Converting a General Partnership to a Limited Liability Company (LLC)

Preface:  Courts are finding that minority partners, are in an employment relationship for purposes of Unemployment Compensation tax assessments. Therefore, if a business has minority partners who receive K-1 income statements, they may be in danger of audits, citations, and penalties.

Is Your Partnership Legal?

Converting a General Partnership to a Limited Liability Company (LLC)

Credits: Tyler W. Hochstetler, Esq

For many years, Anabaptist business owners have often chosen the General Partnership as their business model of choice. The primary incentive for choosing the General Partnership is avoiding employee payroll, and thereby avoiding regulations, taxes, and workman’s compensation premiums.

After enjoying many years of relatively few legal challenges, some partnerships are now facing withering attacks. Pennsylvania regulatory agencies have charged Anabaptist partnerships with stretching the definition of “partnership” too far, and have imposed staggering penalties on these businesses.

In an effort to be wise stewards of business resources, many business owners have operated with 1% partners or minority partners instead of employees. These minority partners have typically been young men, sometimes minors, who exercise very little discretion and control over the activities of the business. They are often added to the partnership at a low capital investment amount, such as $100. They are often paid based on an hourly wage, and are rarely given a significant profit-sharing check.

These minority partners tend to view their work much like employment, and there is often a revolving door of turnover in these businesses. As minority partners exit, they are often repaid at the same or similar rates as when they “bought into” the partnership, rather than receiving a share of the fair market value of the company.

In many cases, one or two majority partners own the majority of the business, and the remaining partners have low ownership interests and low capital investments in the company. The majority partners often make partnership decisions without input from the minority partners, and they often set the compensation rates for everyone, including themselves. In some cases, these partnerships do not hold regular partnership meetings with all partners, they do not allow equal voting rights among partners, and they do not maintain adequate documentation of partnership activities.

As a result of these practices and government budget deficits, certain regulatory authorities have begun to challenge the validity of these partnerships. The Pennsylvania Department of Labor & Industry and Pennsylvania OSHA offices are examples of agencies which have begun to enforce a more liberal interpretation of what constitutes “employment.” These authorities have evaluated the relationship between majority and minority partners, and have often determined that the relationship is more like an employment relationship than a legitimate partnership. Fines and penalties are assessed accordingly.

Frustratingly, these authorities rarely give concrete guidance as to the definition of who is a legitimate “partner.” These authorities determine who is an “employee” based on vague standards such as a “totality of the circumstances.” They enjoy nearly unfettered discretion in determining who should be classified as an employee.

In an Unemployment Compensation audit, the agency will often audit a partnership for multiple years of business activities. These audits are stressful and expensive. Auditors sometimes paint with a broad brush in ruling that one or two partners are the “employers” and everyone else is an “employee.” They then assess unemployment taxes for several years at once, and add on penalties and interest payments. Subcontractors can also become entangled in the web of the auditor’s review, adding another layer of complexity. The burden of proof then tends to shift onto the partnership to prove that the auditor erred in classifying everyone as employees.

In an OSHA examination, roofing partnerships are especially vulnerable. Often a competing contractor or concerned citizen complains to OSHA when young men are roofing without harnesses and safety equipment. OSHA seizes the opportunity to interview young, minority partners. When those partners do not answer questions to their satisfaction, OSHA can levy punitive penalties on the partnership. Many minority partners are not prepared to answer questions regarding their ownership interests or the partnership structure.

Several partnerships have challenged the assessments by Unemployment Compensation and OSHA. Several recent Anabaptist cases which were appealed in Pennsylvania courts (by other attorneys) have failed. Courts are finding that minority partners, as described above, are in an employment relationship for purposes of Unemployment Compensation tax assessments. The Pennsylvania legislature has also contributed to this discussion with the 2011 passage of the Construction Workplace Misclassification Act (Act 72). This law addresses the misclassification of independent contractors, but it appears to have emboldened regulators in evaluating partnerships.

It is important to note that both General Partnerships and LLC’s taxed as partnerships are affected by these changing interpretations to partnership law. Consequently, if a business has minority partners who receive K-1 income statements, they may be in danger of audits, citations, and penalties. As one solution, some General Partnerships and LLC partnerships have elected to place all of their minority partners on payroll to protect themselves from audits and assessments.

When making this conversion, partnerships may begin looking for an alternative business structure. The LLC is a recommended option because of its protection from legal liability, its pass-through tax status, and the low amount of legal paperwork required. There are several steps involved in converting a General Partnership to an LLC.

In Pennsylvania, converting a General Partnership to an LLC requires filing a Statement of Conversion (Form DSCB: 15-355) with the Pennsylvania Department of State. A Docketing Statement must also accompany this form. A registered address will be required, which should match any existing registered address that the partnership may have filed with the state in order to conduct business under a fictitious name.

Further, when converting from a General Partnership to an LLC, a corporate designator is required. This means that your business name must include the letters “LLC” or a similar designator in the name.

After you have filed the appropriate forms with the state, and they are approved and returned to you, your entity should consider several other steps to effectuate the conversion. Depending on the circumstances, the business may also want to consider updating its vehicle titling, transportation licenses, sales tax registrations, real property deeds, bank accounts, and other paperwork which remains in the old partnership name.

Every LLC should generally have an LLC Operating Agreement. You should consult with legal counsel in drafting an LLC Operating Agreement for the converted partnership. This Operating Agreement will contain information such as who will manage the LLC, who owns the LLC, and how the LLC will continue or cease if one member passes away or withdraws.

The LLC should also consult with a competent accountant throughout the conversion process to ensure that the appropriate tax paperwork and payroll information is established and filed in a timely manner. Workman’s compensation coverage should be purchased in most cases, although some states (including Pennsylvania) have religious exemptions for certain employees. Unemployment compensation registration should be completed with the state as well.

Partnerships should also recognize that employee tax withholdings will increase the tax burden of the business. Compensation adjustments should be considered in order to reconcile the cost increase. Once employees understand that the employer is now paying a portion of their tax burden, and withholding and remitting the remainder of their tax burden, they will often be appreciative.

One of the biggest liabilities for a partnership is an unhappy minority partner that files a workman’s compensation claim or unemployment compensation claim. Having employees on payroll can result in happier employees, more peace of mind, and a better testimony of compliance and living in peace with our authorities. May God grant you wisdom in discerning the best course of action for your business in this changing legal climate.


Tyler W. Hochstetler, Esq. is an Anabaptist attorney who is licensed in Pennsylvania and Virginia. He serves as in-house counsel for Anabaptist Financial, and also has a private law practice, representing Amish and Mennonite clients.



Partner or Employee – Taxes in Pennsylvania On Employees

Partner or Employee – Taxes in Pennsylvania On Employees

Preface: Abner owns 1%, has an LLC capital account of $100, and works 50 hours per week at a $9.95 per hour rate. Is Abner a partner or employee? Abner owns 1%, has an LLC capital account of $100, and works 50 hours per week at a $19.75 per hour rate + OT. Is Abner a partner or employee?

Credits: Jake Dietz, CPA

Have you ever wondered if your LLC should hire employees that receive W-2s, or instead use 1% members that receive K-1s and are treated as self-employed? In the past, Pennsylvania allowed LLC’s taxed as partnerships and general partnerships to avoid Unemployment Compensation (UC) taxes by treating workers as 1% or 2% partners instead of employers. PA has begun to crack down on this practice. PA will now treat most 1% partners or LLC members as employees if they receive compensation for services. Furthermore, PA can go back to previous years and reclassify the minority owners as employees.

On page 2 of “Controlling UC Costs for Contributory Employers”, REV 04-16, Pennsylvania states that

“The UC Law presumes that services performed for remuneration constitute “employment,” and that the individual performing the services is an “employee.” Accordingly, a member of an LLC performing services for the LLC is presumed to be an employee of the LLC. However, employee status will not apply if the independent contractor test in section 4(l)(2)(B) of the UC Law is satisfied. Under section 4(l)(2)(B), a member is an independent contractor if, with respect to work performed for the LLC, he or she is (a) free from direction and control and (b) customarily engaged in an independently established trade, occupation, profession or business.”

Pennsylvania law assumes that someone getting paid to work for an LLC is an employee, unless the independent contractor test can be successfully applied. There is not a set ownership percentage amount at which you are automatically a self-employed independent contractor, and below which you are automatically employed. Pennsylvania can exercise their judgment. Some factors PA may consider include capitalization and voting rights. If the LLC has equal ownership percentages, capital percentages and voting rights (such as 4 members with a 25% share) then they likely can avoid UC tax. Do all the members have voting rights, or does one member with the highest percentage make all the decisions? If minority members have no voting rights, it may be hard to argue that they are “free from direction and control.” Does one member have most of the capital?  For example, if the total capital accounts are $10,000, and four 20% members have capital accounts with only $100 each, and a fifth 20% member has a capital account of $9,600, then that could be a problem. If one member is making all the decisions and has most of the capital, then PA may say that the other workers are employees subject to direction and control whose compensation is subject to UC tax.

What should be done if you are the majority owner of an LLC with minority members that would likely be reclassified as employees if audited by PA? If it is just a few minority members, you could consider inviting them to purchase a greater interest in the LLC and to take part in management. Before making that decision, however, consider if you are willing to share management responsibilities with them. Also, are the minority members willing to take the financial risks of greater ownership, and are they willing to invest the capital? The ramifications for this decision extend beyond UC taxes.

Another option would be to switch the minority members over to employees. In that case, all employment taxes apply, unless there are exemptions for them. FICA employment taxes can be avoided with proper exemptions, but if the exemptions are not in place they must be paid. Other taxes cannot be avoided, including UC tax.

If the decision is made to switch from self-employed minority members to W-2 employees, then careful thought should go into structuring the compensation. For example, let’s look at hypothetical ABC, LLC, and its minority member, Abner. Abner owns 1%, has an LLC capital account of $100, and works 50 hours per week at a $20 per hour rate. Nobody in the LLC has filed Form 4029 to be exempt from self-employment or FICA taxes. Abner is not paid overtime. He pays, on his personal tax return, 15.3% of his earnings as self-employment tax. Abner therefore would get $1,000 per week for 50 hours at $20/hour. He needs to pay, when he files his taxes, $153 as self-employment tax. If the LLC switches Abner to an employee and continues pay him $20 an hour, then Abner would get $1,100 per week (40 hours at $20/hour and 10 overtime hours at $30/hour.) Furthermore, he would only need to pay his portion of FICA taxes, which would be 7.65%, or about $84. He would also have a small portion of Unemployment Compensation to pay, but most of that tax will be paid by the LLC. That sounds fantastic for Abner! The LLC, however, may not be as happy about the arrangement. Not only is the LLC now paying Abner $100 more than before, but the LLC is also paying half the FICA taxes, which comes to approximately $84, plus Unemployment Compensation, and possibly additional payroll tax or insurance. There are other factors to consider as well, including the increased administrative burden, the tax benefits of deducting payroll taxes for income tax purposes, and the possibility of now qualifying for the Domestic Production Activities Deduction, which requires W-2 wages.

Another option might be to continue treating Abner as a partner for income tax purposes, but to begin paying UC taxes on him as if he were an employee. There could still be some risk to this option, however.

This blog is not tax or employment law advice. It is solely for awareness on applicable employment and tax statutes with regards to entrepreneurship. If you would like help walking through your options, please contact our office.

Special Use Valuation for Farmers

Preface: Proper estate planning can save tax dollars. Here’s a rule applicable for family farms.

Special Use Valuation for Farmers

A special rule (special use valuation) applicable to farmers may allow the next generation of a family to continue to operate a farm rather than sell it to meet estate tax obligations. Because fair market value considers the property’s value at its highest and best use, estate tax that is based on fair market value could make it prohibitive to continue to operate the farm as a family enterprise. For example, a farm may be worth $1 million to a developer to construct townhouses and a shopping mall, but only $400,000 to the farmer who wishes to continue operating it as a farm.

Under special use valuation, an executor may elect to value real property used in farming at a value based on its use as a farm, rather than at its fair market value. The election is irrevocable, and the reduction in value is limited to a ceiling amount depending on your year of death: $1.1 million for 2015; $1.11 million for 2016; and $1.12 million for 2017.

To elect special use valuation, the property must be put to a qualified use. That is, it must be used as a farm for farming purposes. Qualified woodlands may also qualify for special use valuation. It must also pass to qualified heirs. These include the decedent’s ancestor, spouse, lineal descendants of the decedent, his spouse or his parent, or the spouse of any lineal descendant. All property, including personal property, used in the farm must comprise 50 percent of the adjusted value of the gross estate and the real property used in the farm must comprise 25 percent of the adjusted value of the gross estate.

In addition, material participation in the operation of the farm for a total of at least five years in the eight years immediately preceding the decedent’s death, disability or retirement is required. If the qualified heir ceases to use the farm property or sells the property within ten years of the decedent’s death, an additional recapture tax is due.

If you would like to discuss how special use valuation might affect your estate planning, please contact your estate specialist.


Respectful Calculations For Expenses On Business Mileage

Preface: Automobile mileage in business is a tax deduction. What are the options and how can you apply this tax deduction?


Respectful Calculations For Expenses On Business Mileage  

Businesses generally can deduct the entire cost of operating a vehicle for business purposes. Alternatively, they can use the business standard mileage rate, subject to some exceptions. The deduction is calculated by multiplying the standard mileage rate by the number of business miles traveled. Self-employed individuals also may use the standard rate, as can employees whose employers do not reimburse, or only partially reimburse, them for business miles driven.


Many taxpayers use the business standard mileage rate in particular to help simplify their recordkeeping. Using the business standard mileage rate takes the place of deducting almost all of the costs of your vehicle. The business standard mileage rate takes into account costs such as maintenance and repairs, gas and oil, depreciation, insurance, and license and registration fees.


Beginning on Jan. 1, 2017, the standard mileage rates for the use of a car (also vans, pickups or panel like trucks) is:

  • 53.5 cents per mile for business miles driven, down from 54 cents for 2016
  • 17 cents per mile driven for medical or moving purposes, down from 19 cents for 2016
  • 14 cents per mile driven in service of charitable organizations


The business mileage rate decreased half a cent per mile and the medical and moving expense rates each dropped 2 cents per mile from 2016. The charitable rate is set by statute and remains unchanged.


The standard mileage rate for business is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs.


Taxpayers always have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates. If instead of using the standard mileage rate you choose to use the actual expense method to calculate your vehicle deduction for business miles driven, you must maintain very careful records. You must keep track of the actual costs during the year to calculate your deductible vehicle expenses. One of the most important tools is a mileage log book. Fleets must use actual expense methods.


Our office can help you compare the benefits of using the business standard mileage rate or the actual expense method