Self-employment Tax: Are Limited Liability Companies still the Entity of Choice in Ohio?

The answer to this question, in the vast majority of situations, is still "yes." However, one must keep the issue of self-employment tax in mind when determining whether to use a limited liability company ("LLC") instead of a corporation. Internal Revenue Code §1401 imposes self-employment tax upon the earnings of a self-employed individual, generally defined as an individual who works 500 hours or more, has personal liability for debts or contracts for the LLC. As a result, some practitioners have begun drafting LLC operating agreements so that the entity resembles a limited partnership in an attempt to eliminate or minimize the impact of self-employment tax. Basically, the operating agreements of these entities are drafted so that only the member with "general partner" like authority is subject to self-employment tax. Other practitioners have gone so far as to form LLC's that have two classes of membership interests, where one class has management authority and the other class does not. One member of the LL

C will own, for example, three units of membership interest with management authority, and seven units of membership interest with no management authority. The remaining members will own ten units each without management authority.

The theory is that the units without management authority are treated as "limited partner" units and are not subject to self-employment tax. The units with management authority are treated as the "general partner" units and are subject to self-employment tax. The advantage to the member with the three management units and the seven non-management units, is that she is only subject to self-employment tax on 30% of her distributions from the company. The remainder of her earnings would be free from self employment tax because they were paid to her on the basis of her "limited partnership" units. Before utilizing the structure described above, it is important to note that the Internal Revenue Code makes no reference to "members" of LLC's. The only authority as to whether a member will be treated as a general or a limited partner for purposes of I.R.C. §1401 are some private letter rulings that involve members of personal service companies being treated as general partners. Additionally, the IRS issued proposed r

egulations in 1994 and 1997 that were intended to provide practitioners with guidelines for drafting operating agreements that permitted the above structure. However, these proposed regulations were withdrawn by the IRS.

Consequently, there is no clear guidance whether such structures should be utilized. Nevertheless, The Daily Tax Report reported in June of 2003 that the IRS was stating publicly that if a taxpayer were to conform with the latest set of proposed regulations, the IRS would not challenge how the taxpayer handles the self-employment tax issue. While this seems to open the door for the utilization of the above structure if organized pursuant to the 1997 proposed regulations, there is no definitive indication from the IRS on this issue. Consequently, there is a split of opinion as to whether such structure should be utilized to avoid self-employment tax at this time. Therefore, clients should be advised to consult with their tax advisor before attempting to limit the impact of self-employment tax within an LLC versus choosing another entity such as a corporation where the self-employment tax issue is not present. This self-employment tax issue notwithstanding, the general consensus is still that the "pros" of an L

LC generally outweigh the "cons," and that most clients are still best served utilizing an LLC.

For more information concerning Ohio Limited Liability Companies, please contact Joseph P. Fegen: jpfege@climacolaw.com