LLC, taxed as partnership, paying both W-2 and K-1 income to "partners"

[Belgarath]

I've seen this twice in the last two weeks, and I don't understand it. You have a LLC, taxed as a partnership. But the 2 "partners" are reporting income from the LLC both on W-2 and on a K-1. Can somebody explain to me how this works, or even if it is possible? I'd have said that if you are being taxed as a partnership, then all income would be K-1.

Is what they are doing correct? Anybody else dealt with this issue? Thanks!

[Guest jfp]

1. There's an old IRS revenue ruling and/or GCM holding that, for tax purposes, you can't be both a partner in a partnership and an employee of the partnership (and I believe the IRS' conclusion would carry over to LLCs that are treated as partnerships for tax purposes). The clear implication of the ruling is that if you are a partner for tax purposes, than all of your compensation needs to be reported on a k-1, either as a share of p/s earnings or as a guaranteed payment.

2. Based on my experience, however, many (if not most) partnerships and their tax preparers either ignore this or aren't familiar with it, and see nothing wrong with issuing both a W-2 and a k-1 to some or all partners. I'm not saying the IRS position is right or wrong; I'm merely noting that what you're seeing is very common.

[Belgarath]

Thanks. So how do you do the calculation? Suppose 10% formula, with 50,000 of W-2 income. Are you going to calculate 5,000, or are you going to toss it in with the K-1 and do the earned income reduction on the whole amount?

In my next incarnation I'm going to do something easier than pension administration. Like solving the meaning of life... Anybody ever read "The Hitchhiker's Guide to the Galaxy?" I have a dim memory that the answer to the meaning of life was "4" but my memory may be totally wrong on that. Maybe I'll just write Vogon poetry.

[Guest jfp]

Does the plan say that "comp." means "earned income" in the case of a 401© self-employed person? If so, then I think you'd be safe in adding up the W-2 and the earned income.

[QDROphile]

42

[BeckyMiller]

Try GCM 34173. It is still the IRS's position. But I have not seen any enforcement activity on this matter.

Sorry - typo in the original post.

The big issue associated with classifying partners as W-2 employees is whether this can somehow change their status to be eligible for other tax-advantaged benefits - participation in 125 plan, exclusion of health coverage from income, etc.

[Guest Robin S. Vatalaro]

You'd add the K-1 earned income to the W-2. Ideally the LLC would amend its tax return as partnership owners cannot have W-2's under the law (but I do know it happens). If the partnership's tax return were properly amended to eliminate the W-2, the partner's K-1 income would increase by the amount of the eliminated W-2.

Example:

Partner has $50 W-2 and K-1 w/ ordinary income of $5. Notwithstanding the SE tax adjustment, you have $55 in SE income. If the partnership return had been prepared correctly and there was properly no W-2, you'd have no W-2, and a K-1 reflecting $55 of income (because partner draws are not deductible to the partnership notwithstanding guaranteed payment rules).

Hope this helps.

[Belgarath]

Just an update in case anyone is interested. Had the same blasted thing happen again. Found the following tidbit in a writeup on the Web by Pillsbury Winthrop LLP. Naturally, I cannot vouch for the accuracy, although it seems to me to be common sense.

Employee vs. Partner Status

In the only case to ever recognize dual status of a partner/employee, the Fifth Circuit concluded that a taxpayer that received a share of partnership profits plus a fixed salary for his services could exclude the value of meals and lodging from his gross income under Section 119. The Service took a contrary position in Revenue Ruling 69-184, concluding that bona fide members of a partnership could not be employees for purposes of FICA, FUTA, and withholding. The Service recognized that

Such a partner who devotes his time and energies in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.

The Chief Counsel's office, in connection with the preparation of Revenue Ruling, 69-184, asserted that a person cannot be both a partner and an employee of the same partnership for any income or employment tax purposes. More recently, the Service ruled that health insurance premiums paid by a partnership on behalf of a partner for services rendered are taxable to the recipient partner and deductible by the partnership as a guaranteed payment.

Thus, a partner cannot also be an employee of the partnership. In determining the taxation of a profits interest transferred to a service provider, Section 83 and Subchapter K should be mutually exclusive.

[BeckyMiller]

The AICPA Tax Division has entered into a discussion with the Service on this matter. Watch for future developments.

[Mary Kay Foss]

Belgarath, in *Hitchhiker* 42 wasn't the answer to the meaning of life, it was the answer to the Ultimate Question. The next book in the series provided the Ultimate Question.

At the end of *Hitchhiker* I believe that rats went on a speaking tour with the answer. They said that the ultimate question was:

*How many roads must a man walk down before you call him a man?*

With an LLC, members are supposed to take guaranteed payments instead of salary. The LLC deducts the guaranteed payments in determining net income divided by the members. Many partnerships use guaranteed payments for medical insurance premiums that the individual partner can deduct on page 1 of their 1040.

[jquazza]

Wouldn't you have an exception to this rule for employees who became partners during the year. They can actually receive a W-2 as an employee for the services performed while not a partner.

In this case you can add the SE income & W-2 for plan purposes but don't apply the SE income rules (i.e. 1/2 SE tax etc..) to the W-2 income.

[Hojo]

I hate to bring this back from the dead, but every time I search the answers seem to be getting older and older......

That being said, I have this exact same situation, and LLC 50/50 partnership with one employee.

The employee gets a normal W2, the two partners get a W2 for $30,000 and also get a K1. i know it's still not really legal, but what do you do in terms of calculating compensation for the plan(s) [potentially setting up a CB and profit sharing plan]?

[mbozek]

You have to follow the definition of comp that is in the plan. If plan includes both self employment income and w-2 income as comp then combine them.

[Hojo]

You have to follow the definition of comp that is in the plan. If plan includes both self employment income and w-2 income as comp then combine them.

There's no plan yet so i guess that means we can use whatever definition we want.....? It just seems so shady.

[shERPA]

Combine 'em. Plan should include SE income and wages in the comp definition.

It's often done because the partners don't make their required quarterly estimated tax deposits. They would owe a penalty on their personal tax returns for failing to deposit on a quarterly basis. Since income taxes withheld via W-2 wages are deemed to be paid in evenly throughout the year (even if they are done just once a year in December only), accountants will often give the partners a W-2 sufficient to cover their income tax withholding.

Not really legit under IRS guidance on how to pay and report income to partners, but the IRS seems to accept it in practice and don't challenge it.

[QDROphile]

Generally a partner in a partnership cannot be an employee of the partnership. If the LLC is taxed as a partnership, then a member cannot have W-2 pay. The exceptions would involve unusual membership interests that are probably not in this picture.

[Bird]

It's common. Add 'em together (after making appropriate adjustments to self-employment income - deduction for 1/2 of the SE tax, and the contributions).

[DocDoc]

I became a partner of a hospital last year. I set up a S Corp and receive K-1 from the hospital . The hospital had a deduction of $18K for my 401K, $35K for my 401K Match, $5K for dependent care, and $30K for my defined benefit, which these amounts showed on my K-1. I am an employee of my S Corp, in which I receive a paycheck every month. Now, my question is: should I add my 401K amount of $18K, dependent care, and my defined benefit to my W2, box 10&12, and deduct $18K+$30K=$48K from my wages, which is box 1? Or should I just leave it a blank on my W2, and have them pass-through from my K-1 when I file my tax return?

[Mike Preston]

You aren't going to like this answer, but there is so much that you have written that needs unscrambling that the best response is that you need to engage a CPA to prepare the W-2 on behalf of your corporation.  To start the unscrambling, be aware that it was required to be completed months ago (January 31, I think).  Maybe somebody else has the time to go into more detail, but since you are going to need an accountant before all is said and done, there isn't much purpose to doing that.