Members of LLC’s paying themselves through Payroll Risks

Since most people are familiar with being paid wages and receiving a W-2 each year, when forming an LLC, they may still expect to be paid wages.  However, LLC members can take guaranteed payments or distributions.  In fact, there are risks for LLCs whose members wish to run payroll for themselves in an LLC.  These risks, however, do not apply to S Corporations.


Treating partners in an LLC as employees can create a number of tax problems.  The IRS has repeatedly opposed treatment that a partner may be both a partner and an employee of the same partnership.


In July 1969, the IRS concluded that, for employment tax purposes, a partner may not be both a partner and an employee in the same partnership.

In Rev. Rul. 69-184, the IRS publicly ruled that a partner may be either a partner in a partnership or an employee of a partnership, but not both, for employment tax purposes.


In 2012, a district court reviewed a case where taxpayers tried to treat themselves as employees for some, but not all, of the LLC’s earnings by paying themselves wages.  The court, citing Rev. Rul. 69-184, held that the taxpayers should have treated all of the LLC’s income as self-employment income, rather than characterizing some of it as wages. “Because Plaintiffs did not elect the benefits of corporate-style taxation under Treasury Regulation § 301.7701-3(a), they should not have treated themselves as employees,” the court said.

Thus the court held that a partner may not be both a partner and an employee of the same partnership.


Besides not following the IRS and court rulings, partners treated as employees run the risk of FICA taxes being over or under paid.

If a partnership decides to treat partners as employees for payroll tax purposes, there is a risk that not all of the partner’s allocable share of partnership income will be reported on Form W-2, because the partnership tax return will not be completed until months after the Form W-2 must be filed with the IRS, and the partnership will not have final numbers to use when it prepares the Form W-2. If a partner is treated as an employee of a partnership and FICA taxes are paid on the partner’s behalf based on the earnings of that partnership, then the partner may overpay employment taxes if the partner’s other self-employment activities have an overall net loss.


Employer-paid benefits are also treated differently from a tax standpoint.  Whereas employees can exclude from income certain employer-paid benefits, partners may not exclude those benefits when the partnership pays them. Health, welfare, and fringe benefits paid on behalf of a partner are generally not excluded from the partner’s income as they are for an employee. The value of the benefits are therefore included in the partner’s gross income. A partnership choosing to treat a partner as an employee has to be extra careful to include the amount of employee benefits paid on the partner’s behalf in the partner’s income.


It is important to note that S Corporation treatment is different from LLC treatment.  Self-employment tax differs significantly for shareholders of S corporations and partners in partnerships. Generally, as long as an S corporation pays its shareholders reasonable compensation, any S corporation earnings flowing to the shareholders above and beyond that reasonable compensation are not subject to self-employment tax. Conversely, partners in a partnership generally pay self-employment tax on 100% of their earnings flowing from the partnership.


Posted in IRS, Taxes