Ownership of the Family Business:  His, Hers, or Both?
SE Tax Risk on Land Rents

Ownership of the Family Business : His, Hers, or Both?

In recent years, the use of a Limited Liability Company (LLC) has become the entity of choice for small, family-owned enterprises. The LLC or similar limited partnership entity generally provides important liability protection, and yet from a tax standpoint, a one-member LLC is an “ignored entity” and does not require separate tax return filing. All of the income, deductions, gains and losses of the entity are reported in the Form1040 of the owner. The intent is to achieve the best of both worlds: liability protection similar to the corporate structure, but without the hassles of a separate tax return.

Husband-Wife LLC

If a business is placed in a one-owner LLC, the entity is ignored for income tax purposes and a proprietorship schedule is included within the Form1040 of that owner to report the business activity income and expenses. But what if the small business is placed in an LLC that has two members, a husband and wife?

In a community property state, there is great flexibility.  The IRS has indicated that a husband and wife may treat the LLC as a one owner, ignored entity, reporting all activity within the 1040 as a proprietorship. On the other hand, if the husband and wife treat the entity as a partnership and file a partnership income tax return, the IRS will also accept that position.

But in any location other than a community property state, even though the only members might be a husband and wife, the tax regulations require the filing of a partnership income tax return for a business if it has two or more owners. The tax return preparation costs in this case can be significantly greater due to the complexity of partnership reporting (a balance sheet is often required as part of the tax return, and there are book-to-tax reconciliations required, detailed ScheduleK-1 income and deduction reporting to each partner, etc.). In general, in a non-community property state where a small business has previously reported as a proprietorship, the taxpayer is often better served to have a single member LLC entity rather than having both the husband and wife included in the ownership.

Self-employment Tax Issues

In the formation of an LLC, an often overlooked issue is the consequence of the self-employed Social Security tax (SE tax). If an LLC member has management authority, the IRS position is that the member is subject to SE tax on his or her share of business net income. This assumes that the LLC is conducting an active business rather than merely investing in rental real estate or holding portfolio securities.

The IRS position is that the mere right to exercise management authority can trigger liability for SE tax. On the other hand, being a member without management authority, as defined in the partnership agreement or the member control document, can avoid the SE tax problem.

In the case of a husband-wife LLC, the SE tax implications can go either way. If the business income is very substantial, the two-member LLC could double the SE tax because each spouse has a full lower-tier base amount subject to the tax (i.e., roughly the first $100,000 of income to each owner is subject to the full 15.3% SE tax, while earnings in excess of $100,000 are only taxed at 2.9%). On the other hand, the SE tax can be less if a portion of the business earnings are allocated to a spouse with a large W-2 who has already maximized the lower tier Social Security base amount.

Example.  Bill is semi-retired and has developed a successful furniture-making business that has become increasingly profitable. His spouse, Sue, is a physician and earns in excess of the lower-tier Social Security base. To provide liability protection, Bill’s business is transferred into an LLC. If he is the sole member-owner of the LLC, the business will continue to be subject to the same SE tax as occurred previously (i.e., the full 15.3% on the about the first $100,000 of net income). But if it is a two-member LLC filing a partnership return, Sue’s share of the business net income is only subject to the 2.9% Medicare tax, not the full 15.3% Social Security SE tax.

In this matter of SE tax implications, there is no single optimum model. Rather, this topic requires a case-by-case analysis of the amount and character of the business income, and the comparative position of each member with respect to exposure to the SE tax.

As a further complication, the IRS proposed regulations that address when an LLC member is subject to SE tax have never been finalized. However, the tentative rules do provide some opportunity to structure LLC membership in a way that avoids or minimizes the SE tax burden. As a result, this is a situation where the design of each newly-formed LLC should give careful consideration to the SE tax implications.

Please let us know if we can assist in advising about the proper structure for your small business activity.

SE Tax Risk on Land Rents

Even among urbanites, it is common to find ag land included in the individual’s investment portfolio. Often this is inherited property, and it is held in landlord status producing rental income to the owner. Collecting rental income on real estate is exempt from the self-employed Social Security tax (SE tax). But the IRS recently issued a Notice, taking a position that for the first time imposes SE tax on certain types of land rents.

The issue relates to ag land that is placed in the popular Conservation Reserve Program (CRP). CRP was first authorized in 1985. Farmland is placed in the program under an agreement with the U.S. Department of Ag, under which the land is not tilled and a grass cover is maintained for conservation purposes. Under this contract, the USDA pays the landowner a rental payment, based on comparable land rents in that geographic area.

There have been several tax court cases addressing the issue of whether CRP is simply a form of land rent that is exempt from SE tax, or whether it is farming business income that should be subject to SE tax. Two court cases have held that active farmers (as opposed to landlords) who place their land in CRP must report the CRP rents as active business income, in the same manner as any other USDA ag subsidies. But until this point, there has been no authority suggesting that landlords or investors who held land that produced CRP rents could be subject to SE tax.

It is important to note that this IRS position attempting to impose SE tax on all CRP rents is only in proposed form. At this point, there is nothing binding about the tentative IRS position. However, somewhere in the next year or so we can expect the issuance of an official IRS position, and we may well be faced with the need to pay SE tax on all CRP rents.

If the IRS does ultimately take this position of imposing SE tax, in a few cases it may actually enhance some tax returns. If CRP income is construed as subject to self-employment tax, it would also represent earned income that could support tax deductible funding of a self-employed retirement plan. Also, the income would be eligible for farm income averaging, meaning that it could be taxed at a lower income tax rate based on your prior three-year history.

Again, stay tuned. Nothing is final yet, but those who own land on which CRP rents are collected will want to pay attention as this issue moves forward.

If you have any questions concerning the tax issues discussed here, please contact us at info@marg.com.

.