Self Employment Taxes, NIIT and Pass-Through Entities

Self Employment Taxes, NIIT and Pass-Through Entities Joseph C. Mandarino Atlanta, Georgia Smith, Gambrell & Russell, LLP 1230 Peachtree St. NE Suite 3100 Atlanta, Georgia 30309 www.sgrlaw.com

Overview A. Background Changes to Payroll Taxes B. Net Investment Income Tax C. Self-Employment Tax D. Analysis and Examples E. S corporations

Background Significant changes to the payroll tax regime became effective 1/1/2013. In addition, a new tax, the Net Investment Income Tax ( NIIT ), went into effect on the same date.

Pre-2013 Tax Landscape compensation income for self-employed OASDI tax on OASDI tax basis medicare tax of 2.9% on all compensation income compensation income for employees OASDI tax on OASDI tax basis (split by employer and employee) employer pays medicare tax of 1.45% on all compensation paid to employees employee pays medicare tax of 1.45% on all compensation income

Post-2012 Tax Landscape compensation income for self-employed medicare tax of 2.9% on all compensation income up to the following thresholds: $200,000 for single filers $250,000 for joint filers $125,000 for married filing separate returns medicare tax of 3.8% for compensation income above the threshold

Post-2012 Tax Landscape compensation income for employees: employers pay medicare tax of 1.45% on all compensation income up to the following thresholds: $200,000 for single filers $250,000 for joint filers $125,000 for married filing separate returns identical tax paid by employees for compensation above these thresholds employers pay medicare tax of 1.45% employees pay medicare tax of 2.35%

Summary Payroll Tax Rates for Compensation Income -- 2014 W-2 employees selfemployed 2014 compensation income employerlevel tax employeelevel tax combined tax individuals $0 to $117,000 7.65% 7.65% 15.30% 15.30% $117,000 to $200,000* 1.45% 1.45% 2.90% 2.90% $200,000* and up 1.45% 2.35% 3.80% 3.80% *$250,000 for joint filers

Tax Landscape Concern new payroll taxes will cause taxpayers to structure income so it does not qualify as compensation income convert compensation income into passive income (dividends, capital gains, etc.) Solution levy a new tax on passive income so it is on equal footing as compensation income.

Tax on Net Investment Income Variously referred to as: the unearned income medicare contribution tax the net investment income tax ( NIIT ) the Obamacare tax Applies to individuals, estates and trusts. Effective 1/1/2013 -- enacted as part of the 2010 Health Care Act.

Tax on Net Investment Income The tax is equal to 3.8% of the tax base. Tax base is the lesser of: the net investment income of the taxpayer or the excess of the modified AGI of the taxpayer over the threshold amount. The tax does not apply to C corporations or to nonresident aliens.

Tax on Net Investment Income Modified AGI for these purposes is identical to AGI for most taxpayers. For taxpayers who utilize the foreign earned income exclusion under Code Section 911, there are additional adjustments that are made.

Tax on Net Investment Income The threshold amount is: $250,000 for joint returns and surviving spouses $125,000 for separate return filers $200,000 in all other cases

Tax on Net Investment Income Recall that one purpose of the NIIT was to equalize the medicare taxes on compensation income and unearned income. The NIIT and the additional medicare taxes on compensation income may apply to the same taxpayer in the same tax year, but not to the same items of income: NIIT only applies only to net investment income and cannot apply to items subject to medicare/selfemployment taxes no overlap

Tax on Net Investment Income Estimated tax rules apply to NIIT. The quarterly computations that are made for estimated taxes will have to be adjusted to account for this additional tax.

Tax on Net Investment Income What is net investment income? Gross income from interest, dividends, royalties and rents. Net gain from the disposition of property. But, does not include gross income or gain from certain types of trades or businesses

Tax on Net Investment Income Trade or Business Exclusion In general, net investment income does not include gross income or net gain from a trade or business. But, NIIT does apply to gross income or net gain from a trade or business in two cases: a trade or business that is a passive activity with respect to the taxpayer, and a trade or business that consists of trading in financial instruments or commodities.

Tax on Net Investment Income Subject to NIIT: income from a partnership or S corporation that does not arise from a trade or business (i.e., investment income) that is a passive activity with respect to the taxpayer, or that arises from trade or business of trading in financial instruments or commodities). Not subject to NIIT: income from a partnership or S corporation that arises from a trade or business other than specified above.

Tax on Net Investment Income UNDERLAP OPPORTUNITY: if pass-through income is not subject to NIIT (i.e., arises from a trade or business, not passive, not trading business), and if that pass-through income is not subject to selfemployment tax, then the income is only subject to regular income taxes.

Self-Employment Tax A. Background B.General Rule C. Trade or Business Income D. Guaranteed Payments E.The Limited Partner Exception F. The Proposed Regulations -- Background G. The Proposed Regulations -- Summary H. Rules Applicable to Service Partnerships Only I. Rules Applicable to All Partnerships J. Multiple Interest Exception K.500 Hour Exception L. General Application of Rules to LLCs

Background In the case of a self-employed individual, compensation income is subject to a payroll tax substantially similar to the medicare/oasdi taxes that apply to employees. The self-employment payroll tax ( SECA ) is composed of three parts: a 12.4% tax on the first $117,00 of self-employment income (this is the 2014 base and is adjusted for inflation each year) a 2.9% tax on all self-employment income from $117,000 to $200,000,* a 3.8% tax on all self-employment income in excess of $200,000* (*$250,000 in the case of joint filers)

SECA General Rules Only income from a trade or business is subject to SECA. If an entity taxed as a partnership carries on a trade or business, the partners are subject to self-employment tax on that income unless an exception applies. Key exception -- a limited partner generally does not pay self-employment tax on partnership income.

SECA General Rules Example Newco is a general partnership. It has two equal partners, Smith and Jones. Smith runs the business. Jones provided capital, but is not otherwise involved in the operation of the business. In 2015, Newco has $2 million in earnings from operations. Absent other facts, the operating income is subject to SECA. Both Smith and Jones will be liable for SECA taxes on their $1 million shares. NB: If Newco was formed as a limited partnership and Jones was a limited partner, he would pay no SECA tax on his share of the operating income, a savings of approximately $51,000 in taxes in this example.

Trade or Business Income Threshold issue -- no SECA tax is due if the income is not trade or business income. Largely a facts and circumstances test. Key: continuous and regular involvement in an activity; primary purpose for involvement is for income or profit. Sporadic activities, or passive, investment-type activities do not count. developing real estate probably a trade or business. buying existing commercial office building that is triple net-leased to a single tenant and holding the building for receipt of rents probably not a trade or business

Guaranteed Payments The limited partner exception does not apply if a partner receives compensation for services performed for a partnership in the form of a guaranteed payment. A partner who otherwise satisfies the definition of a limited partner discussed below may nonetheless be subject to SECA if he or she is entitled to a guaranteed payment.

Guaranteed Payments Guaranteed Payment -- in brief, a guaranteed payment is a payment by the partnership that is made without regard to the income of the partnership. Example 1: an obligation to pay an LLC s managing member $1,000 a week without regard to whether the LLC has income. This is a guaranteed payment. Example 2: an obligation to pay an LLC s managing member the first $1,000 of that week s profits (if any). This is probably not a guaranteed payment because it depends on whether the LLC has profits. Because it is often easier to figure out whether a partner is entitled to a guaranteed payment than whether he or she is a limited partner, it makes sense to make this determination first.

Limited Partner Exception There is specific statutory relief from SECA taxes for limited partners. BUT -- the Code does not define the term limited partner for these purposes. The IRS issued proposed regulations in 1997 to interpret the term limited partner for purposes of Code section 1402(a)(13).

Limited Partner Exception These regulations take a broad interpretation and are useful for planning purposes and for users of LLCs. However, the proposed regulations are not effective until finalized and they have been out there for seventeen years! Although the proposed regulations do not constitute authority, and are not binding on any court, compliance with them is likely to be viewed as reasonable, and it seems unlikely that any penalties could be assessed for structuring partnership arrangements in such a way as to comply with these regulations.

Overview of Proposed Regulations The regulations apply to any entity that is classified as a partnership for federal income tax purposes. Does not matter what the entity is under state law. The regulations apply to limited partnerships, LLPs, LLLPs, LLCs, and any other state law entities that can be classified as a partnership for federal income tax purposes. A member of a tax partnership is treated as a limited partner (and thus escapes SECA taxation) only if the proposed regulations are satisfied the fact that a person is a limited partner for state law purposes is irrelevant. The structure of the proposed regulations is to treat an individual partner as a limited partner by default an individual loses this position only if certain tests are failed.

Service Partner Exception A service partner can never be a limited partner for these purposes. In general, a service partner is any member of a service partnership. However, a member of a service partnership is not treated as a service partner if he or she provides only de minimis services to or on behalf of the service partnership. A service partnership is a partnership in which substantially all the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting. Important: The general partner of a service partnership cannot be a limited partner, even if he or she performs no services. That is not because of the service partnership rules, but because of the tests described below (a general partner will ordinarily have personal liability and will authority to contract on behalf of the partnership and therefore fail tests #1 and #2 below).

Three Tests The regulations set out three tests -- failing any of the three tests pushes a partner out of the default classification and he or she is not a limited partner. Test #1 -- A partner loses limited partnership status if the partner has personal liability for the debts of the partnership by reason of being a partner. Test #2 -- A partner loses limited partnership status if the partner has authority to contract on behalf of the partnership. Test #3 -- A partner loses limited partnership status if the partner participates in the partnership s trade or business for more than 500 hours during the partnership s taxable year.

Multiple Interest Exception A person can hold more than one class of interest in a partnership. For example, an individual may be the general partner of a limited partnership, but may also hold some limited partnership interests. Similarly, some LLCs have manager and non-manager interests. Typically, such a person would fail Tests #1 and #2, depending on state law, and Test #3 depending on the facts of the case.

Multiple Interest Exception However, the regulations create an important exception for multiple interests. The person is nonetheless treated as a limited partner with respect to a class of partnership interests that he or she holds that meets the following test: people otherwise classified as limited partners own a substantial, continuing interest in that specific class of partnership interest (for these purposes, at least 20% of the class must be owned by such other limited partners), and the person s rights and obligations with respect to that specific class of interest are the same as the rights and obligations in that class of partnership interest held by such other limited partners.

Multiple Interest Exception Example Adams is the sole manager-member of Newco LLC. Newco has manager and non-manager LLC interests. Adams owns 100% of the manager interests, but also owns 80% of the non-manager interests. Bryant owns the remaining 20% of the non-manager interests. Ordinarily, Adams would flunk test #2 and all his income from Newco would be subject to SECA. However, Bryant owns a substantial interest in a separate class of interests (the non-manager interests) that Adams also owns, and they have identical rights. Therefore, Adam s income attributable to his non-manager interest is not subject to SECA.

500 Hour Exception An individual would otherwise fail to be a limited partner if he or she participates in for more than 500 hours in a year. BUT -- the person is nonetheless treated as a limited partner if he or she meets the following conditions: the person only fails the 500-hour test (not tests #1 or #2) the person holds only one class of partnership interest; people who are otherwise classified as limited partners own a substantial, continuing interest in the same class of partnership interest (for these purposes, at least 20% of the class must be owned by such other limited partners), and the person s rights and obligations with respect to that class of interest are the same as the rights and obligations in that class of partnership interest held by such other limited partners.

Application of SECA Rules to LLCs Manager-Managed LLCs In the case of manager-managed LLCs, the non-manager members typically will not flunk test #1 (liability for LLC s debts) or test #2 (authority to contract on behalf of the LLC). However, they may flunk test #3 (more than 500 hours of work). In addition, if the LLC is classified as a service partnership they may lose limited partnership status regardless of what tests they fail. The manager-member will typically flunk test #2. In addition, he or she may flunk test #3. Also, if the LLC is classified as a service partnership he or she may lose limited partnership status. Note that in some cases it may be possible to mitigate any tax effects by using the multiple-class-of-interests and 500- hour exceptions.

Application of SECA Rules to LLCs Member-Managed LLCs In the case of member-managed LLCs, the members typically will flunk test #2 (authority to contract on behalf of the LLC). They may also flunk test #3 (more than 500 hours of work). In addition, if the LLC is classified as a service partnership they may lose limited partnership status. As above, in some cases it may be possible to mitigate any tax effects by using the multiple-class-of-interests and 500- hour exceptions.

Analysis RECALL if pass-through income is not subject to NIIT, and if that pass-through income is not subject to selfemployment tax, then the income is only subject to regular income taxes.

Analysis KEY QUESTION: Can a partner be active with respect to a trade or business and still come within the limited partners exception to the SECA rules? If partnership operates a trade or business and it is not a passive activity with respect to that partner, then NIIT does not apply to the income. If the partner qualifies for the limited partner exception, then SECA tax does not apply to the income.

Passive Activity Rules To determine if a trade or business is passive with respect to a partner we use the rules under IRC 469. Under those rules, we have to determine if a partner materially participates in an activity. BUT different tests apply depending on whether the partner is classified as a limited partner AND this limited partner test is different than the limited partner test for SECA!

Material Participation Tests There are SEVEN tests for material participation: (1) participates for more than 500 hours in a year; (2) participation in the activity constitutes substantially all of the participation in such activity of all individuals; (3) participates for more than 100 hours, and such participation is not less than the participation of any other individual; (4) the activity is a significant participation activity (SPA), and the individual's aggregate participation in all SPAs exceeds 500 hours; (5) materially participated for any 5 years of the previous 10 years; (6) the activity is a personal service activity, and the individual materially participated in the activity for any 3 previous years; or (7) participates in the activity on a regular, continuous, and substantial basis during such year.

Material Participation If classified as a limited partner under the 469 rules, only tests 1, 5, and 6 apply: (1) participates for more than 500 hours in a year; (5) materially participated for any 5 years of the previous 10 years; (6) the activity is a personal service activity, and the individual materially participated in the activity for any 3 previous years;

Limited Partner Status for 469 Proposed regulations issued in 2011 address who is a limited partner under the 469 rules. An interest is treated as a limited partner interest if the holder of such interest does not have rights to manage the entity at all times during the entity s taxable year under the law of the jurisdiction in which the entity is organized and under the governing agreement.

Limited Partner Status for 469 BUT an individual who otherwise is treated as a limited partner under this test is exempted if he or she also holds an interest in the partnership that is not treated as a limited partner interest.

Problems/Solutions Partner cannot satisfy material participation as a 469 limited partner but would if he/she were not a 469 limited partner. Partner acquires class of interest that is entitled to management at same time as he/she acquires the limited partner interest.

Problems/Solutions Partner satisfied material participation test by working 500 hours in the business but thereby flunks test #3 of the SECA limited partner test. If partner owns only one class of interest, ensure that at least 20% of that class is also held by partners qualifying as limited partners. If partner owns multiple classes of interest, ensure that at least 20% of those other classes are held by partners qualifying as limited partners.

S Corporation The application of SECA rules to S corporation is different than for partnerships. Generally, the formal salary received by an S corporation shareholder is subject to payroll taxes, but the rest of the income that flows through to the shareholder is not subject to payroll taxes. There is no need to thread the needle of two different definitions of limited partner!

S Corporation Employees/Shareholders An employee/shareholder who works 500 hours for an S corporation will generally meet the material participation test under 469. Therefore, provided the S corporation is not trading financial instruments or commodities, the shareholder s share of income will not be subject to NIIT.

S Corporation Employees/Shareholders The formal salary received by such a shareholder will be subject to payroll taxes, but the shareholder s share of income will generally not be subject to such taxes. However, the salary must be reasonable if the salary is unreasonably low, the IRS can reallocate and subject the newly characterized salary to payroll taxes.

SUMMARY income tax applies? meets material participation test? YES payroll tax applies? NIIT tax applies? income tax applies? NO payroll tax applies? NIIT tax applies? salary of shareholder of S corporation yes yes no yes yes no distributive income of shareholder of S corporation yes no no yes no yes partner classified as limited partner for SECA yes no no yes no yes partner not classified as limited partner for SECA yes yes no yes yes no

Self Employment Taxes, NIIT and Pass-Through Entities Joseph C. Mandarino Atlanta, Georgia Smith, Gambrell & Russell, LLP 1230 Peachtree St. NE Suite 3100 Atlanta, Georgia 30309 www.sgrlaw.com