Entity Tax · Brief · Working level
Self-employment tax across entities: the limited partner question and the S corporation arbitrage, honestly assessed
Partners generally pay self-employment tax on their distributive shares; S corporation shareholders pay FICA only on wages. The limited partner exception is unsettled for LLC members, and the S corporation arbitrage is real but smaller than advertised.
The self-employment tax treatment of business profits depends almost entirely on entity wrapper. General partners and active LLC members generally owe SE tax — 15.3% up to the Social Security wage base ($176,100 in 2025), 2.9% Medicare plus the 0.9% additional Medicare tax above it — on their full distributive shares. S corporation shareholders owe FICA only on their W-2 wages; distributions escape both SE tax and, for active owners, the net investment income tax. That asymmetry drives more entity elections than any other single rule, and it deserves a more honest accounting than it usually gets.
The unsettled middle: who is a "limited partner"?
Section 1402(a)(13) of the Internal Revenue Code excludes a limited partner's distributive share from SE income — a 1977 rule written for passive investors in state-law limited partnerships, silent on LLCs, which did not meaningfully exist. Proposed regulations from 1997 (never finalized after a congressional moratorium) would have tested for personal liability, authority to contract, and more than 500 hours of participation. Courts have since converged on function over form: Renkemeyer, Campbell & Weaver, LLP v. Commissioner (law firm LLP partners taxed on service income), Castigliola (PLLC lawyer-members), and Soroban Capital Partners LP v. Commissioner (Tax Court 2023, holding that even state-law limited partners in a limited partnership face a functional inquiry into whether their share is a return on investment or on labor). The IRS has active exam campaigns here. As of mid-2026 the safe description: active service-providing members should assume SE tax on their shares; genuinely passive members retain a credible exclusion; and fund managers relying on state-law limited partner status are litigating, not resting.
Guaranteed payments for services are SE income in all events — see guaranteed payments vs. distributions — and partners can never be W-2 employees of their own partnership, which also means partner compensation never enters an R&D credit wage base.
The S corporation arbitrage, priced
The comparison for an active owner with $300,000 of business profit (2025 parameters, illustrative):
| Structure | Amount subject to SE/FICA | Approximate SE/FICA cost |
|---|---|---|
| Sole proprietor / active LLC member | ~$300,000 (after the 92.35% factor) | ~$32,000 |
| S corporation, $150,000 reasonable wage | $150,000 | ~$22,900 |
| S corporation, $80,000 aggressive wage | $80,000 | ~$12,200 |
The honest footnotes shrink the middle row's ~$9,000 advantage and put the bottom row's ~$20,000 at risk. Wages must clear the reasonable compensation floor, and reclassification brings both halves of FICA plus penalties — the fight detailed in S corporation reasonable compensation, along with the research-credit wage base that a low salary quietly forfeits. Lower wages also reduce retirement plan contribution ceilings, can worsen the Section 199A wage limitation for higher-income owners, and cost half the FICA saved in lost above-the-line deductions. Add payroll administration and, in some states, entity-level taxes on S corporations. Real, positive, and materially smaller than the brochure number.
Choosing on SE tax alone is a mistake
SE tax is one line in a longer ledger. Partnerships offer special allocations, debt basis, and profits interests; S corporations offer the FICA gap and simplicity; the choice also moves credit flows and exit treatment, mapped in entity choice and tax credits. And the arbitrage does not apply at all to passive owners (no SE tax in either form, though NIIT may apply), to loss-year companies, or to professionals whose entire profit is fairly attributable to their labor — where reasonable compensation approaches 100% of income and the gap disappears. The IRS challenges the extremes in both directions: zero-wage S corporations and "limited partner" fund principals. The middle, documented, is defensible.
Frequently asked questions
- Do LLC members pay self-employment tax on their share of profits?
- Usually, if they are active. Section 1402(a)(13) excludes a 'limited partner's' distributive share, but the term is undefined for LLCs, and courts — Renkemeyer, Castigliola, and Soroban Capital (2023) — apply a functional test: members who actively perform services are not limited partners regardless of state-law label. Passive, investor-like members have the stronger exclusion argument.
- How much does the S corporation self-employment tax strategy actually save?
- Roughly 15.3% of the gap between the owner's distributive-share income and reasonable compensation, up to the Social Security wage base, then 2.9%–3.8% above it. For $300,000 of profit and $150,000 of reasonable wages, savings run in the rough range of $15,000–$20,000 a year — before the costs: payroll administration, reduced QBI wage-vs-income effects, smaller retirement plan bases, and reclassification risk.
- Are guaranteed payments subject to self-employment tax?
- Yes. Guaranteed payments to a partner for services are self-employment income under Section 1402 regardless of the partner's limited or general status, and they are not W-2 wages. A partner cannot convert service compensation into passive income by relabeling it, and a partnership cannot put a partner on payroll to create FICA wages.