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Proper Tax Treatment of LLC Members’ Compensation May Not Be What You Think

August 21, 2015

The proper way to compensate LLC members for their services.

It’s not unusual for limited liability companies (LLCs) to treat members, who work for the company, as employees. They pay them wages, provide them with W-2s and withhold payroll taxes, just like they do for any other employee. But unless an LLC elects to be taxed as a corporation, this treatment violates federal tax rules.

The proper way to compensate LLC members for their services is through “guaranteed payments,” which are subject to self-employment (SE) tax. According to the IRS, LLC members who are active in the business also are subject to SE tax on their distributive shares of the LLC’s income, regardless of whether that income is distributed.

Case in Point

In a 2014 Chief Counsel Advice (CCA) memorandum, the IRS rejected the argument that an LLC’s members should be treated like S corporation shareholder-employees for tax purposes. S corporation shareholders who work in the business must receive “reasonable compensation” in the form of wages and are treated as limited partners with respect to their distributive shares. Limited partners are exempt from SE tax on their distributive shares (except for guaranteed payments).

The subject of the CCA was an investment management company, organized as an LLC, that provided a variety of professional services to a family of funds. These services were performed by the LLC’s members, who worked in the business full-time, receiving wages and W-2 forms.

The IRS concluded that, because the LLC was a partnership for tax purposes, it was required to treat its members as partners, not S corporation shareholders. Therefore, they should have been compensated with guaranteed payments, which are subject to SE tax. The IRS also found that the members — who performed extensive services for the LLC in that capacity — did not act as limited partners, so their distributive shares were subject to SE tax as well.

The CCA doesn’t necessarily preclude treatment of LLC members as limited partners, provided their role more closely resembles that of a passive investor. But when members perform substantial services as part of the LLC’s business, the IRS will take the position that their distributive shares are subject to SE tax.

Is Your LLC Treating Members’ Compensation Properly?

If your LLC hasn’t elected to be treated as a corporation for tax purposes and you’re treating members as employees, these members could be at risk for back taxes and penalties. For help alleviating the risk or other information about the tax impact of entity structure, please contact us.

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