Have to pay self-employment tax for guaranteed payment ?

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Latest post 03-12-2010 3:04 PM by Drew. 4 replies.
  • 03-11-2010 4:02 PM

    • KB Park
      Consumer
    • Top 500 Contributor
    • Joined on 09-06-2005
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    Have to pay self-employment tax for guaranteed payment ?

    One of my client has a 50% ownership in LLC. He received $100K in 2009 as aguaranteed payment for his work for the LLC. But, the LLCs had a big loss, $300K, in 2009. Then, he will have to report $100K (guaranteed payment) and $150K partnership loss. Does he have to pay self-employment taxes or no because he had net loss, $50K, in 2009 ?

     

     

      

  • 03-11-2010 4:54 PM In reply to

    Re: Have to pay self-employment tax for guaranteed payment ?

    Found this on the internet:

    • Question: How Does a Limited Liability Company Pay Income Tax?
    • A limited liability company (LLC) is a form of business organization recognized by all states. Forming an LLC provides limited liability protection for owners, who are taxed at their personal tax rates. A limited liability company is not a taxing entity, and it is not recognized by the Internal Revenue Service for tax purposes. So how does an LLC pay income tax? The IRS says that an LLC may be taxed as a partnership or a corporation (for a multiple-member LLC), or be disregarded as an entity separate from its owner (for a single-member LLC).
    And since I haven't a clue as to what that means I suggest that your friend hire a tax pro to do his taxes for him.
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  • 03-11-2010 11:58 PM In reply to

    Re: Have to pay self-employment tax for guaranteed payment ?

    KB Park:
    One of my client has a 50% ownership in LLC. He received $100K in 2009 as aguaranteed payment for his work for the LLC. But, the LLCs had a big loss, $300K, in 2009. Then, he will have to report $100K (guaranteed payment) and $150K partnership loss. Does he have to pay self-employment taxes or no because he had net loss, $50K, in 2009 ?

    I'll assume a couple of things here.

    First, that the LLC is organized in the U.S. and the LLC did not make an election to be treated as a corporation. That would mean that the LLC is treated as a partnership for U.S. federal income tax purposes.

    Second, I'll assume that the partnership had a loss of distributable net income (DNI) of $200,000 before the guaranteed payment is taken into account. That means that it is an ordinary loss, not a capital loss. As a result of the guaranteed payment, the partnership's DNI is now a loss of $300,000.

    Third, I'll assume that the partnership agreement is well drafted and contains the necessary provisions concerning make up of losses to the capital account and that the partnership allocations have substantial economic effect. Futher, I assume that the partnership agreement says that Partner X (your client) and Partner Y (the other partner) will share equally in all the profits and losses of the partnership. A careful review of the partnership agreement would be needed to make sure of these things.

    If any of my assumptions are not correct, that could change the result.

    With those assumptions, the result is provided by the rule in Revenue Ruling 56-675. It provides that the guaranteed payment is subject to self-employment tax only to the extent that it exceeds that partner's share of the loss of DNI. So, in this case, Partner X and Partner Y each have $150,000 loss of DNI. Partner X has a guaranteed payment of $100,000. Since Partner X's guaranteed payment is less than the $150,000 share of the loss, he has no self-employment tax to pay.

    Suppose, though, that Partner X's share of the partnership loss was only $80,000 instead of $150,000. In that case, Partner X would have $20,000 of income subject to self employment tax ($100,000 guaranteed payment less the $75,000 loss).

    If you are not familiar with partnership taxation matters, I suggest you refer your client to someone who is. Partnership taxation can be complex, and if you make an error on the return, it can have effects not only for that return but for future ones as well, compounding the problem.

  • 03-12-2010 12:58 AM In reply to

    Re: Have to pay self-employment tax for guaranteed payment ?

    adjuster jack:
    And since I haven't a clue as to what that means I suggest that your friend hire a tax pro to do his taxes for him.

    Well, Jack, I give you credit for trying to help. However, what you posted is not on point for the poster's question.

    I'll explain what you posted, though, since you are not sure what it means.

    For federal income tax, the tax code recognizes only 3 kinds of business entities: sole proprietors, partnerships, C-corporations, and S-corporations. (Estates and trusts are not business entities and thus are outside of this discussion.) All business entities must fall into one of these catagories regardless of how they are organized under state law.

    The classification of corporations under state law is easy. They are C-corporations unless they qualify for and make the S-corporation election.

    The classification of a sole proprietorship is also easy.

    The problem is classifying other business entities under state law, e.g. LLCs, general partnerships, LPs, LLPs, LLLPs, etc. For these entities, the Treasury regulations say that if the entity has just a single owner, it is by default treated as a sole proprietorship of the owner (i.e. the entity is "disregarded" and the owner of the entity is treated as though he or she operated the business directly). If the entity has two or more owners, it is by default treated as a partnership. In both cases, the entity may elect to instead be treated as a corporation for federal tax purposes. And once the election is made to be a corporation, it may also elect to be treated as a S-corporation if it meets the requirements for it. These rules are for entities created or organized in the U.S. The rules for classifying foreign entities is different.

    In the case of sole proprietors, partnerships, and S-corporations, the owners include the income on their return and pay the tax. Only in the case of C-corporations does the business entity itself pay tax on the business income.

    In the poster's case, it was a LLC with two owners. That is by default a partnership for federal income tax. The issue the poster raised is one unique to partnership taxation. In general, partners in a partnership agree to share the profits and losses of the business enterprise. But in some cases, they will agree that one or more partners may receive a payment from the partnership that must be paid regardless of the income or loss of the partnership. This often occurs when one partner is contributing something more than the others, i.e. more capital or more work done for the partnership. This is known as a guaranteed payment. So, in this case, Partner X got $100,000 guaranteed payment from the partnership even though it lost $200,000 (before the guaranteed payment is accounted for). The partnership gets to deduct that payment, bringing the loss to $300,000. Partner X has $100,000 of income from the guaranteed payment and $150,000 share of the $300,000 loss.

    The issue then is whether Partner X must pay self-employment tax (Social Security and Medicare taxes) on the $100,000 even though he overall still had a $50,000 loss for the year on the partnership. As I said in my reply to the original poster, the basic answer to that question is no. Under Rev. Rul. 56-675, you net the guaranteed payment with the partner's share of the ordinary loss to determine what amount, if any, will be subject to self-employment tax.

  • 03-12-2010 3:04 PM In reply to

    • Drew
      Consumer
    • Top 10 Contributor
    • Joined on 03-30-2000
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    Re: Have to pay self-employment tax for guaranteed payment ?

    Totally aside, if one has NO income subject to employment taxes then one is NOT covered  in some respects for  various SS benefits for himself or family for that year  and could lose disability coverage  --and because of the rather quirky  coverage math and bend points as to  basic coverage  your client might be very wise to make sure he has some countable / taxable employment  at least up to about $9000 which is about 1st bend point. .

    Good years do NOT average out bad years in many SS contexts--true after you hit 35 covered years the worst years drop out of base if better years are added--but if you dont have some countable  current work history you may come up short if injured/disabled.



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