Other than guaranteed payments under Sec. 707(c), when members receive payments for services performed for a limited liability company (LLC) that is classified as a partnership for federal income tax purposes, the first issue is to determine whether the member is performing the services in the capacity as a member or as a third party. When services are performed outside the member's capacity as a member, the transaction is treated for tax purposes as occurring between the LLC and a third party (Sec. 707(a)). Payments (other than guaranteed payments) received for services performed in the member's capacity as a member are generally treated as a distribution of the member's share of LLC income.
When payments made to a member acting in the capacity as a member are treated as distributions of LLC income, the payment is a current distribution under Sec. 731 (income is generally recognized only to the extent the distribution exceeds the member's basis in the LLC). However, the member reports the distributive share of income (whether distributed or not) in its tax year that includes the LLC's year end. This may result in the member's reporting income before payment is received. The timing rule for recognizing guaranteed payments is similar. Alternatively, if payments are made to a member acting outside the capacity as a member (i.e., treated as made to a third party), a cash-basis member does not report income until the payments are received.
In addition to the member's timing for income recognition, whether services are performed as a member or as a third party affects the LLC. For example, consider an LLC formed to design and construct an office building. Assume one of the original members is an architect who contributed $50,000 cash (10% of all contributed capital) for a 10% interest in all LLC items. If this member provides the necessary architectural services for the project in his capacity as a member and receives no payment (other than his allocable share of LLC income and cash flow), the value of his services is not capitalized to the cost of the building or deducted by the LLC. If the same individual had been paid a fee in addition to his distributive share of LLC profits (acted outside his capacity as a member) to perform the architectural services, the LLC would be required to capitalize the fee paid as part of the cost of the building.
At times it is difficult to determine whether a member performing services for the LLC is acting as a member or a nonmember. The intent of the parties and the structure of the transaction generally determine if a member is treated as performing services as a nonmember. If a member performs the same type of services the LLC renders, he or she is often acting in his or her capacity as a member. Additionally, he or she is most likely acting as a member if he or she does not receive any payment (other than distributions of income allocated to him or her under the Sec. 704 rules) for services performed for the LLC.
Caution: In certain situations, Sec. 707(a)(2)(A) provides a disguised-payment-for-services rule requiring payments that would otherwise be treated as distributions of the member's share of LLC income to be treated as a payment for services made to a nonmember (see below).
The courts generally have held that the determination of whether a partner is acting in a nonpartner/nonmember capacity is based on the facts and circumstances. The Fifth Circuit in Pratt, 550 F.2d 1023 (5th Cir. 1977), held that a partner who performs incidental services generally acts as a nonpartner, whereas a partner who performs continuing services, such as ongoing management services, generally acts in the capacity of a partner, especially if the services are integral to the business activities for which the partnership was formed and in which it is engaged. The court also held that services addressed in the partnership agreement generally are provided by partners in their capacity as partners.
The IRS has indicated that the circumstances surrounding the services, such as whether partners are required to pay their own expenses in performing the services and whether they perform similar services for others, are also relevant (Rev. Rul. 81-301). The structure and documentation of the arrangement are also important.
In Herrmann, 132 Fed. Cl. 459 (2017), the court disagreed with the IRS's contention that a partnership's payment to a partner was a distribution of partnership income. Instead, the court found that the payment was in exchange for services performed as a nonpartner. Key factors cited by the court were (1) the payment was based on a bonus formula and not tied to the partnership's success; (2) payments were not in accordance with the partnership agreement regarding distributions of profits to partners; and (3) payments were disproportionate to the partner's ownership share of the partnership.LLC members as employees
According to Rev. Rul. 69-184, an individual cannot be both a member and an employee of an LLC classified as a partnership for employment tax (Social Security, Medicare, and unemployment tax) purposes. This ruling provides no analysis, authority, or other discussion other than its conclusion. The consequences of this prohibition against employee status can be far-reaching. For example, an LLC member's cash compensation is not considered wages or salary for federal income tax withholding or Federal Insurance Contributions Act tax purposes but is instead generally treated as a guaranteed payment under Sec. 707(c), or as nonemployee compensation if the member is not acting in his or her capacity as a member (see the next section). Therefore, LLC members are generally subject to self-employment tax on compensation received from the LLC. Also, many fringe benefits can be provided tax-free only to employees (not LLC members).
Note: In the preamble to T.D. 9766, the IRS reaffirmed its position in Rev. Rul. 69-184. The IRS noted that several commentators have suggested modifying Rev. Rul. 69-184 to allow LLCs classified as partnerships to treat members as employees in certain circumstances, such as when employees in an LLC obtain a membership interest as an employee compensatory award or incentive. However, until further guidance is issued, the IRS will continue to follow the conclusion set forth in Rev. Rul. 69-184 that an individual cannot be both a member and an employee.Services provided by a member acting as a nonmember — Sec. 707(a)
Members who provide services to the LLC other than in their capacity as a member recognize income under the general income recognition rules, based on their tax accounting method. Likewise, the LLC deducts or capitalizes the payment based on its tax accounting methods (Sec. 707(a)(1)). However, accrual-method LLCs generally cannot deduct a payment before the year a cash-method member includes it in income.
Example 1. Payment for services to a member acting as a third party: L Inc. is a member in H Investors LLC, which is classified as a partnership. L provides property management services and acts as a leasing agent for commercial properties owned by H. L also renders similar services to other third-party real estate owners. During the year, in accordance with a management fee agreement, H pays $78,500 to L for management services. This fee is based on the same rates that L charges other third-party owners for similar services. The fee does not affect L's allocation of LLC income. Both H and L are accrual-basis taxpayers.
The fact that the services provided to the LLC are of a nature that L also provides to third parties and that the payment does not affect L's income allocation are indications that L is acting as a nonmember. Assuming that it is correct to treat L as a third party with respect to the management fee it receives from the LLC, H deducts the management fee as a business expense in the year that the expense is properly accrued. Likewise, L reports the fee as income when the income accrues. L's Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., from H does not reflect the management fee paid to L (other than to the extent it reduces the LLC's taxable income that is allocated to all members).
Caution: If L were a cash-basis taxpayer, the LLC's deduction would be deferred until the year that L receives payment.
When the LLC makes payments for services to members acting as nonmembers, the LLC should generally issue that member a Form 1099-NEC, Nonemployee Compensation, to report the amount paid.Services provided by a member acting as a member
A member acting as a member is usually compensated for services rendered to the LLC either with a guaranteed payment or simply an allocation of a share of LLC income or loss. Members who receive only their distributive share of LLC income or loss do not report the value of their services as income (i.e., they report only their share of LLC income or loss). Likewise, the LLC does not deduct (or capitalize, as the case may be) the value of the member's services.
For example, if a member who owns a 25% interest in a real estate development LLC is a builder who supervises the construction of a building for the LLC and receives no payments from the LLC (other than distribution of his 25% share of LLC income), the value of his services is not treated as an expense of the LLC and, consequently, is not expensed or capitalized as part of the building's cost. Had the LLC paid a third-party builder to construct the building, the builder would have reported the fee as income, and the LLC would have capitalized the fee to the cost of the building.
Preferential income allocations and distributions: Members who perform services in their capacity as members are sometimes allocated a share of LLC income in addition to the allocation based on their share of capital (often called a preferential allocation). In some cases, it is appropriate to treat this as an allocation of the member's share of the LLC's income. Such a preferential allocation of income generally has the same effect on LLC income as a guaranteed payment. The member receiving the allocation reports it as income, and the allocation to the service-providing member effectively reduces the income to be allocated among the other members.
Example 2. Preferential allocation of LLC income to a member providing services as a member: Assume the same facts as Example 1, except that instead of paying L a set amount, H's operating agreement provides that L will receive a special allocation equal to 10% of LLC gross revenues. During the year, H's gross revenues are $660,000.
L's special allocation is $66,000 ($660,000 gross revenue × 10%). Whether the payment is a management fee (that is, a payment to a member acting as a nonmember) or an allocation of LLC income is a question of fact. Generally, the allocation will be treated as a management fee paid to a nonmember if the members expected it to approximate the fee L normally receives for comparable services to third parties and it is reasonably certain that the payment will be made. However, if the property is a speculative project without any leases when the members enter into the operating agreement, L may be at enough risk with respect to receiving the payment that the arrangement is respected as an allocation of LLC income followed by a payment of that distributive share. See the discussion above for details on making this determination.Disguised-payment-for-service rules
In some cases, amounts distributed to members are recharacterized as payments to nonmembers. Sec. 707(a)(2)(A) provides that if (1) a member performs services for an LLC; (2) there is a related direct or indirect income allocation and a distribution from the LLC to the member; and (3) the performance of such services and the allocation and the distribution, when viewed together, are properly characterized as a transaction between the LLC and a nonmember, it is treated as such. In other words, the distribution to the member is treated as a payment for services made to a third party under Sec. 707(a)(1). The payment is deducted or capitalized by the LLC according to the character of the services provided by the member and recognized as compensation by the member acting in the capacity as a nonmember. If the service provider has a significant entrepreneurial risk with respect to the LLC, this rule generally does not come into play.
This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Limited Liability Companies topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).
|Sheila Owen, CPA, is a senior specialist editor with Thomson Reuters Checkpoint. For more information about this column, contact email@example.com.