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Treating LLC Members as Employees

For an LLC that’s electing to pay tax as an S-Corporation or C-Corporation, it is perfectly fine to treat the members of the LLC as employees. Where it goes awry is when LLC members of partnerships or disregarded entities are treated as employees, and...

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For an LLC that’s electing to pay tax as an S-Corporation or C-Corporation, it is perfectly fine to treat the members of the LLC as employees.  Where it goes awry is when LLC members of partnerships or disregarded entities are treated as employees, and this happens to be a growing trend.

For the most part, payroll companies will sell their payroll services to LLCs, never bothering to ask them their tax election.  But the law is clearly stated –  TD 9766 points out that partners in partnerships (or LLCs electing partnership status) and sole-proprietorships (or single-member LLCs as disregarded entities) cannot be treated as employees.

The important question is this: What happens to the employee that is given interest as a partner in an LLC?  That would nullify the way that they are paid, and any wages paid to them would have to be considered guaranteed payments to partners.  

From the IRS’s viewpoint, a partner cannot be an employee.  Furthermore, the employee can no longer participate in benefit plans.  The reason for all of this is that partners and sole-proprietorships pay their FICA (self-employment tax) on their personal tax returns, not on a W-2 form.

Rev. Proc. 2001-43 addresses the receipt of the interest in a partnership, which is usually done in lieu of wages.  As long as certain conditions are met, then there is no taxable effect to the partner.  However, any partner that receives both a W-2 and a K-1 may not be in compliance with the safe harbor provisions in the Rev. Proc.

As I mentioned earlier, this problem is exacerbated by payroll company salespeople.  They simply sell payroll services to clients, never thinking of the tax election that the LLC has made, and that is where the problem begins for us.  How do we report wages paid to a disregarded entity?  We aren’t supposed to report them as wages, but if we don’t, the client pays FICA taxes on the amount twice.  

If we get the client’s information early enough, we can apply for a late S-Election and thereby allow for the wages paid.  But what happens when we miss the March 15th deadline?  Do we simply report these amounts as wages on the Schedule C or Form 1065? Although technically incorrect, when I come across this situation, I report the wages as an expense.  After all, I don’t want the client to pay income tax and FICA tax on the wages twice.

In summary, you need to educate those clients of yours who are paying themselves as employees, and who are disregarded entities.  


This Month’s Top Payroll Social Media Posts:

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