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David Green
David Green

Using LLCs to minimize taxes

Proper planning can minimize both the 0.9% additional Medicare tax and the 3.8% net investment income tax on high-earning couples.

July 17, 2014
by David L. Green, CPA/CFF

Beginning in 2013, high-income individual taxpayers are subject to a new tax on earned income in addition to the Social Security or self-employment tax they are already paying. The burden is especially heavy for self-employed taxpayers who must pay the full tax on self-employment income as well as the new tax. (Employees have to pay only half the tax, while the employer pays the other half.) The total tax on self-employment income could be as high as 16.2%. The good news is that using limited liability companies (LLCs) can, in some instances, reduce these taxes.

Additional Medicare tax on earnings

An additional Medicare tax on earnings is levied on earned income in excess of $250,000 for couples filing a joint return, $125,000 for married couples filing separate returns, and $200,000 for all other taxpayers. The tax, which is 0.9% of the amount in excess of these levels, is levied on wages and net earnings from self-employment income. Self-employment income is income derived from a trade or business.

A trade or business generally includes any activity carried on for the production of income from selling goods or performing services. It is an activity carried on for a livelihood or in good faith to make a profit. The trade or business can be operated as a sole proprietorship, a partnership, or an LLC. It can also be carried on in corporate form. Net self-employment earnings are defined as gross income less allowable deductions. The taxpayer reports his or her income on Schedule C, Profit or Loss From Business, or Schedule F, Profit or Loss From Farming, in the case of a sole proprietorship, or on Schedule E, Supplemental Income or Loss, if the income is from a partnership or an S corporation. For an LLC the income can be reported on Schedule C, Schedule F, or Schedule E, depending on how the LLC is taxed and the type of income it earns.

Self-employment tax

Self-employment tax is levied on net earned income from all of the taxpayer’s trades or businesses at the rate of 12.4% of net earned income up to $113,700 for 2013 and $117,000 for 2014, plus the regular Medicare health insurance tax of 2.9% on the entire net earned trade or business income. The self-employment tax is paid on this income regardless of any other losses the taxpayer may have to report.

Example

In 2013, J has a business in which he materially participates that earns $500,000 annually . His wife, S, does not participate in the business. J will pay $27,490 of self-employment tax, which is the total of:

The Social Security portion of the tax, which is the maximum taxable amount ($113,700) multiplied by 12.4% (0.124 × $113,700) = $14,099,

Plus the regular Medicare portion of the tax, which is the amount of his self-employment income adjusted for the 50% self-employment tax deduction ([$500,000 × 0.9235] = $461,750) multiplied by 2.9% (0.029 × $461,750) = $13,391

$14,099 + $13,391 = $27,490

Because his self-employment income is above the threshold, he also owes an additional Medicare tax of $1,906, which is:

The adjusted self-employment income less the additional Medicare tax threshold for married filing jointly, multiplied by 0.9%  ([$461,750-$250,000] × 0.009) = $1,906.

This makes his total self-employment tax and additional Medicare tax $29,396 ($27,490 + $1,906). However, the couple will be able to take a deduction for 50% of J’s self-employment tax (but not the additional Medicare tax).

Assume that J forms an LLC called White Cloud LLC, owned 50/50 by J and S. Assume further that a fair wage for J’s services is $70,000 per year. J is White Cloud LLC’s sole manager. J’s earned income is $285,000 ([$500,000 - $70,000] × 50%= $215,000 + guaranteed payment of $70,000 = $285,000). S does not work in the business, so she would have no earned income.

The couple’s tax on self-employment income would be as follows:

Additional Medicare tax on earnings ([$285,000 × 0.9235) – $250,000] × 0.009) $ 119
Self-employment tax ($113,700 × 0.124) + [($285,000 × 0.9235) × 0.029] 21,732
Total 21,851
Savings ($29,396 – $21,851) $ 7,545

Sec. 1402 (a)(13) states that in the case of a limited partner the distributive share of any item of income is excluded from net earnings from self-employment income, except Sec. 707(c) guaranteed payments.

Prop. Regs. Sec. 1.1402(a)-2(h) defines a limited partner as an individual who does not:

  1. Have personal liability for the debts of or claims against the partnership;
  2. Have authority (under the law of the jurisdiction in which the partnership is formed) to contract on the partnership’s behalf; or
  3. Participate in the partnership’s trade or business for more than 500 hours during the partnership’s tax year.

S, as an LLC member, does not have personal liability as a partner. The only debts that she would be liable for are debts that she agreed to accept personally. Therefore, she could easily pass the first test.  

State law may prohibit a nonmanager from contracting on the LLC’s behalf. If it does not, the operating agreement should be carefully worded so that S does not have this authority. In that case, she would pass the second test.

If S does not work more than 500 hours in the LLC’s trade or business, she will pass the third test, will be treated as a limited partner, and should not be subject to self-employment tax on her share of the LLC’s net income.

How does S prove that she does not more than work 500 hours in the partnership’s trade of business? Proving a negative is always harder than proving a positive. It is best if S has a full-time job in an unrelated field. If not, here are suggestions:

  1. Do not include S’s personal automobile or any of her personal assets (such as her phone or computer) on the depreciation schedule.
  2. Keep a record of S’s involvement in other outside activities. Make sure that these do not directly benefit the LLC.
  3. Keep a detailed, contemporaneous log of S’s work for the LLC, being sure she does not log more than 500 hours in a tax year.
  4. Make a list of S’s other responsibilities, such as work in the home, and estimate how much time she commits to them each year.
  5. Pay S a reasonable guaranteed payment for the time she works for White Cloud.
  6. Have S contribute capital to the partnership.

Tax on net investment income

Also beginning in 2013, taxpayers are subject to a surtax on the lesser of net investment income or modified adjusted gross income in excess of an indexed threshold amount. The threshold is $250,000 for joint filers, $125,000 for married filing separately, and $200,000 for all other cases. Net investment income includes interest and dividends, rent and royalty income, and income from passive activities. Is S subject to this surtax?

For an activity not to be passive, the owner of the interest must materially participate in the activity. Temp. Regs. Sec. 1.469-5T(e)(1) provides that a limited partner is not treated as materially participating in an activity, unless the partner meets one of three exceptions under Temp. Regs. Sec. 1.469-5T(e)(2):

  1. Participates for more than 500 hours,
  2. Materially participated in the activity for any five years of the previous 10, or
  3. For a personal service activity, materially participated for any three previous tax years.

Under Sec. 469(h)(5), in determining whether a taxpayer materially participates in an activity, a spouse’s participation is taken into account. If J materially participates, S’s interest would not be considered passive under Sec. 469(h)(5).

Results

By careful use of LLCs, some married couples can reduce the amount of self-employment tax as well as the new additional Medicare tax that they pay.

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David L. Green, CPA/CFF, CVA, CFE, is the president of Green & Co. PC in Pocatello, Idaho.