LLC Members with Material Participation

Client is a 50% owner in a partnership (Multi-member LLC). Client meets the material participation requirements and therefore the income from the partnership is non-passive. The K1 the taxpayer receives doesn't have anything listed for self-employment earnings. I understand there isn't definitive guidance on this from the IRS, but would you 1. Report the earnings subject to SE tax and ignore the fact it wasn't reported correctly 2. Have the preparer of the partnership return correct the K1 to reflect SE earnings or 3. Report the income as non-passive income, but not subject to SE tax. Thank you!

I'd figure out if the income was SE income under Sec. 1402 and report accordingly. Material participation for 469 is not the issue.

Based on the facts you described, the income is subject to S/E tax. The individual is clearly an active participant in the operations of the entity, as evidenced by the fact that they meet the material participation tests. If the income of the LLC is from a 162 trade or business then I don't see how you avoid this result. If the income is instead all portfolio in nature (like interest and dividends) then that's different, but if it's all Line 1 ordinary income, then it's self-employment income for the active service partners.

The draft 1065 instructions included the following, which is a good summation of the issue: "Whether a partner (including a member of an LLC treated as a partnership for federal income tax purposes) qualifies as a limited partner for purposes of self-employment tax depends upon whether the partner meets the definition of a limited partner under section 1402(a)(13); whether a partner is a limited partner under state limited partnership law is not determinative. Relevant to this determination is whether the partner merely invested in the partnership and is not actively participating in the partnership's business operations; a partner who is performing services for a partnership in their capacity as a partner and that is, based on the facts and circumstances, acting in the manner of a self-employed person is not a limited partner for self-employment tax purposes. See Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137, 150 (2011)."

Client meets the material participation requirements and therefore the income from the partnership is non-passive

Which of the 10 material participation tests does the taxpayer meet? The 500hr test?

1997 Prop. Regs. Sec. 1.1402(a)-2, LLC member's distributive share not be subject to self-employment tax unless the
member had:
• Personal liability for the LLC's debts;
- Authority to contract for the LLC; or
• Participated in the LLC's business for more than 500 hours per year.

Also, "service partners" in a service partnership automatically excluded from claiming limited partner status; income subject to self-employment tax

After Renkemeyer, IRS put on notice that LLC members providing services to an LLC would be at risk of
having their distributive shares treated as self-employment income.

Thank you! It's only a two person partnership with my client essentially performing all of the work and the second partner is a passive investor. I'm not sure he managed 500 hours in the first year, but he's effectively performing all of the activity and has authority to contract for the LLC so I'll plan on treating this as self-employment income.

What burden of responsibility is there for the partnership to report this correctly? For example, as a preparer of a partnership return, are you determining each partners role in the business on a case by case each year or leaving it open to interpretation at the individual level?

What burden of responsibility is there for the partnership to report this correctly? For example, as a preparer of a partnership return, are you determining each partners role in the business on a case by case each year or leaving it open to interpretation at the individual level?

IMO, box 14 is the 1065 preparer's responsibility. Should anything be shown here?
In your case, that's pretty clear, but there are many instances where it isn't so clear and I think a preparer can be provided some grace in potentially missing that item.

IMO, box 14 is the 1065 preparer's responsibility. Should anything be shown here?
In your case, that's pretty clear, but there are many instances where it isn't so clear and I think a preparer can be provided some grace in potentially missing that item.

I agree and would advise dialogue with the 1065 preparer to understand why they're not treating your client's distributive share as subject to SE tax. If the 1065 preparer and you don't agree after that conversation, there's nothing stopping you from reporting the income subject to SE tax and filing Form 8082, but I would hope it wouldn't come to that.

I'm assuming this is Box 1 income?

This is box 1 income and is primarily a service (consulting) business. I'll attempt to reach out to the preparer and see if they can provide further clarification. If not, proceed with reporting it subject to SE tax and filing the 8082.

Thank you everyone!

A few points:

From #3:

a partner who is performing services for a partnership in their capacity as a partner

Those are critical words, “in their capacity as a partner.” If this is manager-managed, and work done is in that capacity, and work isn’t done in the capacity of a partner (because it is not permitted as per the OA), there’s a case for no SE tax. But you’d want that coupled with a reasonable guaranteed payment. I’m bringing this up so that you go into the discussion with the 1065 preparer fully aware of relevant issues. This has been discussed many times on this forum. Also, kind of unrelated, some practitioners are not taking a position on the SE issue. They’re leaving it up to the 1040 preparer, whether right or wrong. That’s a possibility in your situation too. In any case, you’ll just have to feel out the preparer to ascertain his or her reasoning for no SE tax, assuming he or she actually thought about it and has a reason.

and filing the 8082

Don’t bother. If you find it’s subject to SE tax, then just treat it as such and move on.

LOL. Shocked that anyone cares about or uses box 14....can't say it matters much to me, software doesn't tie to it from my experience.

A few points:

From #3:

a partner who is performing services for a partnership in their capacity as a partner

Those are critical words, “in their capacity as a partner.” If this is manager-managed, and work done is in that capacity, and work isn’t done in the capacity of a partner (because it is not permitted as per the OA), there’s a case for no SE tax. But you’d want that coupled with a reasonable guaranteed payment. I’m bringing this up so that you go into the discussion with the 1065 preparer fully aware of relevant issues. This has been discussed many times on this forum. Also, kind of unrelated, some practitioners are not taking a position on the SE issue. They’re leaving it up to the 1040 preparer, whether right or wrong. That’s a possibility in your situation too. In any case, you’ll just have to feel out the preparer to ascertain his or her reasoning for no SE tax, assuming he or she actually thought about it and has a reason.

and filing the 8082

Don’t bother. If you find it’s subject to SE tax, then just treat it as such and move on.

Thank you, this is very helpful. To expand on that, I have a client in a similar situation, but he receives a W2 from the partnership. His W2 compensation is for his role in helping run the company. He subsequently is a 10% owner in the partnership. I don't have access to the OA, but assuming this is manager-managed, would you treat the box 1 ordinary income as not subject SE tax?