Our corporate partner, Haynes and Boone, LLP, has shared the following special article with our members and readers. Written by Kenneth Bezozo, partner, and Erin Watkins, associate, in the Business Planning and Tax Practice Group, this article provides excellent information regarding self-employment taxes. Enjoy!

Self-Employment Taxes for Business Owners and Investors

Self-employment taxes can be a land mine for business owners or investors. Because self-employment taxes may apply to someone who is not “self-employed” in the traditional sense of the word, an individual may find him or herself on the hook for unexpected tax liabilities when the tax man comes knocking.

Unfortunately, the rules governing self-employment taxes are complicated and lack clarity, particularly with respect to owners of interests in limited liability partnerships (LLPs) and limited liability companies (LLCs). This article is intended to enlighten readers about these issues.

What Are Self-Employment Taxes?

Self-employment taxes (aka SECA tax) are Social Security and Medicare taxes similar to those shared by employers and employees and withheld from employees’ pay (aka FICA tax). Self-employed individuals are almost without exception liable for self-employment taxes in addition to income tax.

Social Security. The Social Security component of the tax is 12.4% of the first $106,800 of self-employment earnings (this amount is reduced, however, by the amount of any earnings received during the year by the individual as an employee). Note that in 2011, the tax is decreased to 10.4%, but only for one year.

Medicare. The Medicare component of the tax is 2.9% of self-employment earnings. This amount is increased by an additional 0.9% beginning in 2013 on self-employment earnings over a threshold amount ($250,000 for those married filing jointly, and $200,000 for individuals).

What Are Self-Employment Earnings?

Self-employment taxes are imposed on an individual’s “net earnings from self-employment,” with an exemption for those with less than $400 in self-employment earnings. Net earnings from self-employment are defined as the gross income derived from any trade or business carried on by such individual, less deductions attributable to such trade or business, plus a partner’s distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he or she is a partner. References to a partner refer to any equity owner in an entity taxed as a partnership and so may include partners in a general, limited or limited liability partnership and members of an LLC (subject to the exclusion of a limited partner’s distributive share of a partnership’s income or loss as discussed below).

What Is Excluded From Self-Employment Earnings?

There are a myriad of items excluded from the calculation of self-employment earnings, including rentals from real estate, stock dividends and bond interest (unless received in the course of trade or business) as well as certain gain or loss from the disposition of non-inventory property and the distributive share of any item of income or loss of a limited partner.

How Does This Apply to Me?

C Corporations. Shareholders in C corporations are not subject to self-employment taxes on dividends received from the corporation.

S Corporations. An S corporation shareholder’s share of the net income of the S corporation is not subject to self-employment taxes. However, the Internal Revenue Service may challenge a service provider’s compensation as unreasonably low and determine that a portion of that service provider’s allocable share of corporate income should be treated as compensation.

Trusts and Estates. Income derived from a trade or business carried on by an estate or trust generally is not included in determining the self-employment earnings of the individual beneficiaries of the estate or trust.

Sole Proprietors. Sole proprietors are typically subject to self-employment tax on all income as earnings from self-employment, subject to the various exclusions noted above.

General and Limited Partnerships. In general, a general partner’s distributive share of income is subject to self-employment taxes while a limited partner’s is not. Also, if an entity pays a partner in a manner determined without regard to the income of the partnership, such payment or benefit is a “guaranteed payment” and subject to self-employment taxes.

Limited Liability Partnerships and Limited Liability Companies. Because the applicable governing statute was enacted before the advent of LLPs and LLCs, there is a lack of definitive guidance with respect to whether the distributive share of income of an LLP partner or LLC member is subject to self-employment tax. It is the exclusion of a limited partner’s distributive share that causes confusion in this area.

“Limited partner” is not defined by statute, and whether an entity is a limited partnership or an owner is a limited partner generally is a question of state law. The Internal Revenue Service has proposed regulations defining “limited partner” based on factors such as authority to contract, personal liability, and participation in the trade or business. However, because the regulations are not final, they do not govern whether an LLP partner or LLC member may in fact be a “limited partner” for purposes of determining self-employment earnings. The Tax Court has recognized that individuals who are mere investors in a partnership or a limited liability company and who do not actively participate in the partnership or company’s business operations should not be subject to self-employment tax on their distributive share of the entity’s earnings, but the application of that standard to LLPs and LLCs remains subject to debate.

If you have any questions about your possible self-employment tax exposure, please contact a tax professional for further guidance.

About the Authors:

Kenneth Bezozo is a partner and Erin Watkins is an associate in the Business Planning and Tax Practice Group at Haynes and Boone, LLP. They can be reached at and , respectively. Mr. Bezozo has extensive experience in representing business entities and individuals in state and federal taxation matters and business planning, including structuring, formations, operations, mergers and acquisitions, dispositions and restructurings. He also has substantial experience in handling federal and state tax controversies and bankruptcy and workout taxation. Ms. Watkins has experience in both state and federal taxation as well as various business planning matters and has worked with partnerships, LLCs, private and publicly held corporations, and individual investors.