This is even more confusing because we have some conflicting guidance from the IRS.
First, of all, let’s look at the two types of LLC that you may have. It could be member-managed or it could be manager-managed. Initially, most CPAs took the position that if an LLC was member-managed, then it would be treated more like a general partnership. In that case, every member would pay self-employment tax. If it was manager-managed, it would be treated like a limited partner. The manager would pay self-employment tax and the member would not.
But wait, what if the member also happened to be a manager? At that point, the rules started to get blurred. The manager payment was clearly a ‘guaranteed payment’ and reported separately on the Form K-1, so that it was subject to self-employment tax. But there isn’t clear guidance on how to treat the income that flows to the member. Is it subject to self-employment or not? Good question.
In one case, the Tax Court agreed with the IRS’s position that a member’s income in a manager-managed LLC was considered passive. Or rather, in this case the member’s loss was considered passive and thus not able to be used to offset other income.
Yet, the IRS has given us some proposed regulations that indicate regardless of the type of LLC (member or manager-managed), if the member is spending more than 500 hours per year in the business, then it’s active. And that means self-employment tax.
So don’t assume anything when it comes to LLCs and self-employment tax. This is definitely something to strategize with your CPA.