Let the conversation begin on LLC Partnership SE income

Technical topics regarding tax preparation.
#1
adamant  
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I value the opinions of the contributors here, and I have been reading more and more on this issue of late.

I know there are professionals on both sides of this issue, specifically, whether an LLC member's distributive share of income is subject to SE tax.

I have read many things and while most point to an "all of it is" (certainly the IRS' position) approach, there have been a few small victories in court that point to the contrary.

I recently purchased my practice, and I would say that 90% of the small-business partnership owners were not being taxed for SE purposes. I believe that many of these have exposure. As you can imagine, as the "new guy" preparing taxes, increasing their tax liability substantially isn't the most favorable move to make as far as retention goes.

However, I believe that if I can educate them intelligently so that they have full understanding of the issues, the current environment, and the precarious precipice they are on, that they will be appreciative of that knowledge.

Another thing I'd like to discuss, let's say the regulators decide to go all in and clear, definitive rules, would the IRS go "scorched earth" on an SE crusade? Or would it be implemented in a fashion where the unwritten rule is that we'll let bygones be bygones, but don't let us catch you with your hand in the cookie jar again?

Thanks everyone!

A few good reads (OK, I decided to add more than a few):
https://www.taxlawforchb.com/2016/11/bi ... ng-doing/#
https://www.irs.gov/pub/irs-wd/201640014.pdf
https://www.lexology.com/library/detail ... 2047431f68
https://www.cbiz.com/insights-resources ... es-article
https://www.forbes.com/sites/anthonynit ... 74c2f164a5
https://www.forbes.com/sites/anthonynit ... c5237378a8
https://www.thompsoncoburn.com/docs/def ... e3f147ea_2
https://www.forbes.com/sites/procedural ... 449bee1f5f

A few conversation points:
- How have you handled these in the past?
- Have you changed your stance?
- How do you approach this conversation with client's?
- What is your standard of "active"?
 

#2
skip  
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I think this quote from the Forbes article is the best summary of the issue:

“The key, at least from the Tax Court’s perspective, is to determine whether the income that the member receives is more related to the capital investment in the entity or the services that the members perform in their capacity as individuals.”
 

#3
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adamant wrote:I recently purchased my practice, and I would say that 90% of the small-business partnership owners were not being taxed for SE purposes. I believe that many of these have exposure. As you can imagine, as the "new guy" preparing taxes, increasing their tax liability substantially isn't the most favorable move to make as far as retention goes.


My first thought reading this paragraph was: That really sucks AND I hope the party you purchased from had an earn-out clause to lessen/minimize the consequence to you for their failings.

- How have you handled these in the past? - How do you approach this conversation with clients?
For +95% of active partners in small business partnerships, they should have SE tax applied to ordinary income earnings (not rental, of course). I did inherit a few partnerships that had created A-B interests and only applied SE tax to the A interests. Since guidance is pretty clear that you can't bifurcate an individual's activity as it relates to their interest, our firm felt pretty comfortable standing on the 'SE tax applies' position. I clearly explained the authority and the difference between the previous justification and the current justification. Most of the time, I'd couch it in "we've received more clear guidance since these were first established" and you are sitting on some real risk if we don't change now. We lost one somewhat significant client, but this dynamic was only about a third of why we lost them. The remainder understood that guidance evolves or we elected 'S' status to maintain the previous FICA exposure.

- Have you changed your stance? NO

- What is your standard of "active"?
A member actively involved in the management of the business that has the authority to contract on behalf of the entity. If we can establish that a partner's role is that of advisory/investor status, we usually try to modify the operating agreement to remove contracting authority from that individual. This provides solid ground to leave K-1 Box 14A blank for them when preparing the 1065.
~Captcook
 

#4
adamant  
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No hard feelings with the seller of my book, he's been more than generous and amiable. Honestly, from what I'm gathering in this community, it was a rather typical stance to take around here.

I've had the conversation with a few clients already this tax season and it has been mostly positive. There are some that I will absolutely convert to an S-Corporation this year, but some businesses aren't that easy.

For instance, I have a group of clients that are that in a very very similar situation to the "Hardy" case mentioned above. However, I think they meet monthly and do discuss items of the business fairly often. The fine line of active passive investors is a little grey there for me.

They are all minority owners, but outside of the group of 6-7 docs, no one else really uses the surgery center. They all have their own separate S-Corps for their medical practices, and they have all already maxed out SS, so the exposure isn't massive relative to their tax bills, but it is still quite material, it would likely be $9-10K/yr.

Thanks for your comments, both very helpful.
 

#5
Doug M  
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Welcome skip!
 

#6
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I have a large group of docs in a surgical center. We're of the opinion that their use of the facility as a vendor doesn't influence their active/passive nature for purposes of SE tax.
~Captcook
 

#7
adamant  
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That is my inclination with my group as well.

Just curious, what type of ownership do they have? Are they listed as LLC Member Managers? What about the Operating Agreement, what does it say about their management capacity?

(yes, I'm playing devil's advocate)
 

#8
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A member actively involved in the management of the business that has the authority to contract on behalf of the entity.

Not if he holds that authority in his capacity as a Manager.

However, I believe that if I can educate them intelligently so that they have full understanding of the issues, the current environment, and the precarious precipice they are on, that they will be appreciative of that knowledge.

The current environment is that the IRS lacks resources and has to spend a lot of those to develop these types of cases. But as we know, hogs get slaughtered.

I recently purchased my practice, and I would say that 90% of the small-business partnership owners were not being taxed for SE purposes


When you say not, you mean, “not at all?”
 

#9
adamant  
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Jeff, correct, even when they have a 50/50 husband/wife setup, neither had SE Income.

Funny you mention that analogy, that's what I tell a lot of my clients, get fed, be a pig.
 

#10
Wiles  
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Here are a few similar discussions we have had here:
SE Tax, LLC Partner Distributive Share
Husband-wife LLC - only one spouse participates
Multiple Entity LLC Tax Structures That Are Legit

adamant, was the non-SE-taxed income being subject to the NIIT?
 

#11
adamant  
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Thank you Wiles, exactly the type of discussion I was looking for.

Would be nice if we could have a "Sticky" post on there where a few of us could index some of these types of posts by topic.

A quick-reference guide of sorts.
 

#12
Wiles  
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In our pursuit towards tax simplification, I wonder if, one day, Congress will consolidate the rules for "pass-through" entities into one set of rules. Included in these rules would be the ability for the business owner to apply the reasonable compensation rules to designate their "wage" income separate from their business income.

For the layman, it seems ridiculous to have to choose this entity or that to get this sort of tax treatment.
Last edited by Wiles on 17-Feb-2018 3:08pm, edited 1 time in total.
 

#13
adamant  
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Wiles wrote:adamant, was the non-SE-taxed income being subject to the NIIT?


Wiles, it was not. I hadn't even thought of that. Kind of puts them in a catch-22 eh?
 

#14
adamant  
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So, as I read through the many threads on this (awesome discussion in those threads by the way), I've noticed a few things where many agree these arguments ultimately (or rather likely) hinge on.

So below I've gathered some questions whose answers may have bearing on this issue (and please add to this, because I know I'll miss some...also please detract from this, I'm pulling from our discuss and other sources I've been reading over):

    - Is your LLC member-managed or manager-managed?
    - Has your LLC member ever participated in management decisions?
    In 'Hardy' the Tax Court didn't care (or maybe forgot to check) that the LLC member was a 'manager', only that he didn't participate in management activities. However in 'Castigliola' this was a main point of their argument, the existence of management powers. (Both cases dropped in 2017 w/in three months of each other).

    - Is your business largely service-based?
    - Is your business capital intensive?
    - Does your LLC have multiple classes of members?
    - Has your LLC member personally guaranteed LLC debt?
    - Are guaranteed payments being made and to whom?
    - What percentage ownership does your LLC member have? Constructively with "nominee" spouse?
    - W-2s out to LLC Members are like a warm electric security blanket in a bathtub full of water.
    - Are the services provided by the LLC member "significant" (would you loosely apply the 500 hours test here?)?


Here are a list of threads on this forum relevant (several of which Wiles already linked), but I'd like to keep this post as a decent index for future readers (and myself):
viewtopic.php?f=8&t=8611
viewtopic.php?f=8&t=9338
viewtopic.php?f=8&t=8273&hilit=bifurcate
viewtopic.php?f=8&t=4012
viewtopic.php?f=8&t=6781
 


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