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.