There is a form of doing business that many professionals use. A Limited Liability Company (LLC) or a Limited Partnership (LP). Any active participant in such an entity is subject to Self-Employment tax (15.2%) on their share of earnings. That can get painful.
So, when tax becomes a burden, what does the average American do? They try to find a “legal” way out of paying that tax.
Some smart folks thought they had come up with a fool-proof concept for owners of LLCs and LPs who are not officers to avoid paying Self-Employment tax on their share of earnings. They argued that such were “non-participating members.” They still receive a salary for their employment services, which is subject to Social Security and Medicare withholding (just like everybody else who gets W-2 wages).
So, their thinking is, “I’ve already paid Social Security and Medicare Tax on my earnings, thus any share of profits from the LLC or LP are not self-employed earnings, just profits, not subject to Self-Employment tax.”
What does the IRS do when they find out that some “smart persons” have come up with a scheme to reduce paying taxes? They attack it of course. From the IRS perspective, everything is black or white. It is or it isn’t. Schemes that try to create some gray smoke usually will find the IRS trying to pull them down. That means a concentrated IRS audit program to go after anybody trying to get away with what the IRS considers to be a wrong application of tax law.
Now the taxpayers have an avenue to fight the IRS if they believe they are right. It’s called the Tax Court. In 2017, the Tax Court ruled that law practice members who actively participated in an LLC’s operations (rendered legal services on behalf of the law practice) and were in management weren’t mere investors and were liable for self-employment taxes.
That leaves those who are not in management in the gray area of claiming they are not subject to self-employment taxes. The IRS is now auditing LLC and LP owners in law, medicine, accounting, architecture, and other service sectors. Expect the IRS stand to be all members who actively serve, whether in management or not, are subject to Self-Employment taxes.
Will the IRS prevail? It depends on whether the Tax Court case of 2017 stands without modification or there is a new Tax Court case that addresses this more clearly. There is already one taxpayer who was assessed Self-Employment taxes on all members (regardless of management participation or not). Of course, those taxpayers have appealed their case to the Tax Court. We may all soon find out where the Tax Court is going to fall on this one. They will either shut the IRS down or free them up.
In the meantime, if you are a member of an LLC or an LP, you can expect your risk of being audited by the IRS to go up. (Assuming your LLC or LP had a substantial profit.)
Did you hear? Job 9:15 says, “Though I am in the right, I cannot answer him; I must appeal for mercy to my accuser.”
Kelly Bullis is a Certified Public Accountant in Carson City. Contact him at 882-4459. On the web at BullisAndCo.com. Also on Facebook.
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