For federal income tax purposes, a person may not be treated as both a “member” and an “employee” of a limited liability company (an “LLC”). This client alert discusses: (a) the alternatives that may be used to award LLC membership interests to an individual while preserving the ability to treat the individual as an employee of the LLC; and (b) the benefits that may be provided to an employee that are unavailable to a member who provides services to the LLC.
Except where otherwise noted, references to an LLC are to an LLC with more than one member that is taxable as a partnership for federal income tax purposes. If an individual owns 100% of the equity interests in an LLC that operates an active business, the income of the business generally must be reported by the owner on the owner’s individual income tax return as self-employment income from a sole proprietorship.
Treatment as an Employee
- A member in an LLC that provides services to the LLC (a “service member”) may not be treated as an employee for federal income tax purposes. Consequently, the service member will not receive a W-2 reflecting the service member’s wages paid by the LLC but instead will have such compensation reflected in a K-1 as a “guaranteed payment.”
- A service member must pay both the employee and employer portions of FICA taxes (including OADSI and Medicare payroll taxes). The effective rate on the combined FICA taxes is 15.3% on compensation up to a wage base cap of $106,800 (as adjusted) and 2.9% on compensation above $106,800. The service member may deduct 50% of any FICA taxes paid.
- Three alternative structures may be available to permit individuals to own interests in an LLC and to be treated as employees of the LLC for federal income tax purposes: (i) use of an employee leasing company; (ii) formation of individually owned S corporations; and (iii) ownership through a tiered LLC structure.
Employee Fringe Benefits
- Certain employee fringe benefits that are excludible from the income of an employee are includible in the income of a service member.
- With respect to service member income, certain items are deductible individually by the service member, certain items are deductible subject to certain limitations; and certain items are not deductible.
- A service member may not be a participant in a “cafeteria plan” sponsored by the LLC.
Treatment as an Employee
A member in an LLC that provides services to the LLC (a “service member”) may not be treated as an employee for federal income tax purposes. Payments of amounts that are in the nature of “wages” are classified as “guaranteed payments” to a service member. Guaranteed payments are reported to the service member on the K-1 issued by the LLC (and are deductible by the LLC) and must be treated as self-employment income by the service member for federal income tax purposes. Self-employment income is subject to FICA tax, which has two components, OASDI and Medicare payroll taxes. OASDI payroll tax is owed at a rate equal to 12.4% on the first $106,800 (the 2010 threshold, which generally increases each year based on an average wage escalation factor) of self-employment income, and Medicare payroll tax at a rate equal to 2.9% on all self-employment income without any threshold limit (with 50% of the aggregate FICA payroll tax paid treated as paid by an “employer” and therefore deductible as a business expense). Because the LLC is not obligated to pay the “employer” half of FICA with respect to a “guaranteed payment” to a service member, the LLC may make an additional payment to the service member equal to the FICA payroll taxes the LLC would owe if the service member had been permitted to be an employee. The service member may deduct these amounts as the “employer” portion of FICA taxes, putting the LLC and the member in the same economic after-tax position as wages paid to an employee who is liable for only one-half of the FICA taxes.
For example, assume that an individual is paid $50,000 as compensation in a year. If the individual is treated as an employee, then the individual will be required to pay $7,650 in aggregate FICA payroll taxes (which will be withheld by the employer). The employer also is required to pay an additional $7,650 as the “employer” portion of FICA taxes (increasing the total amount of payments by the employer to $57,650), and the employer may deduct these amounts as business expenses. In contrast, if the individual is a service member of an LLC (rather than an employee), then the individual is required to pay the entire $15,300 in FICA taxes and may report $7,650 as a deductible expense on the individual’s federal income tax return (as the “employer” portion of FICA taxes). If the LLC pays the individual an additional $7,650 (increasing total compensation to $57,650), the LLC may deduct this additional amount as a “guaranteed payment.” In either case, the LLC makes total payments equal to $57,650 and has total deductions equal to $57,650. As an employee, the individual has net cash of $42,350 (ignoring income tax obligations and after payment of $7,650 as the “employee” portion of FICA taxes) and has net income equal to $50,000. As a service member, the individual has net cash of $42,350 (ignoring income tax obligations and after payment of $15,300 as the “employee” and “employer’ portions of FICA taxes) and has net income equal to $50,000 ($57,650 minus the deduction of $7,650 for the “employer” portion of FICA taxes). Thus, the individual also has the same net after-tax position in either case.
In addition to the obligation to pay the “employer” portion of FICA payroll taxes, a service member may not be eligible for “W-2” income tax withholding treatment. The member must file quarterly estimated tax payments with respect to both federal income taxes and FICA payroll taxes to avoid penalties related to taxes owed for the year. While avoiding withholding might be beneficial to certain “employees” of the LLC, most individuals prefer the convenience of regular income tax withholding rather than saving a portion of each check and paying an estimated amount four times a year, especially if the member receives a relatively low level of compensation from the LLC.
In addition to guaranteed payments, a service member must treat all allocations of ordinary income from the LLC (but not capital gain) as self-employment income. Thus, if the LLC has net business income (i.e., income from operations in excess of all deductions and expenses, including the deduction for any guaranteed payments), the service member’s share of this income is treated as self-employment income. If the service member otherwise has compensation income, including guaranteed payments from the LLC in excess of the wage base cap described above ($106,800, as adjusted annually), then this treatment only increases the members taxes by the 2.9% Medicare tax (50% of which is deductible, reducing the effective tax rate). On the other hand, for a lower-wage service member, these additional income allocations are subject to both the 12.4% and 2.9% tax provisions. These additional taxes on allocations of ordinary business income might be avoided entirely through the alternatives discussed below.
An LLC might use one of three alternative strategies to permit all service providing owners to be classified as employees for federal income tax purposes:
Alternative 1 – Employee Leasing Company. The first approach involves forming a separate employee leasing company to employ the workers who own equity interests in the LLC and lease these workers to the LLC. The leasing company generally is taxed as a C corporation, but the payments to the leasing company are designed to minimize taxable income to the leasing company by closely matching the leasing company’s expenses (generally limited to wages and benefit payments such as health insurance premiums), resulting in little (or when taking the most aggressive tax position, zero) income tax owed by the leasing company. Certain states, however, have expressed objections to this approach (or even prohibit this structure altogether). In addition, this approach does not eliminate completely the risk that income allocated to members that provide services to the LLC must include all ordinary income allocations as self-employment income.
Alternative 2 – Separate S corporations. Under this alternative, each member of the LLC that provides services to the LLC holds the membership interests through an S corporation owned 100% by the member. The service provider may be an employee of the LLC because the S corporation is treated as the member rather than the individual. This structure requires the creation of multiple S corporations which are subject to annual filing fees. In addition, a member no longer is able to deduct certain types of loss allocations (generally losses resulting from guaranteed debt or qualified nonrecourse indebtedness on real property) because the losses flow through the S corporation.
Alternative 3 – Tiered LLC Structure. The final alternative involves admitting the individuals who provide services to an LLC (the “Operating LLC”) as members of a separate LLC (the “Investment LLC”). Under this structure, the Investment LLC owns membership interests in the Operating LLC rather than the service members owning membership interests in the Operating LLC. The Operating LLC and the Investment LLC each will be treated as a separate partnership for federal income tax purposes. This structure generally is available only if the Operating LLC has separate investors that do not provide services to the Operating LLC. The members of the Investment LLC can be employees of the Operating LLC because they are treated as “partners” in the Investment LLC rather than as “partners” of the Operating LLC which employs them. The Investment LLC should have a separate business purposes (i.e., a purpose other than avoidance of federal income tax) for its existence to justify its formation as a separate partnership for federal income tax purposes. Generally, the desire to centralize the management of the interests owned by these employees is sufficient business justification for the structure. If available, this alternative avoids the limitations of the other alternatives (i.e., the disfavor of leasing companies by states under Alternative 1 and the inability to take certain losses, as well as the cumbersome structure and cost of multiple S corporations, under Alternative 2).
Employee Fringe Benefits
Income Inclusion for Certain Employee Fringe Benefits
In general, a service member in an LLC cannot exclude from income amounts paid on behalf of the member as follows:
- amounts paid under an accident and health plan;
- amounts paid by an employer to an accident and heath plan;
- up to $50,000 of group-life insurance on an employee’s life; and
- meals or lodging furnished for the convenience of an employer.
In contrast, amounts paid by the LLC with respect to these fringe benefits on behalf of an employee are excludible from the employee’s income. With respect to health insurance, deductions available to the service member on the member’s individual income tax return generally offset this income, putting the service member in the same net after-tax position as an employee. Other fringe benefits, however, may be non-deductible or deductible subject to certain limits (such as the limitations imposed on miscellaneous itemized deductions). Thus, the service member might not be in the same after-tax position as an employee with respect to payments for these fringe benefits.
Participation in a Cafeteria Plan
A service member may not participate in a “cafeteria plan” (also commonly known as flex-spending accounts) because the member is not an employee of the company. Specifically, the service member cannot use “pre-tax” dollars to pay for expenses covered by the company’s cafeteria plan, such as day care expenses and non-reimbursed health care expenses. The service member generally will not be entitled to any deductions on the member’s individual income tax return with respect to these expenses. Thus, the service member generally will not be in the same after-tax position as an employee with respect to the items covered by a cafeteria plan.
Please contact Richard E. Aderman or Michael J. Schaller if you have any additional questions or concerns.
Pursuant to regulations governing practice before the Internal Revenue Service, unless expressly stated otherwise, any tax advice contained herein cannot be used, and is not intended to be used, by a taxpayer for (i) the purpose of avoiding tax penalties that may be imposed on the taxpayer under the Internal Revenue Code or (ii) the promotion or marketing of any tax-related matter or program.