Most professional services firms choose to form as a Limited Liability Company (LLC). For law firms, this entity may be called a Limited Liability Partnership (LLP or LLLP). While there are many benefits to forming as an LLC, business owners need to make this decision with their eyes wide open.
An LLC provides the flexibility to operate as a partnership for operational and profit allocation purposes (or sole proprietorship for a single member) while granting the legal limited liability protections of a corporate entity. The defaults for federal and virtually all state and local tax reporting are partnership for multiple owner entities and Schedule C reporting for single owners.
It is not unusual for LLC owners to desire “employee” treatment so they can receive paychecks with all federal, state, and local income taxes withheld and remitted to the respective agencies. In this scenario, however, compensation is incorrectly reported on the W-2 at year end, while residual profit is reported on a K-1.
In interpreting the Internal Revenue Code (IRC), the IRS and the courts have successfully maintained that a partner cannot be an employee and partner, nor can a proprietor be an employee. There is no stated IRC section for this point, but the courts have supported the IRS’s position based upon a 1959 3rd Circuit ruling in the Robinson case.
If an LLC treats an owner as both a partner and an employee, the following may result:
- An IRS audit could determine that the owner is liable for self-employment taxes and related penalties and interest. The partnership would need to amend payroll returns to recover taxes, assuming the statute of limitations has not tolled.
- A partner receiving membership interest for service provided may be charged with additional compensation for the value of the membership interest received.
- Partners are prohibited from participating in employee cafeteria benefit plans. If the entity has such a plan, the plan may be disqualified, which would impact all employees.
- If the partnership operates in multiple states, the state apportionment factors and the net profit of the enterprise would be affected.
- The entity may meet resistance from its tax return preparer, who may be unwilling to sign the return because it does not meet applicable IRS reporting and disclosure requirements.
Fortunately, there are ways to mitigate these issues.
The most simple is to elect out of the default and be taxed as a corporation with a Subchapter S election, if the owners desire flow-through treatment. A more exotic option is to develop a tiered partnership structure in which the partner owns an upper tier partnership interest, but is properly employed by a lower tier partnership in which he or she does not hold a direct partnership interest.