Could a single-member LLC deduct the owner's one-half self-employment-tax adjustment when computing taxable earned surplus?

Plain-English summary

A single-member LLC could not deduct the owner's one-half self-employment-tax adjustment in computing the LLC's taxable earned surplus.

The LLC was treated federally as a sole proprietorship. Its owner reported LLC income on Schedule C and deducted one-half of self-employment tax on the individual's Form 1040.

Rule 3.562(f)(1) used taxable income and deductions related to the LLC and reported on the owner's federal return. But Rule 3.562(f)(2) barred amounts for compensation of the member because a sole proprietor was not an employee of the LLC for federal purposes.

The Comptroller treated the self-employment-tax deduction the same way. It arose from tax imposed on the individual owner's earnings and was a federal adjustment allowed only to the individual. Texas treated the LLC as a corporation for franchise-tax purposes, so the owner-level deduction did not reduce LLC reportable federal taxable income.

The letter distinguished ordinary employee salaries and payroll taxes of a C corporation, which could reduce reportable federal taxable income to the extent deducted federally.

Currency note: This is a pre-2008 earned-surplus computation. Texas replaced that tax with the margin tax effective January 1, 2008.

What this means for you

Owners of federally disregarded LLCs

An item shown on the owner's individual return was not automatically an LLC deduction for the former Texas tax. The item had to relate to the entity rather than the owner's individual tax status.

Tax professionals

The letter grounds the difference in federal classification: owner self-employment tax is not the same as employee payroll tax paid by a corporation.

Common questions

Q: Why was the deduction denied?
A: It was an individual adjustment tied to the owner's self-employment tax, not an LLC expense.

Q: Could a C corporation deduct employee payroll costs?
A: Yes, to the extent those costs were deducted in computing federal taxable income.

Citations and references

• 34 Tex. Admin. Code Sec. 3.562(f)(1)-(2)
• Texas Tax Code Sec. 171.110(d)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9907724L

Original ruling text

July 2, 1999

Dear **:

In your letter of June 14, you requested clarification regarding the deduction
of self employment taxes for a single member LLC treated as a sole
proprietorship for federal income tax purposes.

You indicate that one-half of the self-employment taxes imposed on the LLC's
income reported on Schedule C, Form 1040, are deducted on page 1 of the
individual's federal income tax return.

I presume that your inquiry relates to the computation of federal taxable
income on Schedule B of the franchise tax report.

As you indicate in your letter, Rule 3.562(f)(1) addresses the computation of
reportable federal taxable income of an LLC treated as a sole proprietorship
for federal income tax purposes. That rule provision indicates that reportable
federal taxable income is the taxable income and deductions that relate to the
LLC and which are reported in the individual sole proprietor's federal income
tax return. In addition, Rule 3.562(f)(2) states that the LLC may not deduct
"...any amounts for compensation of the member who is treated as the sole
proprietor for federal income tax purposes." This rule provision is based on
the fact that the sole proprietor is not an employee of the LLC for federal
income tax purposes. It is our position that the deduction for self-employment
taxes is not allowed as a deduction in computing reportable federal taxable
income because the deduction is based on self-employment taxes related to the
earnings of the sole proprietor who is not an employee for federal income tax
purposes.

With regard to corporations, Texas Tax Code Sec. 171.110(d) defines a
corporation's reportable federal taxable income as "...the federal taxable
income after Schedule C special deductions and before net operating loss
deductions as computed under the Internal Revenue Code..." Thus, employee
salaries and applicable payroll taxes are allowed in computing reportable
federal taxable income to the extent they are deducted in computing federal
taxable income.

The federal income tax treatment of a C corporation and the LLC you describe
causes the difference in the computation of reportable federal taxable income.
The federal income tax treatment of the LLC as a sole proprietorship results in
the imposition of the federal self-employment tax which applies only to
individuals. Except for this special federal treatment, no self-employment tax
would result to the individual or to the LLC. Similarly, the federal deduction
for one-half of the self-employment tax applies only to individuals.
Therefore, because the LLC is defined as a corporation for franchise tax
purposes, the federal self-employment tax imposed on the individual is properly
disallowed as a deduction in computing franchise tax.

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

If you have any questions, contact Tax Policy Division. You may call toll free
1-800-531-5441, or our regular number is 512/463-4600. My extension is 3-4662.
You may write me at Tax Policy Division, Comptroller of Public Accounts.

Sincerely,

Bob Jeffcoat
Tax Policy Division