Tax Guru – Ker$tetter Letter

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Unreimbursed LLC Expenses

Posted by taxguru on June 23, 2007

Q-1:

Subject: Re: Partnership question – limited or general partner?

Another question for you, Kerry,

First off, I’m glad you survived tax season – congratulations.

The service company in which my husband holds a partnership (medical services) is set up as an LLC.  Maryland law states the following with regard to service LLCs:

 § 4A-301.1. Liability for negligence in rendering professional services.

 (a)  Individual liability.-   

 (1) An individual who renders a professional service in this State as an employee of a domestic or foreign limited liability company is liable for a negligent or wrongful act or omission in which the individual personally participated to the same extent as if the individual rendered the service as a sole practitioner.  

 (2) An individual who renders a professional service in this State as an employee of a domestic or foreign limited liability company is not liable for a negligent or wrongful act or omission of another employee or member of the limited liability company unless the employee is negligent in appointing, supervising, or cooperating with the other employee or member.  

 (b)  Company liability.- A domestic or foreign limited liability company whose employees perform professional services within the scope of their employment or within the scope of the employees’ apparent authority to act for the limited liability company is liable to the same extent as its employees. 

(c)  Liability no greater than in nonprofessional company.- The personal liability of a member of a domestic or foreign limited liability company that provides professional services is no greater in any respect than the liability of a member of a limited liability company which is not engaged in rendering professional services.

I am familiar with Treasury’s temporary regulation 1.469-5T, and it seems as though if the state of incorporation allows for limited liability for the member, the member is passive and limited partner, even if he/she fails the test for passive activities.  I couldn’t find any ruling/regulation with regard to the professional service industry though, except that if you provided a professional service you CANNOT be considered a limited partner.  Seems to be contradictory.

The issue is the unreimbursed partnership expenses incurred throughout last year.  General partners get to deduct UPE from the Social Security Wages listed on the K-1 to figure out the Medicare tax.  Limited partners, according to the directions on the SE, seem to not have that ability.

So the question is – is he a limited partner for IRS purposes or a general partner?  It’s a small difference, but hey – every little bit helps!  Thanks,

Regards,

 

A-1:

The application of SE tax to LLC income has long been an issue of debate among tax pros, and one I have written about several times over the past few years.

Because of the lack of an explicit law on this matter, there is no cut and dried answer that will satisfy everyone.  Some people take the approach that no LLC income is subject to SE tax, while others apply it to all of the LLC net income.  A common compromise position is to treat it similarly to the comparable issue with S corps.  Under this approach, the member’s income that is directly attributable as compensation for services rendered would be subject to SE tax, while the net income that is a result of being an investor in the business would not be. 

This issue obviously needs to be settled for your husband’s treatment of his share of the LLC income first before addressing the appropriate way to handle his unreimbursed expenses.  If he is reporting SE income from the LLC and those expenses can be connected by him to the generation of that income, he can deduct them against that SE income when calculating the actual SE tax.  Likewise, if none of the LLC income is being reported as subject to SE tax, none of the related expenses would be usable in calculating the SE tax.  Similarly, if he is using the compromise approach I mentioned above, any unreimbursed expenses that are connected to his non-SE investor income could also not be used to offset the SE income.   

I hope this helps you understand how murky this issue is.  This is obviously something that you need to work on with your own personal professional tax advisor.

Good luck.

Kerry Kerstetter

 
Q-2:

Thanks Kerry!

 

The way we have the (as of today, still unfiled but extended) tax returns calculated now, his income is subject to SE tax.  He fails two of the passive/limited partner tests – the 500 hour test and the personal services test, so we didn’t even consider the idea that his guaranteed payments were exempt from SE tax.

 

The confusion lies (and the tax advisor is confused as well) with the directions for Form SE, which states that general partners only may deduct the unreimbursed partnership expenses (UPE) from the social security wages in box 15 of the K-1.  Limited partners do not that get, though perhaps they’re left off because limited partners generally do not pay SE tax on guaranteed payments.  The 1065, which was prepared by another firm, however, identifies my husband as a ‘limited’ partner.  That also has not yet been filed, and should probably then be corrected before it is, so that we can deduct the legitimate UPE from the SECA wage base to calculate the SE tax.

 

I’ll take what you responded as confirmation of the way that we were thinking – since all of his income (guaranteed payments) is subject to SE tax, then he can legitimately deduct unreimbursed partnership expenses from his income on the SE form.

 

Thanks again for your help.

 

Regards,

 A-2:

This is a perfect illustration of why there is so much confusion around the proper tax treatment of this relatively new form of business entity, the LLC, which is basically a hybrid of partnerships and corporations.

Even in a limited partnership, one person had to stick his/her neck out and be a general partner, which made him/her personally liable for all of the business’s debts.  With an LLC, all of the members can be limited in regard to personal liability for the company’s debts.  In essence, nobody is a general partner and everyone is technically a limited partner. 

However, when any of the members take out guaranteed payments, which the LLC deducts as an operating expense, those payments would be treated the same by the member on his 1040 as would guaranteed payments received from a normal partnership, and be subject to SE tax.  Likewise, his unreimbursed expenses used to generate that income would be deductible on his 1040 in exactly the same manner as if he were in a normal partnership, reducing Schedule E and SE income.

The debatable issue regarding SE tax has to do with the K-1 pass-through income, which is the company’s net profit after deducting guaranteed payments.

It’s confusing, but you and your personal professional tax advisors should be able to sort it out for your situation.

Good luck.

Kerry

 

 

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