My recent column on the proper way of compensating the members (owners) of a limited liability company (LLC) generated a ton of e-mail from accountants, lawyers and other tax professionals throughout the country. While most supported this column's handling of the problem, everyone agreed that "the Devil is in the details," and that this has to be one of the murkiest areas in the entire federal Tax Code.
One of my respondents was Alan E. Weiner, a CPA with Long Island, New York-based accounting firm Holtz Rubenstein & Co. Weiner served on a committee of New York CPAs that helped shape that state's LLC law. According to Weiner, all members of an LLC (not just those owning more than 5 percent) are treated as "partners" for tax purposes and cannot receive deductible wages. "Any LLC member owning any percentage, no matter how small, should receive a Form K-1, not the Form W-2 you would use for employees," says Weiner.
If a member will receive a fixed amount of compensation (for example, $50,000 a year) irrespective of the income or loss of the LLC for the year, that is called a "guaranteed payment," which Weiner says is "similar to a salary which an employee receives" and is deductible by the LLC. However, if a working member receives 100 percent of the profits of the LLC business, not a fixed amount, that would not be a "guaranteed payment," since the compensated member receives nothing if there are no profits.
Weiner also points out that LLC members are not required to settle their distributive shares by year-end. "LLCs have up until the time for filing their tax returns--April 15 for a calendar-year LLC--to determine how the LLC's income should be allocated and reported," says Weiner. "That gives the members time to review the financial statements and determine how to allocate the income for tax purposes."
The self-employment tax area for LLCs is a difficult one, according to Weiner, because it is not clear exactly how LLC owners determine their self-employment income. In 1997 the IRS proposed regulations (never formally adopted and therefore not binding) saying that if an LLC member does not work for the LLC in excess of 500 hours during the LLC's taxable year, does not have authority to contract on behalf of the LLC, and does not have personal liability for the debts or claims against the LLC by reason of being a member, he or she is not subject to the self-employment tax on income allocated to the member. "But mathematically," says Weiner, "if the working members are allocated all of the income, there is nothing left for the passive investor and, therefore, with zero self-employment income, there is nothing for passive investors on which to be self-employment taxed."
Finally, Weiner says that an LLC cannot voluntarily withhold income taxes on amounts paid to a member. "What some LLCs do," says Weiner, "is set up a special internal account which is distributed to each member, based on what each member agreed to put into the special account, when quarterly estimated taxes are due, but this is not a voluntary 'withholding tax.' "
IRS Publication 3402, "Tax Issues for Limited Liability Companies," available from the IRS' Web site, goes into these issues in more detail, but Weiner points out that neither this nor any other IRS publication should be used as a substitute for professional advice in this fast-changing and difficult area of tax law.
Cliff Ennico is host of the PBS television series MoneyHunt and a leading expert on managing growing companies. His advice for small businesses regularly appears on the "Protecting Your Business" channel on the Small Business Television Network at www.sbtv.com. E-mail him at email@example.com.
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