Published in NH Business Review (11/23/2017)
No one likes to pay federal income taxes, but for many members of multi-member LLCs, the self-employment tax and the Medicare tax on their income from their LLCs can be almost as bad. On the first $127,200 of this income, the self-employment tax (or SET) rate is 12.4 percent and the Medicare tax rate is 2.9 percent, for a combined rate of 15.3 percent For 2017, this means a combined SET/Medicare tax of $19,461. And this combined tax is almost certain to increase significantly in every future year.
What can LLC members do to avoid these taxes or at least reduce them?
The first thing they need to know is that maybe they shouldn’t avoid them. This is because the lower their SET/Medicare taxes, the less they will receive in Social Security disability, death and retirement benefits. Thus, before they structure their LLCs to avoid these taxes, they should consider their overall federal tax situation and their near-term and potential need for these benefits.
But if, after making the above analysis, they decide that they nevertheless want to avoid the taxes, the second thing they need to know is this: If their LLC’s certificate of formation or operating agreement provides that their LLC is “member-managed” — i.e., if, under these documents, each member has the right to sign LLC contracts — then all of the members of their LLC will owe all of these taxes.
In other words, the members of multi-member LLCs can avoid SET/Medicare taxes on their LLC income only if, for starters, their LLC is “manager-managed” — i.e., if, under their operating agreement, the only members who can sign LLC contracts are members specifically authorized to do so.
This means that if any of the members of a member-managed multi-member LLC taxable as a partnership want to avoid the above taxes, they have to amend the above documents to make their LLC manager-managed.
However, merely having a manager-managed LLC won’t suffice by itself to protect members from the above taxes. Instead, they can achieve this avoidance only if they adopt one of two quite difference tax techniques:
• By default, most multi-member LLCs are taxed as partnerships under Subchapter K of the Internal Revenue Code. However, federal tax law allows multi-member LLCs to elect to be treated not as partnerships but as S corporations for federal tax purposes, and the net income of S corporations is not subject to Social Security taxes or the Medicare tax.
Thus, the members of LLCs that are taxable as S corporations owe these taxes only on their compensation from their LLCs (their salaries and bonuses) and not on their shares of LLC net income. Thus, they can realize very substantial tax savings if they pay themselves relatively low salaries and take out the rest of their income from their LLCs as distributions of net LLC income. And this will be the case even if their LLC is member-managed. (But beware: If these salaries are unreasonably low, the members may face an unpleasant IRS audit.)
• However, many federal income tax benefits are available to members of LLCs taxable as partnerships that are not available to members of LLCs taxable as S corporations. For LLC members who want these benefits, the only way to avoid SET/Medicare taxes is to structure their LLCs to conform to the requirements of a proposed IRS regulation under which the members of LLCs taxable as partnerships can achieve very substantial savings of these taxes if, among other things, their operating agreements provide that their LLCs have two classes of interests.
In operating agreements I draft, these are generally called the LLC’s “manager” and “investor” classes.
The proposed regulation is a little-known regulation even among CPAs and other sophisticated federal tax professionals, and some tax professionals are hesitant to use it because it is merely a proposed regulation. However, if it is properly implemented, it can save LLC members many thousands of dollars a year in SET/Medicare taxes.
Furthermore, on three separate occasions, the IRS itself has publicly affirmed the validity of the proposed regulation for IRS audit purposes. So, while no responsible tax professional will tell you that the use of the proposed regulation is risk-free, many LLC members have willingly accepted this risk to gain tax savings.