The Tax Times: K-1 Income - Is It Subject to Self Employment Tax?

Wednesday, August 27, 2014

K-1 Income - Is It Subject to Self Employment Tax?

Your taxpayer client received a K-1 from a Limited Liability Company (LLC) in which he is a member. On line 14 of the K-1, there is a number being reported as self-employment earnings.

Is it correct? Should your client be reporting his/her share of LLC income as self-employment earnings? If the taxpayer does, they have an additional tax to pay, called the self-employment tax. This self-employment tax is imposed in addition to the regular income tax you already pay, and is imposed on your self-employment earnings. For self-employment income earned in 2013 and 2014, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

Generally, a taxpayer’s share of ordinary income reported on a Schedule K-1 from a partnership engaged in a trade or business is subject to the self-employment tax. However, like any general rule, there are a myriad of exceptions, including one excepting a limited partner's share of ordinary income from a partnership. Should the term “limited partner” be interpreted to include members of a LLC? How about partners in a Limited Liability Partnership (LLP)?

The revised partnership statutes in most states have redefined the term limited partner to expand significantly the extent to which such a partner may participate in the control or activities of the partnership without jeopardizing the partner's limited liability. Also all states have added at least two new types of legal entities since the exception found its way into the Internal Revenue Code: LLCs and LLPs. While there are similarities between LLCs, LLPs, and traditional limited partnerships, the comparison is far from exact.

In a LLC, each member enjoys limited liability. Depending on the type of LLC (i.e., member-managed versus manager-managed), as well as provisions of the operating agreement, members are free to participate in the control and activities of the LLC to any extent.

LLPs arose as a means of protecting professionals from the liability of their partners engaging in negligent acts. Unlike a limited partnership, there is no need in a LLP for a general partner that remains wholly liable for the liabilities of the partnership; rather, each partner remains liable only for his or her own acts. In some states, the privilege of operating within the LLP form is reserved to certain professions (e.g., lawyers, doctors, architects, etc.) but in all cases, the partners of a LLP are free to participate in the control and activities of the entity without jeopardizing their liability protection.

So what is the right answer to the question of whether ordinary income on a K-1 constitutes self-employment earnings? Perhaps the reason why Congress, Treasury, IRS and Courts have found this to be such a vexing issue is that finding the right answer is so highly dependent on the facts and circumstances of each case.

Recent Tax Court cases seems to have focused on the nature of the taxpayer’s activities, and not on the title “limited,” or the liability protection enjoyed. In determining self-employment earnings, it would seem that, such a tack is appropriate. Unfortunately, it means that absent Congress coming forth with some bright-line definition, each situation will need to be analyzed carefully to determine whether the income constitutes self-employment earnings.

Need Help Determining Whether Your K-1 Is Subject To SE Tax?