Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
Today’s article discusses the instances in which a partnership or limited liability company treats its partners or members as employees even though tax law prohibits this practice.
When is a Partner (Title)
We all have pet peeves, and perhaps I’m getting grumpy as I age, but I seem to have more than my share as it relates to the manner in which accounting data is presented. I’ve rarely been accused of being pedantic, but maybe the tag fits with the subject of this article. The subject of this column is not only a pet peeve, but is grounded in law…tax law. And, even though it starts with tax law, it is a subject that affects every partnership and limited liability company doing business as a partnership. Today’s article discusses the instances in which a partnership or limited liability company treats its partners or members as employees.
First, a few disclaimers and explanations. For purposes of brevity in this article, the term ‘partner’ will also mean a ‘member’ in a limited liability company. Additionally, the LLC members referenced herein are those assisting in management and/or providing services to the limited liability company. Finally, with the prevalence of limited liability companies today, I would encourage all readers to scour their LLCs taxed as partnerships for this potential red flag.
Without further preamble, how many times have you seen a individual receive a W-2 for wages from a partnership in which he is a partner? How many of you have actually been responsible for issuing said W-2? Well, don’t freak out just yet, but tax law prohibits this practice. In this installment, we’ll discuss this seemingly obscure law, and how you, as a practitioner or the person responsible for paying partners or accounting for partnerships should be treating partner compensation.
A Long History Made Short1
Partnerships have been around a very long time; as a result, the ever-changing laws and pronouncements have morphed through the years. One thing that hasn’t changed as it relates to partnerships is the fact that courts have always ruled that a partner cannot also be an employee. Cases as far back as those interpreted under the 1939 tax code have supported and maintained this law.
Wilson and Armstrong
One of the first modern court cases considering this conundrum was the Wilson case in 1967. But, the Wilson decision was centered on the issue of whether a partner could exclude the value of meals and entertainment from income, not whether a partner could be paid wages as an employee. The court ruled that, since a partnership could not be the employer of a partner, the value of the meals and entertainment could not be excluded from a partner’s income. Strangely similar, the 1968 Armstrong case brought almost identical case facts to bear (i.e. the meals and entertainment argument), and, not surprisingly, the results were no different than the Wilson ruling. The net result of these two rulings? A partner cannot be treated (or paid) as an employee.
Revenue Ruling 69-184
In 1969, the IRS publicly ruled on this matter with the issuance of Revenue Ruling 69-184. This ruling states that: a) partners of a partnership are not employees of the partnership for purposes of FICA (Social Security tax), FUTA (federal unemployment tax), and federal income tax withholding, and b) a partner devoting time and energy conducting the partnership’s trade or business is considered self-employed and is not an employee.
While there were several cases in the intervening period, the next real challenge to the employee-partner issue was the 2012 Reither case. In this case, the issue before the court was whether the members in an LLC, taxed as a partnership, could avoid self-employment tax on their share of net income because they paid FICA and Medicare on the wages they received from the LLC. As expected, the court cited Revenue Ruling 69-184, and held that the members attempted to defeat the payment of self-employment tax on all of the net income as opposed to just that associated with their W-2 wages. In part, the court decision said, “…they should not have treated themselves as employees” [emphasis added].
“What is our Exposure?”
Recently, my firm was chosen to act as advisor to a group of restaurants. As we began to review the financial statements and income tax returns, we noted the two primary limited liability members responsible for operating and managing the restaurants were being paid salaries. We immediately advised them that tax law prohibited this practice. After they picked their jaws up off the floor, they asked the inevitable question, “What is our exposure?”
(If you have interest in following along, I’ve included a screen shot of Form K-1 from a partnership tax return. Take a look at box 14. You will see it is entitled “Self-Employment Earnings/Loss.” If there is a number here, chances are good that the partner’s share of income is being subjected to self-employment tax.)
To answer their question, I looked at their Forms K-1 to determine if the tax preparer had classified their K-1 income as “self-employment income.” In this case, it was clear that the tax preparer had indeed subjected all of their K-1 net income to self-employment taxes. This meant that the LLC owners had reported their share of the restaurant’s income as self-employment income, and paid FICA and Medicare (the self-employment components) on their wage income as well. After I informed them of this fact, their next question, a bit more emphatically, was, “So, if we paid self-employment tax on our income from the restaurant, and we paid FICA and Medicare on our wages, do we even have any exposure?” I told them that by paying self-employment tax on their restaurant income (from Form K-1) and FICA/Medicare on their wages, they had minimized their exposure to tax, penalty, and/or interest, but hadn’t eliminated it. The bigger issue is that by not following the law, they opened themselves up to IRS scrutiny.
I know what you’re thinking, but before you write me off as some pocket protector-wearing boor, let me pose the following hypothetical analogy. If a police officer pulls you over for running a red light, and as he approaches your car, he sees you’re not wearing your seatbelt, you’re in for two violations, right? And, if you hadn’t run that red light, the seatbelt violation might never have been noticed, or certainly cited, right? Then, by extension and more on point, it is always a wise decision not to give the IRS a reason to look at your books, records, and tax returns, right? Why? Well, other than the obvious, let’s say you overlooked your client paying wages to a partner, and subsequently, the IRS issues an audit notice to investigate these practices and “review other pertinent data.” What else are they going to find? Are your books truly inscrutable?
While it may appear I’m making a hyper-technical point, I assure you, this is not a ‘Chicken Little’ moment. It is quite real and a strangely prevalent issue, and your clients will thank you for insulating them from this unnecessary scrutiny.
In the example above, I indicated the exposure to my new client for misreporting self-employment income as wages on Form W-2 was minimal. Generally, that is correct. However, what if the partner, via his erroneous classification as an employee, participated in the cafeteria plan? As you probably know, employees can exclude from their income certain employer-paid benefits like health insurance; however, the same is not true for partners. Insurance and other fringe benefits paid on behalf of a partner are considered income to that partner. And, just like all income to a partner, these payments are subject to self-employment tax and are fully taxable for federal and state income tax purposes. The point is, if a partner is treated as an employee, and participates in those benefit plans designed only for actual employees, the partnership has opened itself up to unnecessary and potentially costly liability.
Another Technical Caveat…Another Real-Life Example
We have a client in the software industry with an incredibly progressive business and human resources profile. That is, while their growth strategies are quite aggressive and successful, their ability to attract and maintain human talent is impressive as well. One of the techniques they employ is offering ownership of the limited liability company to key employees. This does two things: a) it incents the employee to perform at such a level to potentially obtain a piece of the company in addition to his compensation, and b) the company now has a ‘hook’ into this employee making it more difficult for the employee to leave knowing he may be giving up the value of the company units.
This would appear to be a great situation for the employee and company alike, right? Sure, but here comes the caveat. When the very first employee accepted this offer, it gave him a 2% ownership position in the company. This is certainly not much in terms of influencing policy or culture, but 2% plus a salary and great benefits is a desirable package. Is there any downside here? What about the issue of a partner who provides services to the company not being able to receive wages? Surely this doesn’t apply to an employee with such a small ownership interest? Sorry, but you bet it does. This employee is now a partner, and as such, his compensation went from that of employee wages to payments made to partner. This 2% owner now had to make his own quarterly tax estimates of FICA, Medicare, and federal/state income taxes. In addition, his benefits package, previously excluded income now became additional income to him.
To say the least, this was a lot for both the employee-cum-partner and the founders of the company to swallow. Yet, in the end, the newly minted 2% partner was more than happy to brush aside his new taxation issues to have an ownership position.
1-Noel P. Brock, CPA, JD. “Treating Partners as Employees: Risks to Consider.” Journal of Accountancy. American Institute of Certified Public Accountants, August 1, 2014. Web. May 12, 2016.