LLC taxed as a limited partnership - tax prep

[! Hulio !]

Just wondering if there are any nuances associated with preparing the Form 1065 and Schedule K-1s for an LLC that is taxed as a limited partnership.

One member of the LLC plays an active role in the operation of the LLC, which means all of his share of the income will be subject to self-employment tax, while the other member is a limited partner (invested in the company but plays no active role) and therefore should not be subject to self-employment tax.

For the latter member, should the "limited liability company member" box still be checked off on the Schedule K-1, or the "limited partner" box? As for the self-employment tax, is it just a matter of one partner attaching a Schedule SE to the 1040 while the other one does not?

And just so I am clear, how should the home office deduction be handled? Since it's a partnership, should the LLC reimburse the member for the business use of his home (with the amount reimbursed to be reflected on the "Rent" line on the Form 1065)? What if both members equally share the home--should just one of the partners be reimbursed, should each partner be reimbursed 50/50, or does it not really matter either way?

You really ask the tough questions.
The tax code is clear that "limited partners" are not subject to SE tax, except for guaranteed payments (which are always subject to SE tax); however, the code is silent as to LLC members.

The IRS first tried to answer the question in 1997 with Reg-209824-96. Congress immediately passed a tax law that included a restriction on the IRS that keeps them from issuing a final reg on the subject until July 1998. The IRS (as of 2005) has not issued any final regs on the subject but did not withdraw their proposed Reg so most tax preparers are following the propose Reg as a guideline.

Under the proposed Reg if substantially all of the LLC's business involves the performance of services, any LLC member who provides such services will be a general partner for SE tax purposes [Prop. Reg. §1.1402(a)-2(h)(5)].

If the LLC is a non-service partnership, Proposed Reg. §1.1402(a)-2(h)(2), treats an LLC member as a limited partner not subject to SE tax unless the partner has personal liability for partnership debts, has authority to contract, or participates in the business more than 500 hours during the tax year.

Therefore when I prepare a LLC-1065 tax return I check the box "General Partner or LLC member-managed" for all members except a member that meets the requirements above to not pay SE tax on his share of profit where I would check the box "Limited Partner or other LLC member". The member checked as General Partner should show the amount subject to SE tax on his K-1, box 14 and therefore must fill out form 1040 Sch-SE. The Limited LLC member's box 14 would be blank or zero and the IRS computer would not be looking for the SE schedule.

Originally Posted by aangelica

And just so I am clear, how should the home office deduction be handled?

The partnership should receive from the owner(s) of the home, the completed worksheet on page 24 of pub 587 and reimburse the owner(s) with a tax-free (to the owners) vendor check.

There is no guidance as to what the expense should be called, but I would call it something like "office expense" and deduct it on form 1065, page 1, line 20, "other deductions". The classification "Rent" could cause a question as rent is normally taxable income to the owner with no deduction for expenses of the home. It really doesn't matter if separate checks are given to the 50-50 owners as it is not taxable because it is only a reimbursement of expense.

[! Hulio !]

Another excellent explanation by OldJack! Thanks. Just one more point for clarification, please:

Under the proposed Reg if substantially all of the LLC's business involves the performance of services, any LLC member who provides such services will be a general partner for SE tax purposes [Prop. Reg. §1.1402(a)-2(h)(5)].

Can I correctly infer from this that, in the case of service LLC, a member who DOES NOT provide such services can then be treated as a limited partner for tax purposes?

Originally Posted by aangelica

Can I correctly infer from this that, in the case of service LLC, a member who DOES NOT provide such services can then be treated as a limited partner for tax purposes?

No, for a service LLC I would look for the member to meet the requirements in both cases which includes no service, no liablility of debt, no contract authority, and under 500 hours.

[! Hulio !]

Gotcha. Thanks!