LLC Members and W-2s

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.

Getting The IRS To Believe A College Student Paid For … College

We can argue whether it is a good thing that so many economically-related transactions are reported to the IRS.

It is not just the drag on the economy - which would include practitioners like me, I suppose. It has also allowed the IRS to increasingly delegate its compliance responsibilities to computer algorithms, often functioning without human eyes sparing a glance at the endless notices the IRS sends every year.

And that sets up the problem.  

You see, the notice assumes that you are wrong, and the IRS will likely revise your account – and bill you - should you not reply. That means that you are spending time resolving the matter, or you are sending the notice to me and I am spending time. You and I are being deputized as ad hoc IRS employees.

Personally I want a paycheck and retirement benefits.

This arrangement works fine as long as there is a balance. You agree not to send works of fiction to the IRS and they agree not to contact you like a kid in college wanting money.

That balance is increasingly a thing of the past. Perhaps as a consequence, I am reading or hearing more often that taxpayers should be able to sue the IRS for professional fees incurred with these notices. I am not certain if that means that my client would pay me and then sue, or whether I would sue to receive my fee, but you get the idea. It would be a “reverse penalty” on the IRS. 

I am looking at a pro se decision from the Tax Court. As we have discussed before, “pro se” means the taxpayer is representing himself/herself. It does not technically mean there is no tax practitioner present (for example, I can represent a client in a pro se case), but it probably does mean that there is not a lot of money at issue.

Angela Terrell was a college student. During 2010 and 2011 she was attending Hampton University in Virginia. In the fall of 2010 she registered for the 2011 spring semester. In November, 2010 the University billed her $2,460 for the upcoming semester. In January, 2011 they billed an additional $1,230.

She was borrowing to go through school. In January, after the add/drop period ended, her student loan released $10,199 directly to the university. She paid her tuition and used the rest for living expenses.

Let’s go to the end of the year. The university sent a 1099 for 2011 (technically, a Form 1098-T, but we are on a roll). It showed $1,180 (the $1,230 billed less fees of $50). It did not show what she actually paid.

COMMENT: This reporting was allowable that year.

Angela filed her 2011 tax return and claimed the American Opportunity credit, one of the education credits in the Code. She claimed $2,500.

Wouldn’t you know the IRS sent her a notice? They saw the $2,500. They also saw the 1099 for $1,180.  

The IRS disallowed her credit – in full. They did not even spot her the $1,180.

Surely someone at the IRS would recognize what happened and close the file.

Perhaps in a galaxy far away. In our galaxy Angela and the IRS went to Tax Court.

Did I mention that Angela was a COLLEGE student?

She submitted an account statement from the University – on official letterhead – detailing her tuition charges and payments.

The IRS argued that the 1099 said $1,180, she provided a different number and consequently they could not verify the credit. There was nothing more to see.

Does it sound to you like the IRS even listened to her? 

Here is the Court:

The only dollar amount appearing on that form … is in the box that shows the ‘amounts billed’ for tuition during calendar year 2011. The amount billed to petitioner during 2011 does not control the size of her credit; the relevant number is the qualified tuition that she actually paid during 2011. The Form 1098-T has no entry in box 1, which was supposed to show ‘payments received’ for qualified tuition.”

The Court decided in her favor.

Angela’s case looks very much like the IRS pursuing a frivolous argument, not to mention the inability of IRS machinery to resolve a “duh”-level tax issue at the earliest possible point of contact. Reverse the situation and the IRS would not hesitate to hit you with every penalty imaginable.

Splitting With The IRS Over Insurance

I am reading a case where the Tax Court just entered a “partial” summary judgement. This means that at least one issue has been decided but the remaining issue or issues are still being litigated.

And I think I see what the attorneys are up to.

We are talking about split-dollar life insurance. 

This had been a rather humdrum area of tax until 2002. The IRS then issued new rules which tipped the apple cart and sent planners scrambling to review – and likely revise – their clients’ split dollar arrangements (SDAs). I know because I had the misfortune of being point man on this issue at a CPA firm. There is a certain wild freedom when the IRS decides to reset an area of tax, with revisions to previous interim Notices, postponed deadlines and clients who considered you crazed.

To set-up the issue, a classic split dollar arrangement involves an employer buying a life insurance policy on an employee. The insurance is permanent – meaning cash value build-up - and the intent is for the employee to eventually walk away with the policy or for the employee’s estate to receive the death benefits. The only thing the employer wants is a return of the premiums it paid.

Find a policy where the cash value grows faster than the cumulative premiums paid and you have a tax vehicle ready to hit the highway. 

Our case involves the Morrissette family, owners of a large moving company. Grandmom (Clara Morrissette) had a living trust, to which she contributed all her company stock. She was quite concerned about the company remaining in the hands of the family. She had her attorney establish three trusts, one for each son. The sons, trusts and grandmom then entered into an agreement, whereby each son – through his trust – would buy the company stock of a deceased brother. If one brother died, for example, the remaining two would buy his stock. In the jargon, this is called a “cross purchase.”

This takes money, so each trust bought life insurance on the two other brothers.

This too takes money, which grandmom forwarded from her trust.

How much money? About $30 million for single-premium life policies.

Wow.

Obviously the moving company was extremely successful. Also obviously there must have been a life insurance person celebrating like a madman that day.

The only thing grandmom’s trust wanted was to be reimbursed the greater of the policies’ cash value or cumulative premiums paid.

Which gets us to those IRS Regulations from back when.

The IRS had decreed that henceforth SDAs would be divided into two camps:

(1) The employee owns the policy and the employer has a right to the cash value or some other amount.

This works fine until the premiums get expensive. Under this scenario the employee either has income or has a loan. Income of course is taxable, and the IRS insisted that a loan behave like a loan. The employee had to pay interest and the employer had to report interest income, with whatever income tax consequence followed.

And a loan has to be paid back. Many SDAs are set-up with the intent of the employee walking away someday. How will he/she pay back the loan at that time? This is a serious problem for the tax planners. 

(2)  The employer owns the policy and the employee has a right to something – likely the insurance in excess of the cash value or cumulative premiums paid.

The employee has income under this scenario, equal to the value of the insurance he/she is receiving annually. The life insurance companies publish tables, so practitioners can plan for this number.

But this leaves a dangerous possible tax issue: what happens once the cash value exceeds the amount to which the employer is entitled (say cumulative premiums)? Let’s say the cash value goes up by $250,000, and the employer’s share is met. Does the employee have $250,000 in income? There is a lot of lawyering on this point.

The Court decided that the grandmom had the second type – type (2) of SDA, albeit of the “family” and not the “employer” variety. The sons’ trusts had to report income equal the economic benefit of the life insurance, the same as an employee under the classic model.

This doesn’t sound like much, but the IRS was swinging for a type (1) SDA. If the sons’ trusts owned the policies, the next tax question would be the source of the money. The IRS was arguing that the grandmom trust made taxable gifts to the sons. Granted the gift and estate tax exclusion has been raised to over $5 million, but $30 million is more than $5 million and would trigger a hefty gift tax. The IRS was smelling money here.                 

The partial summary was solely on the income tax issue.

The Court will get back to the gift tax issue.

However, having won the income tax issue must make the Morrissette family feel better about winning the gift tax issue. According to the IRS’ own rules, grandmom’s trust owned the policies. What was the gift when the trust will get back all its money? The attorneys can defend from high ground, so to speak.

And there is one more thing.

Grandmom passed away. She was already in her 90s when the sons’ trusts were set up.

She died with the sons’ trusts owing her trust around $30 million.

Which her estate will not collect until the sons pass away or the SDAs are terminated. Who knows when that will be?

And what is a dollar worth X years from now? 

One thing we can agree on is that it not worth a dollar today.

Her estate valued the SDA receivables at approximately $7 million.

And the IRS is coming after her. There is no way the IRS is going to roll-over on those split dollar arrangements reducing her estate by $23 million.

You know the IRS did not think this through back in 2002 when they were writing and rewriting the split dollar rules.

Now You Say You're Leaving California

I have stumbled into our next story of outrageous state tax behavior.

I was skimming (quickly, trust me) the Supreme Court decision in Franchise Tax Board v Hyatt. It involves a resident of Nevada who sued California. California invoked sovereign immunity, a legal doctrine arising from the era of royalty and asserting that the king can do no wrong and is therefore immune from legal action.

Handy, if you are the king  … or any of California’s countless government agencies.

This case goes back a long way. Gilbert Hyatt moved from California to Nevada in the early 1990s. More specifically, he said he moved in September, 1991. California says he moved in April, 1992.

COMMENT: Sounds like a “poe-tae-toe” versus “poe-taw-toe” moment, on first impression.

California said this meant he owed the state $10 million in taxes, interest and penalties from patent income.

            COMMENT: Of course.

Problem is that the California Franchise Tax Board took some … questionable steps in developing their case against Hyatt:

·        They went through his mail

·        They rifled through his garbage

·        They contacted third parties, including estranged family and people who did not have his best interests at heart

He brought suit … in Nevada courts. There was a previous Supreme Court decision (Nevada v Hall) that allowed a private citizen to bring legal action against a second state, without the second state's consent.

The jury verdict was almost $500 million in damages and fees.

Then California appealed, arguing that Nevada's law limited damages in similar suits against its own agencies to $50,000.  

California got the Nevada Supreme Court to reduce the verdict to $1 million. The Court reasoned that California went a bit further than Nevada would allow, so the $50,000 cap did not apply.

COMMENT: Folks, we need our own state. We could do whatever we want and then hide behind sovereign immunity, hakuna matata or whatever other multi-syllabic nonsense springs to mind.

California was still not happy, arguing that Nevada was exhibiting a “policy of hostility.”      

California appealed to the U.S. Supreme Court, arguing that the Full Faith and Credit Clause of the Constitution applied. The Supreme Court agreed, using words such as "comity" to reduce the damages to $50,000.

My thoughts?

I allow that there may have been a legitimate disagreement at the very beginning of this whole matter. Let’s say that you move most, but not all, of your possessions to another state. You leave some furniture there, as the realtor said that it would help to show and sell the house. You then have a California tell you that you had not really moved until the last chair and framed art had left the state. What are you going to do: sue? You are not moving back to California just to sue. That means that you are suing from another state and California is going to invoke the doctrine of the king’s pantaloons or whatever.

Still, doesn’t it feel … wrong … to have California going through your mail and trash, peering through your windows and contacting estranged relatives? This is behavior beyond the pale. We are not talking about homeland security, where some argument might possibly be made to excuse the king’s overreach. 

We are only talking about taxes.