How to Avoid Self-Employment Tax in a Partnership
Optimize your self-employment tax as a partner. Explore legitimate strategies to manage and reduce your tax obligations in a business.
Self-employment tax funds Social Security and Medicare for self-employed individuals. It’s distinct from income tax and levied on net earnings. For 2024, the rate is 15.3%: 12.4% for Social Security (up to $168,600 in 2024, $176,100 in 2025) and 2.9% for Medicare on all net earnings. An additional 0.9% Medicare tax applies if net earnings exceed specific thresholds.
Partners are generally self-employed for tax purposes, responsible for self-employment taxes on their share of partnership income. Unlike employees, self-employed individuals calculate and pay these taxes themselves, often via estimated payments. This article explores strategies to reduce or avoid these taxes.
Structuring Your Partnership Role
A partner’s involvement significantly impacts self-employment tax liability. General partners and active LLC members taxed as partnerships typically owe self-employment tax on their entire distributive share of ordinary business income. This share of profits, reported on Schedule K-1, is generally subject to the 15.3% rate.
The “limited partner exception” can reduce self-employment tax for individuals with limited liability who do not materially participate in the business’s day-to-day operations. A limited partner’s distributive share of income is typically exempt, provided they meet specific involvement criteria.
Material participation determines if the limited partner exception applies. The IRS defines it through tests: working over 500 hours in the activity, performing substantially all the activity, or participating over 100 hours if no one else participated more. If a partner fails these criteria, their distributive share may qualify for the exception, even as an LLC member.
Partnership or LLC operating agreements can define roles and responsibilities. Clearly stipulating limited involvement and lack of day-to-day duties supports a claim for limited partner status or non-material participation. However, tax court decisions emphasize a partner’s actual role over formal designation. If actively involved, income may still be subject to self-employment taxes, regardless of title.
Characterizing Partnership Income
The type of income a partner receives impacts self-employment tax liability. A key distinction exists between “guaranteed payments” and “distributive shares.” Understanding these is crucial for tax planning.
Guaranteed payments are amounts paid to a partner for services or capital use, regardless of partnership income. Generally subject to self-employment tax, they are viewed as salary for services. This applies even if the partner qualifies as a limited partner for their distributive share.
A partner’s “distributive share” is their portion of the partnership’s ordinary business income or loss that flows through for tax purposes. For general partners and active LLC members, this share is the primary component subject to self-employment tax. The partnership reports each partner’s share on Schedule K-1 for individual tax returns.
Strategic compensation planning influences self-employment tax. For partners qualifying for the limited partner exception due to non-material participation, structuring income as distributive shares, rather than guaranteed payments, can minimize self-employment tax. If a general partner’s entire distributive share is already taxed, additional distributions from those profits are not separately taxed for self-employment purposes.
Electing S Corporation Status for Partnership Members
Individuals can alter how their partnership income is taxed for self-employment purposes by having an S corporation hold their partnership interest. The S corporation becomes the partner, receiving a Schedule K-1 directly from the partnership, simplifying income flow.
This strategy can reduce self-employment tax. The S corporation shareholder receives a “reasonable salary” for services, subject to FICA taxes. Remaining S corporation profits, after salary, can be distributed as dividends, which are generally not subject to FICA or self-employment taxes.
The IRS requires S corporation shareholders who work for the corporation to receive a “reasonable salary.” This prevents reclassifying too much income as distributions to avoid FICA taxes. The IRS considers factors like duties, time, effort, and comparable compensation when determining salary reasonableness. Failing this requirement can lead to IRS scrutiny and reclassification of distributions as wages, subject to FICA taxes.
Operating an S corporation introduces additional compliance and complexities compared to being a direct partner. These include separate tax filings (Form 1120-S), payroll obligations for the shareholder’s salary (including FICA tax withholding), and potential state-level considerations like franchise taxes. Despite these burdens, this strategy is a relevant tax planning tool for active partners or LLC members who would otherwise owe self-employment tax on their entire distributive share.