Incorrect self employment tax for schedule C LLC where not materially participate?

[freeliberty1980]

I have an LLC. I do not materially contribute so I shouldn't be paying self employment tax. I clicked the option under business profile saying I don't materially contribute, but when I go to the self employment tax it still has be paying it. How do I fix this? (Turbo tax home and business version)

[VolvoGirl]

What do you mean you don't materially contribute to it?  Do you have other partners?  You might need to file a separate business return for it instead of schedule C.  If you have a Single Member LLC that is not an S corp  it is a disregarded entity and you file it as self employment on schedule.  Putting money into it or withdrawing doesn't matter.  It is all yours in the first place.  

[Opus 17]

Someone must materially participate.  If there are more than one individual involved in the business and you are a silent partner, then it is not appropriate to file a schedule C using Home & Business.  You have some other kind of business that needs a different kind of return.

If you are the sole owner of the business, but you hand off all activities to a manger and do nothing but collect the profits, you probably need legal and/or tax advice to make sure your business is structured appropriately for that situation.  You are more like a S-corporation where you are the 100% shareholder but someone else literally does all the work and you are completely passive.  But is that really the case?  You don't talk to clients? Hire the workers who do the work?  You don't make calls or do bookkeeping or supervise the manager who directs the business activities?  We would need to know a lot more about the business, and you may need professional guidance. 

[M-MTax]

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@freeliberty1980 wrote:

.....when I go to the self employment tax it still has be paying it. How do I fix this?

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If there is a figure is on Line 14 (A Code) of your K-1, that amount is subject to SE tax and the program will treat it as such.

If you are a sole proprietor, it would be highly unusual for you to NOT materially participate in your business. If that is the case, however, then you should be aware that your deductions will be limited by the passive loss rules and you may have to file Form 8582.

[Mike9241]

material participation not required only active participation

Active participation is the least-stringent test, in which the taxpayer does not need to have regular, continuous, and substantial involvement in the operations. Instead, a taxpayer is considered to actively participate if he or she makes management decisions in a significant and bona fide sense

if you don't actively participate either, it's difficult to understand what you do and the activity in general. Perhaps what you have is a partnership which would require filing form 1065. 

[M-MTax]

Active participation is applicable (or not) to real estate rentals, not typical trade/business (Schedule C) activities.

[AmeliesUncle]

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@freeliberty1980 wrote:

I do not materially contribute so I shouldn't be paying self employment tax. 

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Where are you getting that idea?  I am not aware of any rule that exempts a sole proprietor from self-employment tax if they don't Materially Participate.

[freeliberty1980]

Thanks. I was looking into potentially switching to S Corp, so I will have to talk with someone to determine if the benefits outweigh the additional costs/work involved on my end. I work less than 500 hours, and believe I met the other 6 factors for IRS for me to not be considered as material participation in the business. It was my understanding that meant I wouldn't have to pay self-employment tax on distributions from the solo LLC. 

[freeliberty1980]

It was my understanding the active participation rule was for real estate, but the materially participate rule & factors could be used for other LLCs, I will have to speak with a tax attorney about it, thanks. 

[M-MTax]

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@freeliberty1980 wrote:

It was my understanding the active participation rule was for real estate... 

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It is, you're correct.

However, there are material participation tests beyond the 500-hour test.

See https://www.irs.gov/publications/p925#en_US_2024_publink1000104582

Material participation tests.

You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

1. You participated in the activity for more than 500 hours.

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.

4. The activity is a significant participation activity, and you participated in all significant participation activities combined for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.

5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

[Opus 17]

The whole point of sole proprietorship is that you are the business.  How can you be the business without participating in the business?  If you mow lawns for 50 hours a year but that's the only thing the business does, you materially participate.  If the only thing you do is take calls, make appointments, dispatch subcontractors, and handle the money, you materially participate.  I think we all would be interested to know what your business is that you think is not material participation. 

[AmeliesUncle]

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@Opus 17 wrote:

How can you be the business without participating in the business? 

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A person could hire employees, managers, etc. to take care of everything. 

However, I agree with you that it would be unusual for a Schedule C to not Materially Participate.

But even if they don't Materially Participate, I'm wondering why they think Self-Employment would not apply.

[Opus 17]

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@AmeliesUncle wrote:

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@Opus 17 wrote:

How can you be the business without participating in the business? 

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A person could hire employees, managers, etc. to take care of everything. 

That's material participation.  

[M-MTax]

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@Opus 17 wrote:

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@AmeliesUncle wrote:

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@Opus 17 wrote:

How can you be the business without participating in the business? 

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A person could hire employees, managers, etc. to take care of everything. 

That's material participation.  

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Nope. Material participation would typically require more than simply hiring managers and employees. 

[AmeliesUncle]

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@Opus 17 wrote:

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That's material participation.  

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Which of the seven points that M-MTax posted (from Publication 925 and Regulation §1.469-5T) does that fall under?