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Double Trouble

A new IRS proposal could mean more red tape--and higher taxes--for your partnership.

If your business is organized as a limited liability company (LLC) or a limited partnership, the IRS may have some unpleasant news for you. In a move that is already creating an uproar in the small-business community, the IRS is in the midst of issuing a new regulation targeted at these two types of partnerships.

The regulation will not only mean higher taxes, say critics, but a host of burdensome new record-keeping and information-collection requirements. Slated to take effect next year, the regulation is described by critics as a "stealth" tax increase.

With the recent increase in the number of LLCs, particularly among small-business owners, this regulatory push by the IRS is seen as one way to make sure these partnerships pay their fair share. Not surprisingly, this logic has ignited a firestorm of protests among partnerships and small businesses in general. Opponents of the proposal claim the regulation is being erroneously applied to businesspeople organized under this legal structure.

Here's what the new rule proposes: It would require members of LLCs and limited partnerships to pay self-employment taxes on the total amount of their shares of the partnership's or LLC's profits. (This year, the self-employment tax is 15.3 percent on net income up to $65,400 and 2.9 percent on net income above $65,400.)

Currently, limited partners (and certain members of LLCs) do not pay self-employment taxes on the share of partnership income considered a return on investment. Instead, they just pay federal and state income taxes on these distributions.

Under the proposed regulation, however, the IRS would generally require that the self-employment tax be applied to all income, whether it comes from wages or investments, of limited partners and members of LLCs who participate in the partnership's or LLC's trade or business for more than 500 hours per year. (There would be an exception for service partnerships, such as architects, medical professionals and consultants; in these cases, there would be no minimum-hour requirement, so these individuals pay taxes on all income from the partnership or LLC.) Essentially, they'd be taxed the way partners in a general partnership are taxed.

In addition to the 500-hour test, the rule would apply two other parameters to determine when a partnership distribution would be classified as net income from self-employment. These situations are if the individual has personal liability for the debts and claims of the partnership or has contract authority for the partnership.

The IRS maintains that by using these tests, "the proposed regulations ensure that similarly situated individuals owning interests in entities formed under different statutes or in different jurisdictions will be treated similarly."

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This article was originally published in the September 1997 print edition of Entrepreneur with the headline: Double Trouble.

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