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Earned income is not recharacterized or “netted” for self-employment tax calculation

This is an except from a client email that addresses the point that we don’t recharacterize income by passing it through LLCs, partnerships and S-corporations. Earned income is subject to either wage taxes or self-employment tax.

 

“You asked whether income generated by ZZZZZZ Consulting LLC, taxed as a partnership, can be treated in any manner other than earned income by the partner/member ZZZZZZ Group LLC, taxed as an S corporation, and ultimately its one shareholder, you.

Secondly, you asked whether income earned in this manner, if it is earned income, is properly categorized as self-employment income or whether it might be salary income and whether tax is based on net income from all lines of business – some with income and some with losses.

The initial characterization stems from the distinction between active and passive partnership income. This is defined in IRS Publication 925 at https://www.irs.gov/pub/irs-pdf/p925.pdf.  Clearly this falls into the category of income generated as a result of active participation of the partner. Passive income would be the opposite; where the partner is not active in the business, typically after contributing initial capital.

I presume that your logic might be that an S corporation partner is not a person, so cannot be active in running the business. The IRS does not see it that way. Neither the partnership nor the S corporation forms of business are recognized as having any effect on categorization of income for tax purposes. They simply pass the income characteristics on to the partner/member.

Active income is not recharacterized as passive income by passing through an LLC.

 

We do not net income from different sources before recognizing the requirement to pay wage tax or self-employment tax on the active income.

It would be possible, but not advantageous, to handle this through a payroll accounting of the S corporation. Wage tax would be the same (15%) plus you would have payroll administration costs.

In summary, while it could be possible for ZZZZZZ Consulting LLC income to be taxed as passive income to ZZZZZZZ Group LLC if you were only an investor, not a participant, this is not the case now.”

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