Self-Employment Tax Treatment of Members of Certain Limited Liability Companies

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[EE-45-94]

RIN 1545-AS94

Self-Employment Tax Treatment of Members of Certain Limited

Liability Companies

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed amendments to the regulations

on the tax on self-employment income under section 1402 of the Internal

Revenue Code of 1986. The proposed regulation concerns the treatment of

members of certain limited liability companies. Under the proposed

regulation, certain members of limited liability companies are treated

as limited partners for self-employment tax purposes.

DATES: Written comments and requests to appear at a public hearing must

be received by March 29, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R [EE-45-94], room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8:00 a.m. and 5:00 p.m. to: CC:DOM:CORP:T:R [EE-45-94]),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the definition of manager,

D. Lindsay Russell, (202) 622-3050; concerning other aspects of the

regulation, Marie Cashman, (202) 622-6040; concerning submissions and

the hearing, Carol Savage, (202) 622-8452.

SUPPLEMENTARY INFORMATION:

Background

This document proposes amendments to the Income Tax Regulations (26

CFR part 1) under section 1402 of the Internal Revenue Code (Code).

Self-Employment Contributions Act (SECA) taxes are imposed by

section 1401 of the Code on the self-employment income of every

individual. Self-employment income is defined by section 1402(b) as the

net earnings from self-employment derived by an individual, subject to

certain exceptions. Section 1402(a) defines net earnings from self-

employment generally as the gross income derived by an individual from

any trade or business carried on by such individual, less the allowable

deductions, plus the individual's distributive share, whether or not

distributed, of income or loss described in section 702(a)(8) from any

trade or business carried on by a partnership of which the individual

is a member, unless a specific exception applies.

One provision under section 1402 that would except a partner's

distributive share under section 702(a)(8) from net earnings from self-

employment is section 1402(a)(13). That section excepts from net

earnings from self-employment the distributive share of any item of

income or loss of a limited partner, as such, other than guaranteed

payments described in section 707(c) made to that partner for services

actually rendered to or on behalf of the partnership, provided the

payments are established to be in the nature of remuneration for

services.

In recent years, virtually all of the states and several foreign

jurisdictions have enacted laws providing for the formation of limited

liability companies (LLCs). Although local law varies as to the

requirements for establishing an LLC, the common denominator is that

none of the members of an LLC are liable for the debts and obligations

of the LLC beyond their contributions to the LLC (absent an express

assumption of liability by a member if authorized under the applicable

LLC statute). In addition, under local law LLCs are generally managed

by elected or designated ``managers,'' who may be members of the LLC.

However, in some jurisdictions, LLCs need not be managed by elected or

designated managers. In those cases, all members of the LLC have

management authority.

LLCs in most jurisdictions may be classified for Federal tax

purposes either as partnerships or as associations that are taxable as

corporations, depending on the characteristics of the LLC. For those

LLCs that are properly classified as partnerships for Federal tax

purposes, an important issue is the treatment of its members for

purposes of the self-employment tax under section 1401 of the Code.

Specifically, the issue is whether any of the members are properly

treated as ``limited partners'' within the meaning of section

1402(a)(13) of the Code.

Explanation of Provisions

The regulation contained in this notice proposes to amend the

regulations under Sec. 1.1402 to add a new section (a)-18 that

addresses the self-employment tax treatment of members of an LLC that

is classified as a partnership for Federal tax purposes. For purposes

of this provision, an LLC includes entities formed under the law of a

foreign jurisdiction.

The proposed regulation provides that, generally, a member's net

earnings from self-employment include the member's distributive share

(whether or not distributed) of income or loss from any trade or

business carried on by an LLC. However, the regulation provides that a

member of an LLC is treated as a limited partner for purposes of the

exception in section 1402(a)(13) if: (1) the member is not a manager,

and (2) the entity could have been formed as a limited partnership

rather than an LLC in the same jurisdiction and the member could have

qualified as a limited partner in that limited partnership under

applicable law. If a member of an LLC is treated as a limited partner

under this proposed regulation for purposes of section 1402(a)(13),

then the member's distributive share of income or loss from the LLC

will not be included in net earnings from self- employment, except for

guaranteed payments for services.

For purposes of the first requirement described above, a manager is

defined as a person who, alone or together with others, is vested with

the continuing exclusive authority to make the management decisions

necessary to conduct the business for which the LLC was formed. Under

the proposed regulation, if there are no designated or elected managers

of the LLC who have continuing exclusive authority to manage the LLC,

then all of the members will be treated as managers, even if some

members have greater management authority than others under the

applicable LLC statute and the LLC's controlling documents.

The second requirement described above is intended to address two

concerns. First, some states prohibit the conduct of certain activities

through partnerships generally or limited partnerships in particular.

Thus, one purpose of this second requirement is to make clear that a

business operating through an LLC does not obtain a result for self-

employment tax purposes that it would not be able to achieve by

operating as a limited partnership.

Second, under applicable law, a limited partner may become liable

for the obligations of a limited partnership as a general partner when

the limited partner participates in the management or control of the

business. Thus, another purpose of the second requirement is to ensure

that both a member of an LLC and a limited partner in a limited

partnership who participate in the management or control of the entity

to the same extent are treated in the same manner for self-employment

tax purposes.

For foreign jurisdictions that do not have limited partnership

statutes but have LLC statutes, the effect of the proposed regulation

would be to not permit any of the members of an LLC formed in those

jurisdictions to be treated as limited partners for purposes of section

1402(a)(13). Comments are requested concerning the appropriateness of

this result and suggestions for alternative approaches.

Proposed Effective Date

This regulation is proposed to be effective for the member's first

taxable year beginning on or after the date on which this regulation is

published as a final regulation in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before this proposed regulation is adopted as a final regulation,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for June 15, 1995, beginning at

10:00 a.m., in the Internal Revenue Service Auditorium, Seventh Floor

7400 Corridor, Internal Revenue Building, 1111 Constitution Avenue,

N.W., Washington, D.C.. Because of access restrictions, visitors will

not be admitted beyond the Internal Revenue Building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit written comments by March 29, 1995, and submit an outline of the

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by March 29, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of this regulation is Marie Cashman, Office of

the Associate Chief Counsel, Employee Benefits and Exempt

Organizations, IRS. However, other personnel from the IRS and Treasury

department participated in its development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Secs. 1.1402(a)-1 through 1.1402(a)-3 [Amended]

Par. 2. Section 1.1402(a)-1 through (a)-3 is amended by removing

each reference to ``Sec. 1.1402(a)-17'' and by adding ``Sec. 1.1402(a)-

18'' in its place.

Par. 3. A new Sec. 1.1402(a)-18 is added to read as follows:

Sec. 1.1402(a)-18 Members of certain limited liability companies.

(a) In general. Except as otherwise provided in section 1402(a), an

individual's net earnings from self-employment include the individual's

distributive share (whether or not distributed) of income or loss from

any trade or business carried on by a limited liability company (LLC)

of which the individual is a member.

(b) Certain members treated as limited partners. Solely for

purposes of section 1402(a)(13), a member of an LLC will be treated as

a limited partner only if--

(1) The member is not a manager of the LLC, and

(2) The entity could have been formed as a limited partnership

rather than an LLC in the same jurisdiction, and the member could have

qualified as a limited partner in that limited partnership under

applicable law.

(c) Definitions--(1) Limited liability company. Solely for purposes

of this section, LLC means an organization that--

(i) Is formed under a law that allows the limitation of the

liability of all members for the organization's debts and other

obligations within the meaning of Sec. 301.7701-2(d), and

(ii) Is classified as a partnership for Federal tax purposes.

(2) Member. Solely for purposes of this section, member means any

person who owns an interest in the LLC.

(3) Manager. Solely for purposes of this section, manager means a

person who, alone or together with others, is vested with the

continuing exclusive authority to make the management decisions

necessary to conduct the business for which the LLC was formed.

Generally, an LLC statute may permit the LLC to choose management by

one or more managers (whether or not members) or by all of the members.

If there are no elected or designated managers (as so defined) of the

LLC, each member will be treated as a manager for purposes of this

section.

(d) Effective date. This section is effective beginning with the

member's first taxable year beginning on or after [INSERT DATE THIS

SECTION IS PUBLISHED AS A FINAL REGULATION IN THE FEDERAL REGISTER].

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 94-31434 Filed 12-28-94; 8:45 am]

BILLING CODE 4830-01-U