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
2014 compensation
income
W-2 employees self-
employed
individuals
employer-
level tax
employee-
level tax
combined
tax
$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/self-employment 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.
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 self-
employment tax,
• then the income is only subject to regular income taxes.
Tax on Net Investment Income
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 self-
employment 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.
• 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.
S Corporation Employees/Shareholders
SUMMARY
meets material participation test?
YES NO
income
tax
applies?
payroll
tax
applies?
NIIT tax
applies?
income
tax
applies?
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
