For federal income tax purposes, a person may not be treated as both a "member" and an "employee" of a limited liability company (an "LLC"). This law bulletin discusses: (a) the alternatives that may be used to award LLC membership interests to an individual while preserving the ability to treat the individual as an employee of the LLC; and (b) the benefits that may be provided to an employee that are unavailable to a member who provides services to the LLC.
Except where otherwise noted, references to an LLC are to an LLC with more than one member that is classified as a partnership for federal income tax purposes. If an individual owns 100% of the equity interests in an LLC that operates an active business, the net taxable income of the business generally must be reported by the owner on the owner's individual income tax return as self-employment income from a sole proprietorship.
Treatment as an Employee
- A member in an LLC that provides services to the LLC (a "service member") generally is not permitted to be treated as an employee for federal income tax purposes. Consequently, the service member does not receive a W-2 reflecting the service member's wages paid by the LLC. Instead, the LLC is required to reflect such compensation as a "guaranteed payment" on the K-1 issued to the service member.
- A service member must pay both the employee and employer portions of Federal Insurance Contributions Act (FICA) taxes - including old age, survivors, and disability insurance (OADSI) and Medicare payroll taxes. A 15.3% FICA tax rate generally applies, and consists of two parts: (i) 12.4% on all compensation up to a compensation wage base cap ($142,800 as of 2021, as adjusted annually); and (ii) 2.9% on all compensation (uncapped). The service member may deduct 50% of any FICA taxes paid. An additional 0.9% Medicare tax generally applies to compensation in excess of $200,000 - or $250,000 for a joint return. The deduction for 50% of FICA taxes paid does not apply to the additional 0.9% Medicare tax.
- Three alternative structures may be available to permit individuals to own interests in an LLC and to be treated as employees of the LLC for federal income tax purposes: (i) use of an employee leasing company; (ii) formation of individually owned S corporations; and (iii) ownership through a tiered LLC structure.
Employee Fringe Benefits
- Certain employee fringe benefits that are excludible from the income of an employee are includible in the income of a service member.
- With respect to service member income, certain items are deductible individually by the service member, certain items are deductible subject to certain limitations, and certain items are not deductible.
- A service member may not be a participant in a "cafeteria plan" sponsored by the LLC.
Treatment as an Employee
A service member may not be treated as an employee for federal income tax purposes. Payments of amounts that are in the nature of "wages" are classified as "guaranteed payments" to a service member. Guaranteed payments are reported to the service member on the K-1 issued by the LLC - and are deductible by the LLC - and must be treated as self-employment income by the service member for federal income tax purposes. Self-employment income is subject to FICA tax, which has two components, OASDI and Medicare payroll taxes. OASDI payroll tax is owed at a rate equal to 12.4% on self-employment income up to the wage base cap - $142,800 as of 2021, which generally increases each year based on an average wage escalation factor - and Medicare payroll tax at a rate equal to 2.9% on all self-employment income without any threshold limit - with 50% of the aggregate FICA payroll tax paid treated as paid by an "employer" and thereby deductible as a business expense. An additional 0.9% Medicare tax is generally imposed on self-employment income in excess of $200,000 - or $250,000 for a joint return. That additional Medicare tax is not deducible by the service member as a business expense. Because the LLC is not obligated to pay the "employer" half of FICA with respect to a "guaranteed payment" to a service member, the LLC may agree to make an additional payment to the service member equal to the FICA payroll taxes the LLC would owe if the service member had been permitted to be treated as an employee (i.e., 6.2% of such amount up to the wage base cap and 1.45% of such amount uncapped). As noted above, the service member may deduct these amounts as the "employer" portion of FICA taxes, putting the LLC and the member approximately in the same economic after-tax position as wages paid to an employee who is not liable for the employer portion of the FICA taxes.
For example, assume that an individual is paid $100,000 as compensation in a year. If the individual is treated as an employee, then the individual is required to pay $7,650 in aggregate FICA payroll taxes - which are withheld on behalf of the employee by the employer. The employer also is required to pay an additional $7,650 as the "employer" portion of FICA taxes - increasing the total amount of payments by the employer to $107,650 - and the employer may deduct these amounts as business expenses. Similarly, if the individual is a service member of an LLC - rather than an employee - then the individual is required to pay the entire amount of $14,129 in FICA taxes (i.e., 15.3% of ($100,000 - 7.65% of $100,000)) and may report $7,064 as a deductible expense for income tax purposes - on the individual's federal income tax return - as the "employer" portion of FICA taxes. If the LLC pays the individual an additional $7,650 - increasing total compensation to $107,650 - the LLC may deduct this additional amount as a "guaranteed payment." As with employee treatment, the LLC makes total payments equal to $107,650 and has total deductions equal to $107,650. As an employee, the individual has net cash of $92,350 - ignoring income tax obligations and after payment of $7,650 as the "employee" portion of FICA taxes - and has net income equal to $100,000. As a service member, the individual has net cash of $92,440 - ignoring income tax obligations and after payment of $15,210 as the "employee" and "employer" portions of FICA taxes - and has net income equal to $100,045 - $107,650 minus the deduction of $7,605 for the "employer" portion of FICA taxes. Accordingly, the individual is in a slightly better net after-tax position as a service member, but the LLC is in the same net after-tax position.
In addition to the obligation to pay the "employer" portion of FICA payroll taxes, a service member is not eligible for "W-2" income tax withholding treatment. The member must file quarterly estimated tax payments with respect to both federal income taxes and FICA payroll taxes to avoid penalties related to taxes owed for the year. While avoiding withholding might be beneficial to certain "employees" of the LLC, most individuals prefer the convenience of regular income tax withholding rather than saving a portion of each check and paying an estimated amount four times a year, especially if the member receives a relatively low level of compensation from the LLC.
In addition to guaranteed payments, a service member should treat all allocations of ordinary income from the LLC - but not capital gain and certain other limited exceptions - as self-employment income. Accordingly, if the LLC has net business income (i.e., income from operations in excess of all deductions and expenses, including the deduction for any guaranteed payments), the service member's share of this income is treated as self-employment income. If the service member otherwise has compensation income, including guaranteed payments from the LLC, in an aggregate amount in excess of the wage base cap described above, then this treatment only increases the member's taxes by the 2.9% Medicare tax - 50% of which is deductible, reducing the effective tax rate - and, if applicable, also by the additional 0.9% Medicare tax. On the other hand, for a lower-wage service member, these additional income allocations are subject to both the 12.4% OASDI and 2.9% Medicare tax provisions - but generally not the additional 0.9% Medicare tax. These additional "self-employment" taxes on allocations of ordinary business income might be avoided entirely through the alternatives discussed below - although such treatment is not assured.
An LLC might use one of three alternative strategies to permit all service providing owners to be classified as employees for federal income tax purposes:
Alternative One - Employee Leasing Company. The first approach involves forming a separate employee leasing company to employ the workers who own equity interests in the LLC and lease these workers to the LLC. The leasing company may be a wholly-owned subsidiary of the LLC or may be owned directly by some or all of the members of the LLC. The leasing company generally is taxed as a C corporation, but the payments to the leasing company are designed to minimize or nearly eliminate taxable income to the leasing company by closely matching the leasing company's expenses - generally limited to wages and benefit payments such as health insurance premiums - resulting in little - or when taking the most aggressive tax position, zero - income tax owed by the leasing company. Certain states, however, have expressed objections to this approach - or even prohibit this structure altogether. In addition, this approach does not eliminate completely the risk that income allocated to members that provide services to the LLC must include all ordinary income allocations as self-employment income.
Alternative Two - Separate S Corporations. Under this alternative, each service provider who otherwise would have been a direct member of the LLC holds the membership interests in the LLC indirectly through an entity qualifying as an S corporation that is owned 100% by the member. The service provider who owns the S corporation is permitted to be an employee of the LLC because the S corporation is treated as the member of the LLC rather than the individual service provider - avoiding classification as a service member. This structure requires the creation of a separate S corporation for each such service provider, subject to annual filing fees and other ongoing administrative costs. In addition, the service provider who owns the S corporation is not permitted to deduct certain types of loss allocations - generally losses resulting from a guaranteed debt or qualified nonrecourse indebtedness on real property - because the losses flow through the S corporation. Although all three alternatives potentially permit the service provider to avoid the treatment of business income allocated by the LLC as "self-employment" income subject to FICA, by owning any membership interests in the LLC only through an S corporation, the service provider also might be able to avoid the imposition of the 3.8% net investment income tax that is imposed on certain types of income above certain specified income thresholds - which tax otherwise might apply in connection with the implementation of alternative one or alternative three. Although a detailed analysis of this planning opportunity is beyond the scope of this discussion, under certain circumstances, this structure potentially results in significant tax savings to an applicable service provider.
Alternative Three - Tiered LLC Structure. The final alternative involves admitting the individuals who provide services to an LLC (the "Operating LLC") as members of a separate LLC (the "Investment LLC"). Under this structure, the Investment LLC owns membership interests in the Operating LLC rather than the service members owning membership interests in the Operating LLC. Each of the Operating LLC and the Investment LLC generally is treated as a separate partnership for federal income tax purposes. This structure, however, might not be available if the Operating LLC fails to have additional non-service providing investors. The members of the Investment LLC are permitted to be employees of the Operating LLC because they are treated as "partners" only in the Investment LLC and not in the Operating LLC (i.e., the LLC that employs them). The Investment LLC should have separate business purposes (i.e., a purpose other than avoidance of federal income tax) for its existence to justify its formation as a separate partnership for federal income tax purposes. The desire to centralize the management of the interests owned by these employees generally is sufficient business justification for the structure. If available, this alternative avoids the limitations of the other alternatives (i.e., the disfavor of leasing companies by states and the potential imposition of additional corporate-level taxes under alternative one and the inability to take certain losses, as well as the cumbersome structure and cost of multiple S corporations, under alternative two).
Employee Fringe Benefits
Each of the three alternatives results in the treatment of a service provider as an "employee" rather than a service member, which generally improves the tax treatment of the service provider with respect to certain employee fringe benefits discussed below.
Income Inclusion for Certain Employee Fringe Benefits
A service member generally is not permitted to exclude from income amounts paid by the LLC on behalf of the member as follows:
- Amounts paid under an accident and health plan;
- Amounts paid by an employer to an accident and health plan;
- Up to $50,000 of group-life insurance on an employee's life; and
- Meals or lodging furnished for the convenience of an employer.
In contrast, amounts paid by the LLC with respect to these fringe benefits on behalf of the service provider treated as an employee are excludible from the employee's income. With respect to health insurance, deductions available to the service member on the member's individual income tax return generally offset any income from the payment of such amounts by the LLC on behalf of the service member, putting the service member in the same net after-tax position as an employee. Other fringe benefits, however, may be non-deductible or deductible subject to certain limits - such as any limitations imposed on miscellaneous itemized deductions. Accordingly, the service member might not be in the same after-tax position as an employee with respect to payments by the LLC on behalf of the service member for these fringe benefits.
Participation in a Cafeteria Plan
A service member is not permitted to participate in a "cafeteria plan" - also commonly known as flex-spending accounts - sponsored by the LLC because the service member is not an employee of the LLC. Specifically, the service member is not permitted to use "pre-tax" dollars to pay for expenses covered by the LLC's cafeteria plan, such as day care expenses and non-reimbursed health care expenses. The service member generally is not entitled to any deductions on the service member's individual income tax return with respect to these expenses. Accordingly, the service member generally is not in the same after-tax position as an employee with respect to the items covered by a cafeteria plan.
Note: This bulletin has been updated in November 2021, since its original publication on Feb. 24, 2010.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.