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Reporting of LLC Member Compensation: W-2 or Schedule K-1?

By Kenneth H. Bridges, CPA, PFS     August 2014

Prior to the 1990s, the partnership format was used almost exclusively by professional service firms (e.g. mostly CPA firms and law firms) and real estate and oil & gas ventures.  Companies in other industries were typically structured as C-corps or S-corps.

In 1988, the IRS ruled that a Wyoming limited liability company (LLC) could be treated for income tax purposes as a partnership.  Subsequent to that ruling, states began enacting LLC statutes, and the LLC (taxed as a partnership) became a very common business entity choice. This has created a dilemma as to how to report the compensation of “employees” who happen to have an ownership stake in the LLC; and to-date neither Congress, the IRS, nor the courts have provided any clear direction.

In 1969 the IRS ruled that “bona fide members of a partnership are not employees of the partnership” for purposes of FICA, FUTA and income tax withholding.  Accordingly, it was long accepted that partners in CPA firms and law firms had their compensation reported on Schedule K-1 (rather than on Form W-2), with no withholding thereon, and paid income tax and self-employment tax via required quarterly estimated tax payments.  However, as the LLC format became popular, many persons who had long had all of their compensation reported on W-2 (with withholding thereon) suddenly had a small ownership stake in their LLC employer (particularly in early stage technology companies, where equity-based compensation is very common).  In these cases, should the LLC employer cease withholding on the compensation being paid to those with an ownership stake and report the compensation on a Schedule K-1?

Pursuant to partnership tax rules, a partner’s share of the net profit or loss is reported on Schedule K-1 as a “distributive share” item, whereas compensatory amounts that are determined without reference to the partnership’s net income are reported on the K-1 as “guaranteed payments”. Generally, neither of these amounts are subject to withholding of income tax or FICA, and the partner is responsible for paying the income tax and self-employment tax directly (greatly complicating the worker’s personal tax situation).

The reality is that many LLCs report compensation paid to employee/members on W-2.  The total tax collected by the government is usually identical to that which would be collected if reported on K-1, and the government generally receives the money more quickly and more assuredly via withholding than it would via payments from the employee/member.  For this reason, we are not aware of any situation in which the IRS has actually challenged an LLC’s reporting of member compensation on W-2.  In a recent district court case (Reither, in the U.S. District Court for New Mexico), the court noted in dicta that the IRS had “made no bones” about the fact that the couple treated a portion of their compensation from their LLC as W-2 wages.  The court considered this treatment to be incorrect, but the relevant issue which it ruled on was instead whether or not their additional K-1 distributive share income should be subjected to self-employment tax (which the court ruled it was).

What if an LLC provided a tiny ownership stake (say 0.01%) to each of its employees?  Could the LLC simply stop withholding, paying FICA and payroll taxes and filing payroll tax returns, and report each worker’s annual compensation on K-1?  Or would the IRS in such a case assert that the employees were not “bona fide members” of the LLC?  That would seem a greater risk than the IRS seeking to challenge that compensation should have been reported on K-1 rather than W-2.

To the extent LLC employees receive a meaningful stake in the ownership of the LLC, and the desire is to have them ultimately treated as partners (e.g. such that they can enjoy long-term capital gain treatment upon an eventual sale of the business), the most technically correct and appropriate course of action is probably to report their compensation on Schedule K-1 with no withholding.  However, this desire to be technically correct has to be weighed against the possible disservice you may be doing an employee who has always had their tax obligations satisfied by withholding, and is now faced with the responsibility to make such tax payments on their own.  Hopefully, the IRS or Congress will provide a sensible solution to this dilemma.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.