There is a
tax issue that has dogged advisors for years.
It has to do
with limited liability companies.
What sets it
up is tax law from general partnerships.
A general
partnership is the Gunsmoke of partnerships. The “general” does not means
everybody participates. It does mean that everyone is liable if the partnership
gets sued.
Whoa. There
is clearly a huge downside here.
Which leads us
to limited partnerships. Here only a general partner takes on that liability
thing. A limited partner put his/her capital account at risk, but nothing more.
Forget about signing on that bank debt.
Let’s
present the granddaddy of self-employment tax law:
·
A
general partner is considered self-employed and pays self-employment tax on
his/her distributable income, irrespective of his/her own involvement in the
trade or business.
·
A
limited partner is presumed to not be involved in the trade or business of the
partnership; therefore, he/she does not pay self-employment (SE) tax on his/her distributable income.
o
There
is an exception for “guaranteed payments, which is akin to a salary. Those are
subject to SE tax.
How can we
differentiate a general partner from a limited partner?
It is that
liability thing. The entity is likely being formed under state “limited
partnership” law rather than “general partnership” law. In addition, the
partnership agreement will normally include a section specifying in detail that
the generals run the show and the limiteds are not to speak until spoken to.
Then came
the limited liability companies (LLCs).
These caused
tax planners to swoon because they allowed a member to actually participate in
the business without forfeiting that liability protection.
COMMENT: BTW the banks are quite aware of this. That is why
the bank will likely request the member to also sign personally. Still that is
preferable to being a general, where receipt of the partnership interest
immediately makes you liable.
Did you
catch the use of the word “member?” Equity participants in an LLC are referred
to as “members,” not “partners.”
So how are
LLCs taxed?
Like a
partnership.
COMMENT: I know. All we did was take that car around the block.
Let’s return
to that self-employment issue: is a “member” subject to self-employment tax
because he/she participates (like a general) or not subject because he/she has
limited liability (like a limited)?
It would
help if the IRS had published guidance in this area since the days of the
Rockford Files. Many advisors, including me, reason that once the LLC is income-taxable
as a partnership then it is also self-employment taxable as a partnership. That
is what “like a” means. If you work there, it is self-employment income to you.
But I do not
have to go far to find another accountant who disagrees with me.
What to do?
Some advisors
allow their LLC member-clients to draw W-2s.
Some do not.
There is a
problem, however: a member is not considered an employee. And one has to be an
employee to receive a W-2.
The fallback
reasoning for a long time has been that a member “is like” an employee, in the
same sense that I am “like” LeBron James.
It is not
technically-vigorous reasoning, and I could not guard LeBron with a squad of
Marines by my side.
Then the IRS
said that it would respect a single-member LLC as the employer of record,
rather than going up the ownership chain to whoever the sole owner is. The IRS
would henceforth treat the single-member as a corporate employer for employment
taxes, although the single-member would continue to be disregarded for income
tax purposes (it is confusing, I know). The
IRS included exceptions, examples and what-nots, but they did not include one
that addressed LLC members directly.
The members-want-W-2s
school used this notice to further argue their position. You have the LLC
set-up a single-member subsidiary LLC and have the subsidiary – now considered
a corporate employer – issue W-2s to the members. Voila!
Let’s be
clear why people care about this issue: estimated taxes. People do not like paying
estimated taxes. It requires a chunk of money every three months. Members pay
estimated taxes. Members would prefer withholding. Withholding comes out of
every check, which is less painful, and don’t even talk about that three-month
thing.
The IRS has backed-off
the member/W-2 issue for a long time.
However the
IRS recently issued guidance that the above “parent-subsidiary” structure will
not work, and taxpayers have until August 1 to comply. The IRS did this by
firing its big guns: it issued Regulations. There are enhanced disclosure requirements
when one takes a position contrary to Regulations, and very few practitioners care
to do that. It is considered a “call me to book the audit” disclosure.
The IRS has
given these advisors little more than two
whole months to rope-in their errant LLC clients.
Although the
window is tight, I agree with the IRS on this one, except for that two-month
thing. They feel they have floated the change long enough to alert
practitioners. I would have made it effective January 1, 2017, if only for
administrative ease.
Still this
is an area that needs improvement. While the IRS is concerned that member W-2s
may lead to members inappropriately participating in benefit plans, there is
also mounting demand for member withholding.
Perhaps the
answer is to allow withholding but to use something other than a W-2. One could
design yet another 1099, and the member would attach it to his/her tax return to
document the withholding. Any additional paperwork is a bother at the LLC
level, but it would just join the list of bothersome things. The members
wanting withholding would have to employ their powers of persuasion.
Sounds like the
beginning of a compromise.
