Understanding Self-Employment Tax and NIIT for LLCs and High-Income Individuals
Explore the complexities of self-employment tax and Net Investment Income Tax (NIIT) for Limited Liability Companies (LLCs) and individuals with higher incomes. This detailed discussion covers key aspects such as LLC members' tax implications, the 3.8% NIIT, planning considerations, and upcoming changes. Gain insights into tax planning strategies for maximizing savings and navigating these tax obligations effectively.
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Self-Employment Tax and NIIT for LLCs and Higher Income Individuals December 13, 2016 James R. Browne, Partner Cameron Hess, Sr. Principal Barnes & Thornburg LLP Wagner Kirkman Blaine Klomparens & Youmans jim.browne@btlaw.com chess@wkblaw.com
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
Self-Employment Tax and NIIT for LLCs and Higher Income Individuals: Navigating the Complex Interplay James R. Browne Barnes & Thornburg LLP Dallas, TX 214.258.4133 jim.browne@btlaw.com Cameron Hess WAGNER KIRKMAN BLAINE KLOMPARENS & YOUMANS LLP Mather, CA 916.920-5286 x810 chess@wkblaw.com December 8, 2015
Agenda Introduction LLC Members & Self-Employment Tax LLC Members & the 3.8% Net Investment Income Tax Some Thoughts on Trusts Problems & Planning Opportunities Proposals and Changes on the Horizon 4
Basics PP&AC Act-H. R. 3590 FICA/SET/Additional Medicare Tax New: 0.9% Additional Medicare Tax Code Section 1401(b)(2) - SET (Hospital Insurance) Code Section 3121(b)(2) - FICA 100% Employee/Self-Employed Imposed on the excess amount of wages, self-employment, etc. Net Investment income Tax Code Section 1411 (new Chapter 2A) New: 3.8% Net Investment Income Tax Applies to NII Imposed on the lesser of: a) NII or b) excess amount of MAGI 6
Basics Why do we care? Planning: higher income individuals. Tax Savings: 20% vs 23.8% Tax Rate; 39.6% vs 42.4% Tax Rate Each $250K not s/t 3.8% tax saves $9,750. One-time events high income for regular folks. Personal residence or rental sale (e.g., bought 30 years ago) Big bonus (e.g. for retirement; relocation, incentive) Nonqualified deferred compensation ( Rabbi Trust ) Early disposition of stock from ISO Involuntary conversions (if taxable) 7 LLC member distributive shares have special planning options
Basics: 0.9% Additional Medicare Tax 0.9% Additional Medicare Tax Individuals 0.9% Tax on excess (countable income) > Threshold: Countable: Total (H+W) - wages, self-employment income. Threshold - not indexed for inflation Pay - withhold or estimates (to avoid underpayment penalty) Why Plan: Avoid 3.8% in Taxes 0.9% Add l Medicare Tax + 2.9% Medicare Tax* *SET/FICA HI portion continues uncapped over $118,500 . 8
Basics: 3.8% NIIT 3.8% Net Investment Income Tax Individuals, estates and trusts (not entities) includes Sch K-1 reported income Tax 3.8% x the lesser of: (1) Total NII (net investment income), or (2) Excess MAGI* *Excess MAGI = MAGI minus Threshold Amount. - (Except US persons overseas, MAGI = AGI Line 31 Form 1040.) NII - may deduct related expenses (including alloc. state income taxes) 10
Threshold Amount - Individuals Threshold Status Amount Married, filing jointly $250,000 Married, filing separately $125,000 Single $200,000 Head of household $200,000 11 Qualifying widow(er) with child $250,000
Threshold Amt Estates/Trusts 2016: $12,400 = Threshold($12,300- 2015) Compare: 12,400 vs 125K/200K/250K Beneficiary DNI distributions also create deduction for NII to trust/estate (NII distribution reported to beneficiary) 12
Example 1 Individual Big John (unmarried, in US) has $300,000 NII (rental income) $190,000 AGI (had a business loss) 3.8% NIIT Computation: NII Tax = $0. 3.8% x lesser of (1) $300K NII or (2) $0.0* *(190K AGI 200K Threshold) 13
Example 1a Planning - Irrev. Trust Big John Irrevocable Trust has $300K NII; $190K AGI (business loss) No beneficiary distribution (no DNI Distribution) 3.8% NIIT Computation: NII Tax = $6,748.80. 3.8% x lesser of (1) $300K NII or (2) $177,600* *(190,000 MAGI 12,400 Threshold) But!: If $177,600 DNI distributed, then NII Tax = $0 NII Tax = $0.0 (3.8% x $0 (190K - $177.6K - $12.4K MAGI)) 14
Basics: 3.8% NIIT Taxed Persons Individuals Trusts (standard trusts) Estates Exempt Persons : Foreign Persons C Corporations Foreign Trusts, Tax Exempt Trusts (Pensions, CRATs, CRUTS) Charitable Trusts Partnerships/S corporations No SET overlap: NII excludes income subject to SE tax 15
Basics: 3.8% NIIT NII = Gross Investment Income (GII) less: Allowable Deductions GII Categories: 1. Portfolio Income 163 SAME RULES 2. PAL/PIG 469 SOME CHANGES 3. Finance/Commodity traders-SAME RULES NOT day traders . Reduces value of security/commodity traders tax benefits 4. Net Gain (Dispositions) LOTS OF CHANGES 16
LLC Members & Self- Employment Tax 17
SET on LLC Members Issue: Can an LLC member treat any portion of the member s distributive share of LLC income as exempt from SET under the exception for limited partner distributive share income? The issue is relevant only for LLC members who materially or substantially participate in the LLC business or can otherwise avoid NIIT on the distributive share income 18
SET on LLC Members Historical Background All income from a partnership is included in net earnings from self-employment Prior to 1977, promoters were marketing passive limited partner investments to persons otherwise ineligible for social security benefits; the partnerships promised to generate a predictable stream of self-employment income eligible for social security Congress wanted to curtail this practice of buying social security benefits, so it amended the Code to provide that income received as a limited partner is not self-employment income After 1977, as taxes on self-employment income increased and social security benefits declined, the limited partner rule lost its anti-abuse purpose and became a benefit to taxpayers 19
SET on LLC Members The SET limited partner exception - 1402(a)(13) In computing net earnings from self-employment: Include the 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 he is a member Exclude (in addition to normal exclusions for rents, dividends, gains, etc.): 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) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services Note that the statute expressly contemplates that a limited partner may provide services to the partnership and still have distributive share income excluded from SET 20
SET on LLC Members The 1997 proposed regulations Context: Eroding restrictions on limited partner management activities Growing use of alternative forms of tax partnerships with full or partial limited liability for managing members (LLCs, LLPs, and LLLPs) Increasing SET rate relative to benefits General rule:a limited partner is any individual unless the individual: has personal liability as a partner for the partnership s debts, or has authority (under the law of the jurisdiction in which the partnership is formed) to contract for the partnership, or participates in the partnership's business for more than 500 hours during the partnership s taxable year, or is a service partner in a service partnership 21
SET on LLC Members The 1997 proposed regulations (con t) Class of Interest Exceptions An individual holding more than one class of interest is a limited partner with respect to a class of interest in which (a) limited partners (as defined above) own a substantial ( 20%), continuing interest and (b) the individual s rights are identical to such limited partners rights An individual holding only one class of interest who is not a limited partner solely because he participates in the business for >500 hours is a limited partner with respect to the interest if (a) and (b) above are true with respect to the class of interest These exceptions are intended to exclude from an individual's net earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership A service partner in a service partnership is never a limited partner to any extent (i.e., no class of interest exception) 22
SET on LLC Members Congress responds The 1997 proposed regulations sparked a firestorm of criticism Critics claimed that earnings from self-employment must be limited to the fair value of the services actually rendered to the business, and should not sweep in all income derived from the business based on arbitrary factors such as the number or hours worked or the nature of the business Congress promptly passed legislation prohibiting finalization of regulations with respect to the definition of limited partner under 1402(a)(13) until July 1, 1998 The Senate bill expressed the Senate s view that the proposed regulations should be withdrawn and that Congress should determine the tax law governing self-employment income 23
SET on LLC Members Case law and rulings Renkemeyer, Campbell & Weaver, LLP v. Comm r, 136 T.C. 137 (2011) Law firm organized as a general partnership electing LLP status Abusive facts: transitory corporate holding company; missing partnership agreement; failure to allocate income and distributions according to alleged sharing ratios; low or no compensation for services Dubious reasoning: Court discusses the legislative history of 1402(a)(13) Intent to exclude earnings that are basically of an investment nature The legislative history does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners Because the taxpayers distributive share income arose exclusively from legal services performed on behalf of the partnership, and was not of an investment nature, the income was subject to SET 24
SET on LLC Members Case law and rulings (con t) Riether v. United States, 919 F. Supp. 2d 1140 (D. NM 2012) LLC operates a medical diagnostic imaging business; members receive wages and distributive share income from the LLC; no SET on distributive share (<$10,000 tax effect) Taxpayers assert they can t be self-employed because they received wages No evidence that members lacked management authority, or that wages were reasonable compensation for services Held: distributive share income is subject to SET because taxpayers were effectively general partners Plaintiffs are not members of a limited partnership, nor do they resemble limited partners, which are those who lack management powers but enjoy immunity from liability for debts of the partnership. [Renkemeyer] Thus, whether Plaintiffs were active or passive in the production of the LLC's earnings, those earnings were self-employment income. 25
SET on LLC Members Case law and rulings (con t) Howell v. Comm r, 2012 T.C. Memo 303 Medical technology company (LLC) formed by W and B; H (W s spouse) managed the business with B; LLC paid guaranteed payments to H, B, W and others, leaving only small amounts of distributive share income for W and B; no SET paid on guaranteed payments H&W appear to contend that W was a limited partner not active in the business and her guaranteed payments were either limited partner distributive share income or not payments for services Held: Taxpayers are bound by their tax reporting (guaranteed payment) W performed some services for the LLC, but failed to prove what portion of the guaranteed payments were for services Notably, no SET imposed on distributive share income 26
SET on LLC Members Case law and rulings (con t) CCA 201436049 (May 20, 2014) Investment fund management company organized as an LLC; members were paid a salary, a guaranteed payment for parking and health benefits, and a distributive share; no SET on distributive share Members contributed varying amounts of capital to the LLC Held: entire distributive share income is subject to SET because the income is not income which is basically of an investment nature of the sort that Congress sought to exclude from [SET] when it enacted the predecessor to 1402(a)(13). Accordingly, [the members] are not limited partners within the meaning of 1402(a)(13). No analysis whether the salary and guaranteed payments represented reasonable compensation for services No analysis whether the distributive share income was attributable to invested capital, employee labor, or other non-service factors 27
SET on LLC Members Case law and rulings (con t) CCA 201640014 (June 15, 2016) T/P = franchisee of restaurants operated through an LLC (partnership) owned by T/P, his wife, and a family trust; T/P was the sole LLC manager T/P paid SET on guaranteed payments, but excluded distributive share income under the 1402(a)(13) limited partner exception Relying on Renkemeyer and Reither, the IRS concluded that because T/P provided substantial services to the LLC and was not a mere investor, T/P s distributive share income is not exempt from SET, regardless of whether the income is attributable to employee labor or invested capital The IRS s mere investor test directly conflicts with the statute 28
SET on LLC Members Where are we now? Reporting position: an LLC member s distributive share income from a manager-managed LLC is exempt from SET if the member is paid reasonable compensation for services as a manager This position is easily reconciled with the statute and legislative history, including the arguments that led to the 1997 Congressional moratorium It is consistent with the treatment of S corporations It is not inconsistent with case law (based on applicable facts) IRS position that distributive share income of an active partner is always subject to SET is plainly contrary to the statute, its proposed regulations, Congressional intent (as expressed in 1997), and its litigating position in Howell Service partners in service partnerships have more risk 29
LLCs Passive Activities NII Includes: 469 PALs/PIGs Some rules changed Presumed passive: limited partner rental real estate NIIT Rules to overcome Somewhat Harder to meet than Section 469. 31
LLCs & Real Estate Professionals Rental Real Estate To avoid 3.8% NIIT must both: Be a real estate professional (> 750 hours) Meet one of the 500 hour tests or convince the Service. Other material participation tests are rejected (may use for 469 but not NIIT) 32
LLCs & Real Estate Professionals Rental real estate continued Most related activity safe harbors were rejected. Rejected: Start-up Activities Pre-Development Activities Example: Developer leases back to farmer land held for development. While not passive under Section 469, rental income will be deemed NII. 33
LLCs & Real Estate Professional Material Participation in Rental Real Estate (1.469-5T(a)(1)) A. Real estate professional (>750 hrs) + B. Either 1. participate = > than 500 hours per year, 2. > than 500 hours/year in 5 of 10 prior years Active T/B , and thus not subject to 1411. 34 *Activity Must be Part of That Active Trade or Business
LLCs & Real Estate Professional Material Participation in Rental Real Estate (1.469-5T(a)(1)) Nonsafe harbor Substantial, participate, active trade/business 35
LLCs & Limited Partner 3.8% NIIT Regulations follow same Limited Partner rules under Section 469 apply 36
LLCs & Limited Partner Problem: No statute defines limited partner If Limited Partner, only have 3 tests to prove active. Affected: LLCs, LPs, LLPs, LLLPs, other entities treated as partnership . 37
LLCs & Limited Partner Any interest classified as a limited partner, IRC 469(h)(2) is per se presumed passive. Only Three exceptions: 500 Hours. Taxpayer works 500 hours or more in the particular trade or business activity. Prior 500 Hours. Taxpayer materially participated in the activity in any 5 of the prior 10 years. Service Activity. It is a personal service activity; taxpayer materially participated in that activity in any 3 prior years. 38
LLCs & Limited Partner Temp Treas. Reg. 1.469-5T(e)(3)(i) ...interest [is] a limited partnership interest if (A) . designated a limited partnership interest, .; or (B) The liability of the holder is limited, .. interest shall not be treated as a limited partnership interest . if the individual is a general partner. 39
LLCs & Limited Partner Good News!: Courts reject LP treatment for LLCs: Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2000). LLC. Garnett v. Com r, 132 T.C. 368 (2009). LLPs and LLCs were not limited partnerships. Thompson v. U.S., 87 Fed. Cl. 728 (2009). 469(h)(2) requires a partnership. An LLC member is not a limited partner. Newell v. Com r, T.C. Memo. 2010-23. 469(h)(2) did not apply to the managing member of an LLC. Member is a general partner under 1.469-5T(e)(3)(ii). Lamas v. Com r, T.C. Memo 2015-59. Several LLCs & S Corp. Rejects no material participation. Aggregates S Corps & LLC activities total hours adequate. 40
LLCs & Limited Partner IRS Strikes Back: Prop. Treas. Reg. 1.469-5(e)(3)(i) (11/28/11) ...interest [is] a limited partnership interest if (A) The entity is classified as a partnership for Federal income tax purposes under 301.7701-3; and (B) The holder of such interest does not have rights to manage the entity .. 41
Trusts & 3.8% NIIT High income persons do trust planning Income shifting Asset shifting Using both Trusts + LLC is common Careful planning on trust distributions is needed. Highest Trust tax bracket @ $12,400 NIIT triggered if Trust AGI > $12,400 43
Trust Issue for LLCs & 3.8% NIIT Scenario: Trust owns % in LLC. Is Trustee status = limited partner? Can Trustee materially participate? IRS Declined to Issue Regulations 44
Trustee Material Participation IRS: Trustees rarely materially participate must be directly on title, and principal person acting1 1Position discussed by IRS in TAM 200733023; PLR 201029014; TAM 201317010. COURTS REJECT: Carter Trust v. US 256 F. Supp. 2d 536 (N.D. Tex. 2003). Trustee hired ranch manager. Material participation found through employees and trustee. Aragona Trust v. Com r, 142 TC. 9 (3/27/14). 3 of 6 trustees (related) worked FT for R/E management LLC, wholly owned by trust. Trust can materially participate through trustee- employees; R/E professional exception applied. 45
Problems and Planning Opportunities 46
Planning Trap #1 Using an S corporation to avoid SET/NIIT The properly determined distributive share income of an S corporation engaged in an active non-trading business is unquestionably exempt from both SET and NIIT BUT S corporations have significant disadvantages. (e.g., one class of stock, no entity or foreign shareholders, no 754 election, no 721/731 exclusion for gain on property contributions and distributions, no inside basis step-up at death, etc.) The perceived SET/NIIT benefits may be overstated A properly structured LLC/LP should achieve similar SET benefits. 47
Planning Trap #2 S corporation election for an LLC or LP Tax preparers or other tax advisors often elect S corporation status for an LLC or LP solely to obtain SET and NIIT advantages. This is usually bad advice! Same considerations as any S corporation (see prior slide) Plus additional potential problems if the company agreement is not modified to conform to S corporation requirements; the entity might be classified as a C corporation! 48
Planning Trap #3 S corporation blocker Individual A Individual B Individual C S Corp 1 S Corp 2 S Corp 3 S Corp. S Corp. S Corp. LLC Partnership Individuals are employees of LLC or S corp and are paid wages Distributive share income flows through S corporations NB: Cumbersome and does not eliminate all disadvantages of S corporation ownership 49
Planning Opportunities A properly structured LLC/LP Individual A Individual B Individual C Manager Management Fees S Corp. (or LLC) Manager-Managed LLC Partnership Individuals perform services for LLC as employees of Manager Distributive share income received by individuals as an LLC member having no management rights Same structure can be used for a limited partnership (Manager is the general partner) 50
