Service Members Treated as Employees of a Limited Liability Company? Better Think Twice About That!

Many times over the years I have run across limited liability company (LLC) documents that refer to and classify a service member of a limited liability company as an employee.

This situation often arises where a LLC has a key employee, whom the LLC wants to reward by granting an equity interest in the LLC pursuant to an “employment” agreement. This key “employee” now has an equity interest in the LLC. But the LLC keeps on paying the new member as an employee in line with the traditional withholding for wages and other payroll-related taxes. I have seen this so much recently that I was beginning to think the law had changed from my memory of Rev. Rul. 69-184 where the IRS ruled that a partner of a partnership may either be a partner in a partnership or an employee of a partnership for employment tax purposes, but not both.

I’m happy to say (from a memory standpoint) that the IRS has not changed its view in all these years. The so-called “employee” should be reporting distributions received as a member (or partner of a partnership). The member receives a K-1 and not a W-2, meaning that the member is responsible for reporting, withholding and remitting all of the applicable compensation-related taxes and not just the employee’s portion which occurs in the employer/employee situation. All of the ramifications of this are beyond the scope of this blog.

There are several ways of dealing with this situation, but I will mention only two. Perhaps the easiest way would be to provide for “guaranteed” payments as provided under Section 707(c) of the Internal Revenue Code. This is deemed compensation for which the member includes as income and the LLC deducts—but just not as “salary.” The member would still be required to do his own withholding and remitting, being treated much as an independent contractor for these payments. Another way would be for the LLC to elect to be taxed as a S-corporation where the member could receive a salary in addition to any S distributions. But the S-corporation option brings up other issues beyond the scope of this blog.

If you run a LLC that fits under this factual scenario, the best thing you can do is to see your CPA to figure out how to rectify the situation from both company and member standpoints.

Michael W. Margrave

Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.