Question: Are self-employment taxes due from the managing members of an LLC when the only income to the LLC is earnings from angel investing activities.
By default an LLC is a disregarded entity unless an election is made to be treated as a corporation. When an entity is disregarded, income and losses flow through to the members and maintain their characteristics.
The characterization of gains and the issue of self-employment taxes owed by the managing members is complex question and is very fact dependent. However, in general, there are three broad characterizations of activity, each with its own implications for gains and self-employment tax.
The first categorization is that of “securities dealer”. A securities dealer is one who is engaged in the trade or business of selling securities. A securities dealer will hold an inventory of securities for sale to customers in the regular course of business. Securities held by such a dealer are not considered capital assets and therefore the gain or loss realized is ordinary gain or loss and would be subject to self-employment tax.
A second categorization is “securities trader”. A securities trader is one whose activities rise to the level of a trade or business, but they do not hold an inventory of securities for sale to customers. A securities trader derives income based on the changes in price of the held securities. Since the securities are not held for sale to customers in the ordinary course of business, the securities trader can realize capital gains and losses from the sale of the securities. IRC 1402(a)(3)(A) specifically excludes capital gains from income subject to self-employment tax.
Third is an “investor”. An investor is not engaged in a trade or business. Hence gains or losses on securities transactions are typically capital and not subject to self-employment tax.
It is likely that an LLC engaging in angel investing will be considered as a securities trader, the gains realized from the investment activities will be considered capital gains and will be exempt from self-employment taxes.