Compensation and Fringe Benefits of Partners and LLC Members
With the proliferation of Limited Liability Companies (LLC) as the entity of choice for new businesses, and since the vast majority of LLCs are taxed as partnerships, compensation for LLC members working on behalf of the LLC, and who are treated as members/partners can be problematic.
by John Lohman, CPA
Typically, an individual would prefer a salary or wage with the business paying half the payroll taxes as opposed to receiving guaranteed payments on which he must pay self-employment tax (SE). Partners/members pay SE tax on partnership income and guaranteed payments, which is the equivalent of FICA and Medicare on an employee’s wages.
The Internal Revenue Service has consistently held that a partner in a partnership cannot be an employee of that partnership. An LLC taxed as a partnership is subject to this rule. Unfortunately, paying a partner as an employee could lead to some unpleasant results under audit.
Some issues that can result from treating a partner/member as an employee include:
- FICA taxes may be underpaid if the partner does not pick up all income, including employer and employee FICA, which should be included as guaranteed payments.
- FICA taxes may be overpaid if a partner has other SE losses that may have offset the SE income on which the FICA withholdings were based.
- The LLC/Partnership’s tax deductions may be overstated with regard to payroll taxes.
- DPAD deductions flowing from the LLC/partnership to the members may be incorrect.
- State tax apportionments may be incorrect.
- Payroll and payroll tax deductions will be significantly changed if audited by the IRS.
Some fringe benefits are allowed to include partners, who are treated as employees only for the purposes of that fringe benefit administration, while other fringe benefits are prohibited to include partners/members. Here is a breakdown.
- Partner treatment (not allowed as a benefit; if paid, must be treated as a guaranteed payment):
- Cafeteria plans. A plan can be disqualified completely by including a partner, thus losing the tax benefits gleaned by adopting the plan.
- Employee achievement awards
- Group term life insurance
- Disability insurance
- Medical reimbursement plans
- Health, accident and long-term care insurance premiums
- Health savings accounts
- Meals or lodging provided for the convenience of the employer
- Qualified transportation fringes
- Qualified adoption assistance programs
- Qualified transportation fringe benefits
- Qualified moving expense reimbursements
Some fringe benefits can be provided to a member/partner with no income recognition required by the member and the associated costs being treated the same as if provided to an employee.
- Qualified dependent care assistance program. This is not the child care set aside found in cafeteria plans.
- Qualified education assistance programs
- De minimis fringe benefits (small benefits all employees enjoy such as free coffee or occasional personal use of phones and office equipment)
- Qualified retirement planning services
- Working condition fringe benefits (i.e. business use of company vehicles, professional dues, etc.)
- No-cost additional services
- Qualified employee discounts
- On-premise athletic facilities
One way an LLC can avoid making guaranteed payments is to elect to be taxed as a corporation or S corporation. If such election is made, the owners of the LLC are allowed to be employees paid a W-2 salary or wages. Those who own more than 2% of S corporations are subject to special health insurance reporting rules. This structure has other significant tax consequences and should be carefully evaluated before an election is made. For instance, Michigan does not recognize the LLC corporate election which can lead to problems with unemployment tax administration.
It is not uncommon for key employees or others providing services during an LLC start-up to be awarded an unvested interest in the partnership or LLC for their services. If certain conditions are met, the profits interest is valued at zero and the recipient does not have to recognize income at the time received. One of these conditions is that the recipient is subsequently treated as a partner and picks up his/her share of the entity’s income. Since the IRS does not allow a partner to be an employee, continuing to pay this person as an employee would potentially violate the IRS requirements for non-recognition treatment. If the membership interest awarded does not qualify for non-recognition, then it is valued (and taxed) when vested, at which time the value may be significant rather than zero.
If you have questions about partner/member compensation or fringe benefits, please contact DGN, LLC.