LLCs and Limited Partner SE Taxation

Preface: An LLC with more than one member can be taxed as a partnership, but this brings up an interesting question regarding self-employment tax. Who is a limited partner in an LLC for purposes of the SE tax exemption? The Internal Revenue Code and related regulations do not say.

LLCs and Limited Partner SE Classification Taxation

Credits: Jake Dietz, CPA

Do you get a K-1 from an LLC every year that lists various types of income? Perhaps it also lists self-employment income, which may or may not include all the income on the K-1. This article looks specifically at reporting self-employment income on the distributive share of income for LLC’s taxed as a partnership.

First, let’s look at how partners in a partnership get taxed. Partnerships are pass-through entities for federal tax purposes. The partners of the partnership receive a K-1 allocating to them a share of the partnership’s activity, and then the partner files their personal tax return using information on the K-1. Because partnership items pass-through to the partners, a partner may pay tax on income he never personally received. For example, suppose Samuel is a 50% general partner and received $45,000 for his services to the partnership, which he helps manage. These payments are called guaranteed payments and can be deducted by the partnership. After all expenses were deducted, including the guaranteed payments, the partnership made $20,000 of net income, which it kept in the partnership for future use. Samuel would be subject to income tax on the $45,000 he received as guaranteed payments plus the 50% distributive share of the $20,000 partnership net income, or $10,000. If Samuel is not exempt from self-employment (SE) tax, then he must pay SE tax on the $45,000 guaranteed payments and the $10,000 distributive share.

How would Samuel be taxed if he were a 25% limited partner? Assume Samuel is a limited partner, and he worked for a few days to earn $500 in guaranteed payments. His distributive share of the partnership net income is $5,000. In this scenario, the full $5,500 would be subject to income tax, but only the $500 of guaranteed payments would be subject to SE tax. Why is the $5,000 not subject to SE tax? The Internal Revenue Code in §1402(a)(13) specifically exempts the distributive share (in this example $5,000) of a limited partner’s income from SE tax.

An LLC with more than one member can be taxed as a partnership, but this brings up an interesting question regarding self-employment tax. Who is a limited partner in an LLC for purposes of the SE tax exemption? The Internal Revenue Code and related regulations do not say.

The tax court, however, ruled in Castigliola, T.C. Memo. 2017-62. We can look to this court ruling for guidance. The court considered whether the LLC members were “functionally equivalent to that of a limited partner in a limited partnership.” The court noted that “limited partners typically lack management power but enjoy immunity from liability for debts of the partnership.” The court also noted that the LLC in the case was member-managed. No LLC operating agreement existed that limited the members’ management. Furthermore, the facts indicated that the LLC members participated in management. They were therefore not functionally equivalent to limited partners. The court also noted that “Because there must be at least one partner who is in control of the business, there must be at least one general partner.”

What can we learn from this ruling? If all the LLC members participate in management, then the LLC should probably report the distributive share of income as subject to SE tax, as well as the guaranteed payments. Although the LLC members may enjoy immunity from partnership debts, they should not expect to enjoy SE tax exemption on their distributive share of income if they help manage the LLC.

If the equivalent of limited partners exist in the LLC, then there should be documentation to substantiate the facts. Is there a written operating agreement that supports the argument that they function as limited partners? Is there any other evidence to support or contradict the limited partner claim? There should also be evidence indicating that at least one other member functions as a general partner.

This article is general in nature and should not be considered tax or legal advice. If you have questions on the specifics of an LLC of which you are a member, please contact this office.

What Affect Does Form 4029 Have on Partnerships and Sole Proprietorships?

Preface: Form 4029 Exemptions from FICA taxes can result in a tax landmine of penalties and back tax assessments in certain circumstances. Appropriate application of the tax code can minimize risks. What is permitted and what is not according to the IRS tax code?

What Affect Does Form 4029 Have on Partnerships and Sole Proprietorships?

Credits: Jake Dietz, CPA

Do you want to avoid paying Social Security and Medicare taxes by taking advantage of your form 4029 exemption? If so, entity type and ownership play important roles in avoiding these taxes. Even valid exemptions do not apply in certain situations. This blog addresses how form 4029 affects payroll taxes for sole proprietorships, partnerships, LLCs taxed as one of the previous two options, and corporations. Entity type and ownership play important roles in Social Security and Medicare tax avoidance.

First, here is a little information on Form 4029. It is the “Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits.” Approved forms allow both the employer and employee to avoid Social Security and Medicare taxes if certain conditions are met.

Sole Proprietorships and Single-Member LLC Disregarded Entities

A sole proprietorship is owned by one person and unincorporated. A single-member LLC (SMLLC) is an LLC owned by one member. It is a disregarded entity for federal tax purposes, unless an election is made to be taxed as a corporation. An SMLLC may therefore have the same federal tax treatment as its owner. Sole proprietorships and SMLLCs not taxed as corporations do not need to pay Social Security and Medicare payroll taxes for each employee with a valid form 4029 if the owner also has a valid form 4029.

For example, suppose Reuben is the sole owner of Silver Maple Furniture & Ice Cream Shop, LLC. The LLC never elected to be taxed as a corporation. The LLC hired Amos and George. Both the owner Reuben and employee Amos have form 4029s, but George does not. In the above scenario, the employer would be exempt from paying the employer portion of Social Security and Medical payroll taxes on Amos, but would have to pay those taxes on George. Amos would be exempt from paying the employee portion of Social Security and Medicare payroll taxes, but George would have to pay those taxes on his wages.

If the owner does not have a valid form 4029, then Social Security and Medicare payroll taxes are paid on all employees. This rule applies even if each employee obtained a valid form 4029.

Let’s take the example above and change the facts slightly. George (no 4029) buys the SMLLC from Reuben, and George employs Reuben (valid form 4029) and Amos (valid form 4029). In this situation, all Social Security and Medicare payroll taxes are due, since the employer does not have a valid form 4029.

Partnerships and LLCs Taxed as Partnerships

Form 4029 applies to a partnership or LLC taxed as a partnership if each member has a valid form 4029. If one member has a valid form 4029 and another member does not, then the exemption does not apply to partnership wages.

Let’s assume that Reuben (valid form 4029) decides to bring Amos (valid form 4029) into Silver Maple Furniture & Ice Cream Shop, LLC as another member. Because all the members have valid form 4029s, then each employee that has a form 4029 would also be exempt. If the LLC wanted to hire Justin (valid form 4029), then no Social Security and Medicare taxes would be due on Justin. Both the employer and George, however, would have to pay Social Security and Medicare taxes on George’s wages because he does not have a valid form 4029.

Alternatively, let’s consider what would have happened if Reuben (valid form 4029) brought George (no 4029) into the LLC instead of Amos (valid form 4029). In that situation, all Social Security and Medicare payroll taxes are due because not all the members are exempt.

Corporations

The form 4029 exemption does not apply to corporations, or to its employees. Social Security and Medicare taxes are due even if the owner and all employees each possess a valid form 4029.

Summary

For a form 4029 to take effect, all owners must have valid form 4029s, and the entity must not be a corporation. Furthermore, the exemption only applies to employees that also have a valid form 4029.

Entity type and ownership can affect Social Security and Medicare taxes, and should therefore be factors in the decision-making process. Also, an employee with a form 4029 may want to ask potential employers before accepting a job if the employer is exempt. Contact your tax accountant if you would like help exploring how form 4029 is affected by entity type and ownership.

 

Taking High Compensation Without Dividend Danger

Preface: Proper planning can maximize the amount of compensation a company can pay in a way that will increase its chances of being able to withstand an IRS challenge.

Taking High Compensation Without Dividend Danger

Owners of a closely held C corporation know that the company’s earnings are theoretically exposed to a double tax. Principally, earnings are first taxed to the corporation and those that are distributed to as dividends are taxed on your individual income tax return, without the company getting a deduction for the payments.

On the other hand, the company can deduct the salary it pays you. While you have to pay tax on the salary, unlike dividends, salary is taxed only once. And while dividend income is taxed at net capital gains rates (at a maximum 20 percent rate if all income exceeds a $470,700 threshold for joint filers, $418,400 for single individuals in 2017), that is an additional 15 or 20 percent that you may not otherwise have to pay with proper compensation planning. What’s more, investment income is also subject to the 3.8 percent Net Investment Income (NII) surtax if an individual’s overall income exceeds a $250,000/$200,000 level.

Does this mean that the double tax can be avoided simply by increasing your salary rather than by paying dividends? No, there are two potential problems with that approach. First, the company can only deduct reasonable compensation. Second, if compensation is set at the high end of the scale and is later found to be unreasonable, the IRS can charge the owner with a constructive dividend on the unreasonable portion of the compensation.

What then can be done? Proper planning can maximize the amount of compensation the company can pay in a way that will increase its chances of being able to withstand an IRS challenge.

The basic test of reasonableness, as applied by the IRS and many courts, is whether the amount paid is analogous to that paid by employers in like businesses to equally qualified employees for similar services. In this respect, the total compensation package is examined including contributions to retirement plans and other employee benefits.

As a result, a showing of special skills may help to justify reasonableness. It also can be helpful if the individual performs different roles for the company (for example, chief executive officer and designer of a new product).

Another possible approach may be to set up a portion of an owner’s compensation to be paid as bonuses if profits meet certain levels. While the IRS has attacked such contingent compensation arrangements in family companies, some courts have upheld them where the agreement was set up when the business was started or when the amount of the future earnings was questionable, and the agreement was consistently followed during the ups and downs of the business.

Few businesses start out with the owners able or willing to pay themselves what they are really worth. Even after the business is successful, periods of economic slowdown, may force belt tightening. It is in these situations that an owner may have an opportunity to enter into a formal contract with the company calling for a share of the profits as added compensation when things improve.

If this is done it’s important to include in the corporate minutes the record showing that the owner was underpaid at the time the agreement was entered into. The minutes also should show that the contingent payment out of future profits is merely intended to provide an incentive for the owner to put forth his best efforts to build the business and to make up for the periods of underpayment.

Attention to such details when planning compensation arrangements should help the owner fend off or blunt future attacks on compensation when the business proves highly successful and substantial compensation is paid under the agreement.

Feel free to contact us if we can help you with the complex task of developing a proper compensation package for tax purposes.

 

Why You Need a Buy/Sell Agreement for Your Business

Preface: The cost of a buy/sell agreement is miniscule compared to preventing the turmoil that can result among family members or owners when capital or equity interests are traded. Buy/sell agreements, plain and simple, make sense no matter your business. If you have a corporation, LLC or partnership – any business with more than one equity holder – you need a buy/sell agreement.

Why You Need a Buy/Sell Agreement for Your Business

Any business that has more than one equity holder needs a buy/sell agreement. A buy/sell agreement is a written contract that specifies the steps that will be taken if an equity holder wants to release his ownership.  The documented rules in a buy/sell agreement determine how values will be appraised and payment made during fragile business conditions. In addition, a buy/sell agreement can prevent other partners from selling to other individuals or competitors, such as anyone joint equity holders do not want to hold equity. Buy/sell agreements specify rules for a business entity or other owners to acquire another equity interests in specific in the event of an owner selling for retirement, death, disagreements, defaults, or incapacitation.  So you could say a buy/sell agreement is a “business will,” and prevents unfair treatment of all equity holders in delicate situations arising from the trade of of a business interest.

A buy/sell agreement is typically a legal document prepared with attorney oversight. The document contains a prearranged agreement for a sale of business interests. The agreement is not limited to 1) who can purchase a departing partner’s or shareholder’s equity interests, 2) the methodology or hybrid appraisal for determining value, or 3) events that will spark a buy/sell agreement.

In a corporation, a buy/sell may result in treasury shares, and necessitate terms for the trade value between the shareholder and the corporation. The cost of a buy/sell agreement is low compared to preventing the turmoil that can result among family members or owners when capital or equity interests are sold. Buy/sell agreements, plain and simple, make sense no matter your business. If you have a corporation, LLC or partnership, any business with more than one equity holder, you need a buy/sell agreement.

What do you need to know to talk your attorney and hold an intelligent conversation? First, you can have a redemption buy/sell agreement where your interest is traded to the business, so the other owners don’t need to pay out of their own checking account. Or, you can have a cross-purchase agreement where another equity holder has first right to purchase your interest. A cross-purchase agreement allows partners or shareholders to acquire your interest, or you to buy other equity interests.

Second, and more important, the nucleus of a buy/sell agreement ensures proper valuation of a business when there is an unanticipated pending sale of an interest. Valuation is key to a fair market sales price of an interest. Valuation of your business should occur every several years with a buy/sell agreement to ensure you have a documented benchmark history of the business value from say the basement to the peak.

At a minimum, you should value your business at the writing of a buy/sell agreement, as well as every time the buy/sell is updated. Your buy/sell should also should list specifically the method(s) the appraiser will use to calculate the business value in the marketplace, e.g. the income approach or say a market approach. Typically the most successful buy/sell valuations carefully avoid unnecessary hybrids, e.g. complex combinations of income, asset or market approaches.

In summary, A buy/sell agreement is a written document prepared with attorney oversight, that details the requirements and play rules for trades of a business interest in instances of ownership change. If you own a business interest with partners or shareholders, you need a buy/sell agreement. If you already have a buy/sell agreement, make sure it is updated when necessary. If you do not yet have a buy/sell agreement for your business, talk to your trusted advisor or CPA about obtaining one today.

 

Small Business Tax Reduction Strategies

Preface: Tax planning is an important and vital step to reducing the cost of business. But saving tax dollars isn’t the only prudent or advised consideration. Strategizing with your tax advisor to manage business costs, and plan tax advantaged operating and investing cash flows, with before and after tax dollars, will reward your business

Small Business Tax Reduction Strategies

Taxes are simply a cost of doing business. Yet, like all costs, you can manage them to your advantage. If you’ve read this far, you are an entrepreneur who appreciates the time it takes to plan the tax effect of your income. Maybe planning tax strategies is new to you. Whether it is or not, the strategies are similar year to year–deferring revenue, accelerating expenses, contributing to a retirement account, making charitable contributions, or maximizing depreciation expense. You would be wise to stick with only legal tax reduction strategies. Any other path is risky, may result in lowered business value, and is time-tested to be morally wrong. Other legal loopholes include domestic productions activities deductions for manufacturers or specific tax credits which apply to your industry.

Employee bonuses are a great strategy to reduce taxes and reinvest in your workforce. A well-compensated team will take satisfaction in their work and lessen hidden business liabilities such as employee inefficiencies. Reducing taxes can be done in many more ways.

Investing in marketing and advertising is another strategy for deferring a business tax liability. Advertising and marketing is one of the most efficient methods to defer taxes from one year to the next, or every year. An advertising campaign will help you develop your market position, and defer revenue to later periods. With the increased top line revenue from advertising, you can increase the value of your business over time, too.

Successful tax planning should line up with the business vision. For instance, does it make financial sense to purchase $150,000 of equipment solely to save on taxes? Will the new equipment reduce costs on manufacturing processes and provide a 7% IRR  in the future? Spending cash to purchase necessary equipment such as a truck, robotics, or office furniture, should result in plans for additional future cash flow, such as the development of office staff and plans for office overhead. Otherwise paying the tax at 40% still puts 60% net tax in your bank account for new working capital.

Keep in mind that debt is repaid with income, net of tax, except the interest expense.  So if you have a $150,000 line of credit, you will need to earn say $210,000 or more to repay that line of credit, without reducing working capital. Debt is leverage. If you have debt, you are better off to pay tax and resist spending excessively on fixed assets beyond what is required. With the excess cash you can accelerate the payment of debt, reduce business leverage, and increase equity (and value).

Retirement plans also defer taxes. SIMPLE-IRA’s or SEP-IRA’s are an easy way for business owners to contribute towards retirement and save on taxes. SIMPLE-IRA’s permit up to $12,500 to be contributed and SEP-IRA’s up to $53,000 for 2015. The characteristics of the IRA plans may or may not make them fit well with your business tax planning. If you’re interested, talk about it with your CPA or with a retirement advisor to decide what could work best for tax planning in your business.

Sometimes saving on taxes isn’t everything you need to think about. Are you in compliance with Obamacare? Are you in compliance with labor laws? Nondeductible penalties are an expensive way to learn about the crucial area of compliance. Are you selling your business? Businesses are often valued based on cash flow. The more net income, the more tax paid, often the more value at sale for the seller (you). Why? The business valuation is mostly based on cash flow and net income. This is to say the more tax paid (the higher the tax reported income on the tax return) the larger the gain at sale, because of the value multiple of earnings on the businesses net income.  Don’t worry. Sometimes there is an advantage to paying tax.

In summary, tax planning is important and vital to reducing the cost of business. But saving tax dollars isn’t the only consideration. Working with a tax advisor who can help you manage your business cash flows, with before and after tax dollars, will reward your business.

 

Charitable Giving – Permissible Tax Benefits for Charitable Giving

Preface: Charitable contributions require you need to be very careful and rely on professional help, to keep in compliance the IRS when giving more than say 25 dollars. The IRS is becoming increasingly aware of questionable practices and is cracking down on taxpayers who use them. If a charitable giving scheme sounds too good to be true, it probably is! 

Charitable Giving – Permissible Tax Benefits for Charitable Giving

You probably know that you can get an income tax deduction for a gift to a charity if you itemize your deductions. But there is a lot more to charitable giving. For example, you may be able to indirectly benefit a family member and a charity at the same time and still get a tax break. Or you may be able give appreciated property to a charity without being taxed on the appreciation. These benefits can be achieved, though, only if you meet various requirements including substantiation requirements, percentage limitations and other restrictions. We would like to take the opportunity to introduce you to some of these requirements and tax saving techniques.

 

First, let’s take a look at the basics: Your charitable contributions can help minimize your tax bill only if you itemize your deductions. Once you do, the amount of your savings varies depending on your tax bracket and will be greater for contributions that are also deductible for state and local income tax purposes. To get a current deduction, the charitable gift must be to a qualified organization and must not exceed certain percentage limitations.

 

You also need to substantiate your donations. Generally, a bank record or written communication from the charity indicating its name, the date of the contribution and the amount of the contribution is adequate. If these records are not kept for each donation made, no deduction is allowed. Remember, these rules apply no matter how small the donation. However, there are stricter requirements for donations of $250 or more and for donations of cars, trucks, boats, and aircraft. Additionally, appraisals are required for large gifts of property other than cash. Finally, donations of clothing and household gifts must be in good used condition or better to be deductible.

 

The amount of otherwise allowable itemized deductions is reduced for higher income taxpayers whose adjusted gross income exceeds certain threshold amounts. For 2017, the threshold amounts are $313,800 in the case of married taxpayers filing a joint return or a surviving spouse, $287,650 in the case of a head of household taxpayer, $261,500 in the case of an unmarried individual, and $156,900 in the case of married taxpayers filing separate returns. A taxpayer with AGI over the threshold amount must reduce their otherwise allowable itemized deductions by the lesser of: three percent of the amount of the taxpayer’s AGI in excess of the applicable threshold amount, as adjusted for inflation, or 80 percent of the itemized deductions otherwise allowable for the tax year.

 

Now a word about special gift-giving techniques: There are some strategies that can help minimize your tax liability. Making a gift to another individual outside of the umbrella of a charitable organization is one. For example, you can give up to $14,000 in 2017 tax-free to another individual or $28,000 for married couples making joint gifts. If larger gifts are made, use of a lifetime gift and estate tax exclusion, set at $5.49 million for 2017, might be considered. However, you need to be very careful and rely on professional help. There are a lot of scams and schemes that really push the envelope. The IRS is aware of these abusive practices and is cracking down on taxpayers who use them. If a scheme sounds too good to be true, it probably is!

 

There are other special charitable giving techniques beyond the usual gifts of cash. These include, among others, a bargain sale to a charity, a gift of a remainder interest in your residence and a transfer to a charity in exchange for an annuity.  

Please do not hesitate to contact us if you have any questions regarding the planning of charitable gift of money or property.

To Group or not to Group

Preface: Tax groupings of business activities can solidify tax positions in certain instances. What is a grouping, and when may it may be applicable?

To Group or not to Group

Credits: Jacob Dietz, CPA — jdietz@saudercpa.com

Lancaster, PA

The IRS considers a business activity to be passive if the taxpayer does not “materially participate.” The full complexities and the details of passive activities are beyond the scope of this blog, but generally the IRS will not allow the deduction of passive losses unless there is offsetting passive income of an equal or greater amount, or the activity is entirely disposed.

There are exceptions, however. For an example of how the passive activity rules could work, let’s imagine John owns two businesses. Business A is a restaurant, and John works full-time in the restaurant. Business B is a bakery across the street from the restaurant, and the bakery provides the restaurant with food. John hired an able manager for the baker, so he hardly does any work in that business.

If the bakery and the restaurant are treated as separate activities, then John would be active in the restaurant but may be passive in the bakery. If the restaurant made money and the bakery lost money, then John might not be able to deduct the bakery’s loss until future years if he had no other passive income.

The IRS, however, does allow grouping of activities that form an “appropriate economic unit.” If the bakery and the restaurant had been grouped, then John’s work in the restaurant would count as material participation for the entire activity, thereby making the bakery’s loss nonpassive.

What constitutes an “appropriate economic unit?” There is some discretion in making this determination, but below are some factors from IRS Reg. 1.469-4 detailing some of the considerations.

“(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).”

These groupings are then permanent per the IRS regulations unless “a taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate.” If you are starting a new business, and you already have a business, then consult with your accountant regarding whether the businesses should be grouped. If you fail to group them now, and later try to group them, the IRS might disallow that grouping. There is an exception to the regrouping rule which allows taxpayers to regroup the first time the taxpayer is subject to the net investment income tax.

In Rev. Proc. 2010-13, the IRS lists disclosure requirements regarding tax groupings. If the original grouping was made before 1/25/2010, then no disclosure is required until a change is made. New groupings or regroupings after that date must be disclosed. If there is no disclosure, the IRS can generally treat them as separate activities. What if it is discovered that a grouping has not been disclosed? If the taxpayer discloses the grouping in the first year the omission is discovered, and all previous returns were consistent with that grouping, then the IRS considers it a timely disclosure.

If the IRS discovers the omission of the disclosure, then the taxpayer must have “reasonable cause” for omitting the disclosure. Contact our office if you think you may have some undisclosed groupings on your tax return which should be disclosed.

Even when the disclosure has already been made, the taxpayer may want to continue to disclose that grouping in each tax return. If done correctly, this may help inform the taxpayer and IRS and future accountants that there is a grouping in effect.

This blog is not tax advice. If you would like help walking through your options, please contact our office.

 

 

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.