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Wallstreet Esq.
Wallstreet Esq., Tax Attorney
Category: Tax
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Experience:  10 years experience
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Trying to determine if Passive Rules apply to a particular

Customer Question

Trying to determine if Passive Rules apply to a particular example. If a wife owns a controlling interest in a limited liability company, but spends a few hours at the company annually, but the husband is the Chairman/CEO of the Company. I would normally think that this crosses the threshold of the rules and no longer passive when a spouse is not passive. Although this might be true -- Does this automatically cause the income she derives through her K-1 to to be subject to Self-Employment Earnings on their MFJ Tax Return and subject to SE Tax and the added the 2.9%? If not, what is the rule and exception?
Submitted: 1 year ago.
Category: Tax
Customer: replied 1 year ago.
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Customer: replied 1 year ago.
Based upon: IRC § 469(h)(5), Reg. 1.469-5T(f)(3), Reg. 1.469-1T(j): Participation of both spouses counts. Income or losses for both spouses are non-passive, even if only one spouse rises to any of the seven tests for material participation.This says income or expenses, or is there a special exception that would permit it be excluded from the SE Tax calcs. The original rules were intended to prevent abuse for Passive Losses, but just need to know if it traps one with income and SE Tax too.
Expert:  Lane replied 1 year ago.
Not sure I completely understand your question, Jamie. First, the term chairman and or CEO wouldnt apply to an LLC. Only corporations have CEO's and boards....LLCs are either member managed or manager managed. Manager can be an employee of the LLC but the members are self-employed....In CCA###-##-#### (sept 2014) the IRS concluded that the distributive share of partnership income allocated to members of an LLC was subject to self-employment tax....Honestly, this was big, because the treatment of an LLC member’s distributive share of income for purposes of self-employment income has long been debated–largely due to the Service’s inability (or unwillingness) to finalize regulations governing the issue over the past three decades....SE tax is, of course, charged against Profit, just as Federal Income Tax is charged against profit....IRC Section 1402, like many provisions of the Code, starts off by setting the general rule– i.e., all trade or business income, including a partner’s distributive share of partnership income (profits) , is included in self-employment income–before listing a host of excpetions to that general rule (net income from a LIMITED partner, for example)....It's (in IRS' eyes) only when a partner is PROHIBITED from being involved in the decisions regarding the partnership (i.e., a limited partner) that profits from partnership (LLC) are not self employment....The k-1 will distribute the partner's share of course, based on the operating agreement (or in the case where there is no operating agreement, state law - which in almost every case defaults to equal ownership). And it's that distributive share of profit on which the self-employment is taxed....Bot***** *****ne, after the Chief Counsels memo above, (yes, although specific to one case) taxpayer had better have a very strong argument that there is absolutely no decision making, service provided or other ability to affect operations (a VERY high hurdle for spouses where the operating agreement doesn't take that right away from either member)....IRS is on this one big time
Customer: replied 1 year ago.
Sorry to use the work CEO, except that is the title provided to the husband. There are many LLC's that provide executive titles to their employees. As an employee, the husband is in the senior most position. He receives a modest salary. He doesn't have any direct ownership of the LLC. His wife has the majority controlling ownership and would normally be considered passive, if they were not married. She is legally listed a managing member. Someone stated that if they issued her two K-1's one as Passive (Limited Member) and the other as non-Passive (Managing Member), they could allocate and keep some of the income out of the category of non-passive and out of the realm of SE Tax. Never heard of such an option. Even so, because she is married to a person that is active, then would this not make this option a moot point.
Expert:  Lane replied 1 year ago.
A member in an LLC that has any ownership at all shouldn't be receiving a salary ... should be getting guaranteed payments. (Revenue Ruling 69-184 states that “members of a partnership are not employees of the partnership.”)...And on the k-1 issue, it's the person's ability to control that makes this self-employment income ... can't say that one part of her controls and the other doesn't....And yes I agree on the married piece, but I think that fact that it's her LLC that makes this self-employment income....But again, the husband getting a salary is just wrong ... the reason they let THIS one fly is that the social security and medicare are being paid by his withholding and being matched by the partnership ... if he were getting guaranteed payments the math would be the same ... he'd just be paying it on schedule SE..Guaranteed payments are included in self-employment income, and IRC Section 1402 provides that a partner’s distributive share of partnership income is included in self-employment income....There's nothing here that would indicate, so sorry, that EITHER one of these individuals shouldn't be paying social security and medicare taxes (although again, the husband is paying them in a way that's really incorrect)
Customer: replied 1 year ago.
The husband is not a member of the LLC.
Expert:  Lane replied 1 year ago.
He has no ownership at all?
Customer: replied 1 year ago.
Nope. He is only an employee.
Expert:  Lane replied 1 year ago.
Sorry for the bad assumption... when you said she had controlling interest, my assumption was that the husband had SOME interest. My bad ... ... so now I'm not sure I understand what the married stuff was about above
Expert:  Lane replied 1 year ago.
Regardless controlling interest is NEVER passive ... UNLESS, in the operating agreement, she is given NO management or decision making rights, and even then, given the current environment, it's a stretch... IRS will say that under 1402 it's definitional.
Expert:  Lane replied 1 year ago.
Part of the problem here is that LLC's came AFTER congress stipulated that a LIMITED partner would not be subject to Self-employment income....The intent of Congress in excluding the distributive share of limited partners from self-employment income illustrates:...Because a limited partner couldn’t participate in any management of the partnership, the limited partner’s involvement was essentially limited to his cash investment in the partnership. It would follow, then, that the limited partner’s distributive share of partnership income was akin to earnings on a passive investment, rather than income from the active conduct of a trade or business....As a result, Congress decided, it shouldn’t be included in self-employment income. If the limited partner performed any services for the partnership and was paid a guaranteed payment, that guaranteed payment would be included in his self-employment income, however....THEN (1977 I think) comes along the LLC....In an LLC, unlike a general or limited partnership, ALL of the members of the partnership have limited legal liability....
Customer: replied 1 year ago.
In simple terms. He is only an employee. He makes the management decisions. She is only a member and makes no day-to-day management decisions. She spends little or no time. He spends lots of time. If they were not married, she would clearly be passive. Since they are married, does that cause her income to become non-passive under the Regs stated above.
Expert:  Lane replied 1 year ago.
No she would not be clearly passive... This is about amounts at risk and control...not time spent. Your reading the regs to apply where it's irrelevant (where both spouses are not members)
Expert:  Lane replied 1 year ago.
Read my post above and then add this:...That would seem to indicate that ALL of the members are limited partners. As opposed to limited partners, however, LLC members are permitted to some degree to participate in the management of the LLC, with that permissible degree varying from state to state....As a result, LLC members are a hybrid of general partnership and limited partnership interests that didn’t exist back in 1977, and this poses a huge problem for a tax law that doesn’t yet specifically address the issues created by these hybrid partnership interests....UNTIL the Chief Counsel memorandum I mentioned
Expert:  Lane replied 1 year ago.
But HERE, again, with controlling interest, the ONLY way she could be exempt from Self-Employment tax is to be striped OF any management control or ability to affect operations AND (more important) have nothing more at risk than her investment (depending on her behavior as a responsible person, that's harder to do these days than ever before)...In most states the limited partnership is a more clear vehicle for that ... and is EXACTLY what LIMITED partnerships are for....What they should be looking at is S-Corp election. Pay her a small salary (if any, if she's really not affecting things at all) and have the profits flow through the 1120-S' K-1 (NO SS& Medicare, AKA self employment tax, on THAT portion)
Customer: replied 1 year ago.
Maybe I have been thinking about the rules of Passive vs. Non-Passive when it comes to netting passive losses against passive income. The IRS seemed to create a lot of rules to insure that no one could offset passive income against passive losses if they were active (including a spouse). I think there was a 7 point criteria. Did I assume wrong when I applied the same rules to income? Do these rules only come into play when there are Passive Losses?
Expert:  Lane replied 1 year ago.
Yes, you're thinking about rental income which is ALSO definitionally passive....Rental income is where you see the MATERIAL PARTICIPATION test comes to play (7 parts) - time and time again - to determine whether someone is a real estate investor or a real estate professional or dealer....Here (with self-employed's) you're dealing with a DIFFERENT definition of income self-employment income vs investment (also referred to as passive income but passive is not defined here - as it is in rental income) it's the other way around. With self-employed's (partners, LLC members not electing corporate taxation and sole proprietors) Self-employment income is what's being defined... hence passive in THIS arena means NOT self-employment income....General Partners and LLC members with controlling interests are self-employed
Expert:  Lane replied 1 year ago.
If nothing else, I hope I helped you work through this...Please let me know if you have any questions at all....If this HAS helped, and you DON’T have other questions … I'd appreciate a positive rating (using the faces or stars on your screen, and then clicking “submit That’s the only way JustAnswer will credit us for the work here....Thank you!Lane……I hold a law degree (JD, Juris Doctorate), with concentration in Tax Law, Estate law & Corporate law, an MBA, with specialization in finance & tax, as well as CFP® and CRPS designations. - I’ve been providing financial, Social Security/Medicare, estate, corporate & tax advice since 1986.

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