividends payable to shareholders in S corporations provided that the shareholder has otherwise received a reasonable amount of W-2 income for his personal services to or on behalf of the corporation.

Accordingly, an LLC member owning membership interest in an LLC taxed as an S corporation will pay employment tax on a reasonable amount of wages and salary received from the LLC, but will not pay employment tax on his distributive share of the LLC’s net taxable income.

The main issue for S Corp owners is how much is a reasonable amount of W-2 income. But, assuming the income amount is reasonable, there is no issue regarding the exclusion from ET of all other income paid to the LLC member from the LLC taxed as an S-corporation. This is why most LLCs in asset protection planning are taxed as S-corporations.

Problems With S-Corp Treatment

S-corp tax status creates problems and restrictions in asset protection. To begin with, there are pitfalls in LLC operating agreements prepared for S-LLCs. Operating agreements are critical for LLCs used for asset protection. The agreement can include provisions that limit creditor rights and protect the member’s interests in bankruptcy. Most attorneys use the same base form for drafting all LLC operating agreements regardless of the LLC’s tax elections.

The problem is that operating agreements written for single-member LLCs or LLCs taxed as partnerships do not work well for S-LLCs. The tax law regarding S-corps forfeits the S-election when the operating agreement includes provisions typically designed for the LLCs taxed as partnerships.

For example, an agreement for an S-LLC should limit members to eligible owners of an S-corporation and eliminate differences in members’ rights to distributions or return of capital. Unfortunately, many LLC operating agreements are inappropriate for S-corp LLCs and therefore subject the owners to adverse tax consequences.

Next, taxing an LLC as an S-corporation limits asset protection options. Only individuals may own shares in legal entities taxed as S-corporations. So, S-corp shares may not be owned by irrevocable trusts or partnerships with a few exceptions.

For better asset protection, many prospective debtors would like their shares in a domestic LLC to be held in an offshore asset protection trust or an irrevocable trust for the benefit of other family members. This is not possible if the domestic LLC elects S-corp taxation. An irrevocable domestic or offshore trust may not own membership interests in an S-corp LLC, with few exceptions. There are other technical restrictions and disadvantages applicable to S-corporations in our tax law.

Partnership Alternative

LLCs taxed as partnerships provide flexibility of ownership and are therefore preferred for asset protection planning provided that they do not increase employment tax. The basic tax rule is that guaranteed payments to partners in a partnership are subject to employment tax, but distributive income to partners is not subject to employment tax.

There are court decisions that hold that money distributed to limited partners in consideration for their personal services to or on behalf of a partnership is subject to employment tax. For example, suppose two licensed professionals formed an LLC taxed as a partnership, and the LLC earned income from the members’ professional services. Each member’s distributive share of LLC income would be subject to employment tax.

Creative planning can structure an asset protection plan using LLCs taxable as partnerships and not impose more employment tax than a comparable S-corp LLC. What is required is a clear differentiation between members providing personal services to or on behalf of the LLC and those members owning a passive membership interest. The passive owner cannot participate in the LLC’s business or services and cannot participate in LLC management in order to avoid employment tax on distributive LLC income.

Example

Suppose two spouses have an ownership interest in a valuable business and are concerned about asset protection. Assume that tenants by entireties ownership of the LLC does not solve their problem because both spouses anticipate legal problems.

One spouse, or an entity owned by the same spouse, can be the LLC manager who runs and manages the LLC’s business, and who receives a reasonable salary or a guaranteed payment. The LLC’s membership interests can be owned 1% by the managing spouse and 99% by the non-service spouse. The non-service spouse could contribute their membership interest in the partnership LLC to either an offshore trust or a domestic trust. The managing spouse would pay employment tax on the reasonable guaranteed payment/service income and 1% of LLC’s distributive net income.

The money subject to employment tax may be at risk to creditors, but the more valuable asset—the 99% equity in the LLC business—is better protected in an asset protection trust. Many other plans similarly utilize LLCs taxed as partnerships and isolate limited income subject to employment tax.

The conclusion is that asset protection plans should not dismiss LLCs taxable as partnerships based on an assumption that these LCCs will always result in more employment tax liability than the same LLC taxable as an S-corporation. Planning that involves LLCs that are not member-managed and with owners not engaged in the LLC business can provide better asset protection without increasing employment tax liability.