How to Compensate the Owners of a New Business

Hi all,

I'm starting a business with a partner. We want to pay ourselves based on the amount of work each of us puts towards a project. So if there are 100 man hours, I do 60 hours, he does 40 hours, I would get 60% profit, he would get 40% profit.

From the research I've done, I see two options

1- setup an llc and make our selves both members and employees. However, I think that this would force us to pay taxes such as unemployment tax (again, I think).

2- setup an llp and each of us get a k1 at the end of the year. But here in texas, an llp has to pay $200 per partner per year fee.

How should we go about this?

Questions:

1- If we setup an llc and are both members and have no other employees, do we have to pay unemployment tax?
2- If we setup an llp, can we get one insurance policy for that will cover both of us?

If you work for an LLC or corporation you have to pay yourself salaries. You just can't just declare it dividends or whatever to avoid paying the FICA and other taxes. Yes, you are liable both under FUTA and TUCA for unemployment taxes.

Insurance for what? That's not a legal issue. As your insurer.

We can't even tell whether either the LLC or LLP makes sense without understanding what on earth you are doing. Perhaps you should solicit help from an attorney or CPA.

A LLC organized in the U.S. is treated by default as a partnership for federal tax purposes. Thus the members of the LLC are treated as partners of the LLC for federal income tax purposes. Very generally partners are not employees for federal income tax purposes. There are exceptions to that but they are unusual. That means that the LLC does not pay income tax on it its income. Instead, it files a Form 1065 information return. With that return are Schedules K-1 for each partner (member), a copy of which is provided to the member. The member uses the K-1 to report his share of the LLC income on his return and he ends up paying the tax on the LLC's income. In addition to that, the partner (member) also pays self-employment tax with respect to that income, too. Self-employment tax is how self-employed persons and partners pay Social Security and Medicare taxes. No federal unemployment tax is paid with respect to the earnings of the members (partners) because they are not considered employees for federal tax purposes. This is, by the way, the exact same treatment a LLP would have. So, for federal tax purposes there is no difference between organizing as a LLC versus a LLP.

Texas does not have individual income tax. For state unemployment tax purposes, payments made to LLC members based on their share of the profits are not treated as wages and not subject to the unemployment tax, but other payments by the LLC to the members may be wages and thus subject to the tax. It appears that a LLP is treated more like a general partnership in which no payments to the partners are considered wages, but you’d want to discuss that with a Texas tax professional familiar with business taxation in that state.

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Quoting flyingron

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If you work for an LLC or corporation you have to pay yourself salaries. You just can't just declare it dividends or whatever to avoid paying the FICA and other taxes.

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Not so with a LLC. As I mentioned in my reply, for federal tax purposes a LLC with more than one member is treated by default as a partnership and the members are treated as partners. Partners do not, for federal tax purposes, receive wage or salary. There is no avoidance of FICA tax (Social Security and Medicare) because the partners pay self-employment tax on their share of the LLC (partnership) income. For Texas unemployment tax, the treatment is a little different, but still so long as the only payments are based on the partners distributive shares they are not "wages" and not subject to the tax.

The treatment of a corporation (including a LLC or LLP that has elected to be treated as a corporation) is different. There the payment to anyone for work done for the corporation is treated as wages and subject to the rules for employment taxes, e.g. wage withholding, giving out W-2 forms, etc. But it doesn't look like the OP is interested in a corporation.

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Quoting Taxing Matters

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A LLC organized in the U.S. is treated by default as a partnership for federal tax purposes. Thus the members of the LLC are treated as partners of the LLC for federal income tax purposes. Very generally partners are not employees for federal income tax purposes. There are exceptions to that but they are unusual. That means that the LLC does not pay income tax on it its income. Instead, it files a Form 1065 information return. With that return are Schedules K-1 for each partner (member), a copy of which is provided to the member. The member uses the K-1 to report his share of the LLC income on his return and he ends up paying the tax on the LLC's income. In addition to that, the partner (member) also pays self-employment tax with respect to that income, too. Self-employment tax is how self-employed persons and partners pay Social Security and Medicare taxes. No federal unemployment tax is paid with respect to the earnings of the members (partners) because they are not considered employees for federal tax purposes. This is, by the way, the exact same treatment a LLP would have. So, for federal tax purposes there is no difference between organizing as a LLC versus a LLP.

Texas does not have individual income tax. For state unemployment tax purposes, payments made to LLC members based on their share of the profits are not treated as wages and not subject to the unemployment tax, but other payments by the LLC to the members may be wages and thus subject to the tax. It appears that a LLP is treated more like a general partnership in which no payments to the partners are considered wages, but you’d want to discuss that with a Texas tax professional familiar with business taxation in that state.

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Not so with a LLC. As I mentioned in my reply, for federal tax purposes a LLC with more than one member is treated by default as a partnership and the members are treated as partners. Partners do not, for federal tax purposes, receive wage or salary. There is no avoidance of FICA tax (Social Security and Medicare) because the partners pay self-employment tax on their share of the LLC (partnership) income. For Texas unemployment tax, the treatment is a little different, but still so long as the only payments are based on the partners distributive shares they are not "wages" and not subject to the tax.

The treatment of a corporation (including a LLC or LLP that has elected to be treated as a corporation) is different. There the payment to anyone for work done for the corporation is treated as wages and subject to the rules for employment taxes, e.g. wage withholding, giving out W-2 forms, etc. But it doesn't look like the OP is interested in a corporation.

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However, should the LLC make an S-corp election (election to be taxed as an S-corp) then it would not only be possible to pay the members wages based on work, but also REQUIRED.

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Quoting llworking

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However, should the LLC make an S-corp election (election to be taxed as an S-corp) then it would not only be possible to pay the members wages based on work, but also REQUIRED.

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Yes, of course. Should a LLC (or LLP or any other type of partnership) make an election to be treated as a S-corporation the tax treatment changes. Note that strictly speaking the payment of salary/wages is not required by federal tax law. Instead, what generally occurs is that any distributions/payments that are made by a S-corporation to one of its shareholders are characterized as salary/wages first, up to a reasonable salary for the type of work the shareholder has performed for the corporation. Those wage/salary payments are subject to federal employment tax and federal unemployment tax.

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Quoting Taxing Matters

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Yes, of course. Should a LLC (or LLP or any other type of partnership) make an election to be treated as a S-corporation the tax treatment changes. Note that strictly speaking the payment of salary/wages is not required by federal tax law. Instead, what generally occurs is that any distributions/payments that are made by a S-corporation to one of its shareholders are characterized as salary/wages first, up to a reasonable salary for the type of work the shareholder has performed for the corporation. Those wage/salary payments are subject to federal employment tax and federal unemployment tax.

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That was a bit disingenuous as a response...and a bit disappointing.

An S-corp is not required to distribute any profits at all. The massive amounts of case law out there on the subject however, makes it clear that an S-corp is required to pay working shareholders a fair market wage for the work they perform.

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Quoting Taxing Matters

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The treatment of a corporation (including a LLC or LLP that has elected to be treated as a corporation) is different. There the payment to anyone for work done for the corporation is treated as wages and subject to the rules for employment taxes, e.g. wage withholding, giving out W-2 forms, etc. But it doesn't look like the OP is interested in a corporation.

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Not all payments to a person who performs work for the LLC (taxed as a corporation) are necessarily treated as wages subject to employment taxes (SS & Medicare). The business is required to pay a "reasonable" salary. That is, the salary/wage subject to employment taxes is the amount the IRS (or tax court) considers "reasonable", which is not necessarily 100%. A shareholder is also entitled to a return on his investment, which can be paid by an S corporation as a dividend. Thus, if my LLC invests in rental housing and I spend 12 hours a week providing services to the business, I can still take the profits from capital gains, passive rental income, etc. from the LLC and pay employment taxes only on the compensation I receive for the 12 hours of work I perform a week. So long as I pay myself a "reasonable" salary (usually commensurate with what what would be paid to a non-shareholder employee to perform the same work) then I'm in the clear.

I am at a loss as to why you think my response was “disingenuous.” I made what I believe is a correct statement of the tax law. My statement is also very close to what the IRS states as the tax law as well: “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” See the discussion from the IRS S-corporation Shareholder compensation page. I suppose if you thought my statement disingenuous you must also think the IRS is being disingenuous, too? After all, our statements are much the same.

Note that nowhere on that page does the IRS say that a S-corporation must pay wages. It merely states that if the corporation makes payments to the shareholder that the payments are characterized first as payment of wages up to reasonable compensation for the services provided to the corporation. This statement derives from IRS Revenue Rev. Rul. 74-44 in which the IRS ruled that the $100X that a S-corporation paid out as dividends to a shareholder while paying no wages to the shareholder for the work he did for the corporation would be treated as wages rather than dividends.

This distinction is not merely wordplay. I think you’ll agree that it is quite different if the tax law actually required the S-corporation to pay wages or salaries to the shareholders rather than simply recasting whatever payments are made as wages. A struggling S-corporation may wish to retain what funds it has to grow the business and not pay the shareholders anything. Nothing in the tax law requires that the S-corporation pay the shareholders anything. Look at Subchapter S (IRC §§ 1361-1379) and you will not see any such requirement. If the S-corporation does not pay anything, the tax law does not impose FICA taxes on payments not made, i.e. phantom payments. But if the corporation does pay the shareholders, then as to the payments actually made the tax law does determine the treatment of those payments.

The case law has a number of examples where the courts recast dividends or distributions actually made as wages following the principles of Rev. Rul. 74-44:

“The question here is whether, based on the statutes and unusual facts involved, the payments at issue were made to Mr. Radtke as remuneration for services performed. See Royster Co. v. United States, 479 F.2d 387, 390 (4th Cir.1973). As the district judge determined, these payments were clearly remuneration for services performed by Radtke and therefore fall within the statutory and regulatory definitions of wages.” Joseph Radtke, S.C. v. United States, 895 F.2d 1196, 1197 (7th Cir. 1990).

“Because Mr. Blodgett was petitioner's employee for the periods at issue and performed substantial services for it yet it did not pay him a salary, its distributions to him are deemed wages and thus are subject to Federal employment taxes.” Glass Blocks Unlimited v. Commissioner, 106 T.C.M. 96 (T.C. 2013)

“Sections 3111 and 3301 impose FICA (Social Security) and FUTA (unemployment) taxes on employers for wages paid to their employees. For Federal employment tax purposes, section 3121(d) defines an employee in part as any officer of a corporation. However, there is an exception to employee status for an officer who does not perform any services (or performs only minor services) and who neither receives nor is entitled to receive remuneration. Sec. 31.3121(d)-(1)(b), Employment Tax Regs. For Federal employment tax purposes, the term ‘wages’ is defined as ‘all remuneration for employment’. Secs. 3121(a), 3306(b). The form of payment is immaterial, the only relevant factor being whether the payments were actually received as compensation for employment. Secs. 31.3121(a)–1(b), 31. 3306(b)–1(b), Employment Tax Regs. Consequently, an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee, whose wages are subject to Federal employment taxes.”

Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141, 144-45 (2001) aff'd sub nom. Yeagle Drywall Co. v. Commissioner, 54 F. App'x 100 (3d Cir. 2002)(bolding added).

These three are just a few of the cases. Each of them involves recasting payments actually made as wages. As Veterinary Surgical Consultants makes clear there are two requirements here: (1) that the officer performed substantial services for the corporation and (2) that he actually received remuneration in some form from the corporation. No federal tax case that I’ve seen imposes an affirmative obligation to pay anything to the shareholder. No case creates phantom payments on which to impose FICA taxes either. Instead, the cases all start with the fact that shareholder was paid something and the issue for the court to resolve is the proper treatment of that payment under the tax law.

You are not alone in your belief that that the tax law imposes a requirement on a S-corporation to pay salary. I’ve heard that expressed by others before, too. I’m not quite sure where that belief comes from because based on the foregoing discussion, I contend that belief is incorrect. Now you have stated that “massive amounts of case law out there on the subject however, makes it clear that an S-corp is required to pay working shareholders a fair market wage for the work they perform.” If you contend that these are federal tax cases, please share with me some of the citations on which you rely for your statement. I’ll be the first to admit that I don’t know everything and that perhaps, despite my years of experience in this area, I might nevertheless be wrong. I’d love to see these cases. I’m always willing to learn something new, even at my age. If you don’t have these cases, however, might you be willing to concede that perhaps your understanding of the tax law is mistaken?

If you mean that some state employment tax cases impose a requirement to pay wages or salary to an S-corporation shareholder who does work for the corporation, that may well be the case in some states. There are no such cases in the jurisdictions I practice, but I’ve not researched the employment law in every state. So let me be clear, my statements were made only with respect to what federal tax law requires. State employment law may impose requirements that the tax law does not.

I never accused you of being disingenuous or anything else. I was clarifying a point. A point that I believe you misunderstand very badly, but that is not an accusation of anything, it is an opinion. For example, Rev. Rul. 74-44 deals with a situation in which shareholders paid themselves NO salary specifically to avoid paying employment taxes. If you re-read what I wrote, that clearly is not allowed.

The first case you cite has nothing to do with the issue I'm discussing. Whether payments to salesmen are compensation or reimbursement for meals is not at issue here.

What is at issue is that once a shareholder has been reasonably compensated for the value of the services provided to the corporation, remaining profits can and should be distributed as dividends not subject to employment taxes.

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"Consequently, an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee, whose wages are subject to Federal employment taxes"

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That is exactly true. If an officer is paid for performing services s/he is an employee and his/her wages are subject to employment taxes. I have not said otherwise. Do you have any case law that indicates an officer, paid a reasonable salary of $100k a year (the fair reasonable value of his services) who paid employment taxes on those wages was also held to owe employment taxes for an additional $100k received as dividends representing a return on his investment?

If a person invests $1 million in starting a company he is entitled to a return on his investment that is completely independent of any wages he is paid for services provided to the company. In fact, if he performs zero services, hiring others to perform them instead, then he owes no employment taxes for his income from the s corporation at all.

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Roob v. Commissioner, 50 T.C. 891 (1968) is very instructive. That case provides that regardless of whether a corporation had made a Subchapter S election or not, the determination of reasonableness of compensation is still governed by the dictates of Section 162(a)(1) of IRC. So while a C corp has a natural incentive to inflate salaries to avoid double taxation, which is not allowed, an S corp has a natural incentive to mischaracterize income as not compensation to avoid employment taxes, which is also not allowed. In both cases the rules are the same - reasonable compensation has to be reported as wages. Anything left over is dividends, regardless of tax implications.

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Quoting Bubba Jimmy

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I never accused you of being disingenuous or anything else.

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No, you didn't. llworking specifically said I was “disingenuous” in the reply just before yours. It was to him/her that I directed my comments, not to you. I’m sorry that wasn’t clear. For some reason I had trouble with getting the quote feature to work when I composed that earlier reply so I didn’t quote llworking’s comment.

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Quoting Bubba Jimmy

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What is at issue is that once a shareholder has been reasonably compensated for the value of the services provided to the corporation, remaining profits can and should be distributed as dividends not subject to employment taxes.

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I agree with that, and indeed my statements are consistent with that. What I said in my intial reply in this thread was: “ Instead, what generally occurs is that any distributions/payments that are made by a S-corporation to one of its shareholders are characterized as salary/wages first, up to a reasonable salary for the type of work the shareholder has performed for the corporation. Those wage/salary payments are subject to federal employment tax and federal unemployment tax.” (bolding added.) I did not say, but I think is pretty clearly implied, that once payments totaling the reasonable compensation for the work done have been treated as wages/salary that any payments received beyond that are treated as whatever other type of distribution they are. If that wasn't clear then your clarification on that point is most welcome.

My disagreement in this thread is with the statement that under the tax law an “S-corp is required to pay working shareholders a fair market wage for the work they perform.” There simply is no such requirement. The corporation is not required by tax law to distribute anything to the shareholder. What the tax law says is that if the S-corporation distributes money and/or property to shareholders that the distribution will be treated first as salary/wages paid to the shareholder up to the amount that is reasonable compensation for the work performed. Any distribution beyond that would, as you pointed out, be treated as whatever other type of distribution they are.