non-employee using an LLC

[Guest forohonek]

This is not a question about benefits, per se. But with so many employment experts here, I'm hoping you won't mind offering any thoughts.

The idea: In order to AVOID having employees here's a concept that I want to know if there's any holes that can be shot through it:

Company "A" needs services performed, so it hires LLC "B" to do the work.

LLC "B" advertises for people to work with.

When acceptable people are located, they are offered a membership interest in the LLC for a $100 capital contribution.

The LLC has only two items on the IRS form 1065. Gross revenues (all from Company "A") and guaranteed payments to partners (the newly found people who will work).

The LLC tells the new members that they are in luck! No FICA withholding, and they also get to write off all transportation and other costs "above the line" on the member's Schedule E.

The LLC member of course pays 15.3% SECA, but that's after deducting all their car expenses, some meals expense, and so on.

Seems to be a win-win for the member who gets to write off all his business expenses, that as an employee he'd have to eat on his own.

And a win for the Company as they avoid the various payroll taxes including State unemployment tax and workman's comp premiums.

Of course the members may get their own disability insurance if they want it. And of course the cash paid would be fairly determined, so we're not talking "abuse of employees" here. We're talking about honestly and legally avoiding payroll taxes, and optionally avoiding any unwanted workman's compensation insurance.

[K2retire]

I won't claim to know about the legality of this arrangement, but it does not appear to me that you are avoiding the payroll taxes, merely transferring them from the company to the employee.

[Guest forohonek]

I won't claim to know about the legality of this arrangement, but it does not appear to me that you are avoiding the payroll taxes, merely transferring them from the company to the employee.

To clarify a little. You are somewhat correct. The FICA tax is merely replaced with SECA tax (basically the same tax, one is for employees and the other is for self-employed persons). No sneaky "shifting" of the tax burden is in this planning. The Company and the Worker would all do this head's up, with eyes open.

The payroll tax savings comes from the fact that the SECA would be based on the NET income after deducting transportations costs, and also all State and Federal Unemployment tax are avoided. Optionally State disability and Workman's comp could be avoided, if such coverage is not desired.

The savings could amount to $1,000 or more per person, per year.

[GBurns]

Who will be the employees of the LLC who will provide the labor and services required for Company "A" ?

Who sets their hours and working conditions etc ?

Who will be the employess of the LLC who will provide the services necessary to operate the LLC ?

Who pays the expenses of the LLC ? Rent, telephone, licensing, bookkeeping, insurance etc ?

Where are the expenses reported ? You said that the 1065 only has 2 entries.

What happens in the LLC when either a member leaves or more are needed ?

Being "heads up with eyes open" is irrelevant, if there is a miscalculation of employment status. IMHO these people very likely will be regarded as employees by regulators.

[Bird]

Whether this is a proper arrangement or not really depends on the nature of the working relationship, not the way it is structured. You should take a look at the twenty factor test in Rev Rul 87-41; I think it's more commonly used to determine "independent contractor" vs. "employee" status but I believe it might provide some insight here.

There are factors such as the degree of control over the individual, and how they are paid. I don't consider myself an expert, but I always look at whether someone is paid by the hour or the job as a starting point. If paid by the job, then I'd start with the premise that the person is an independent contractor and look for other factors to confirm or deny that starting point. Likewise, if paid by the hour, I'd start with the premise that the individual is an employee...of course independent contractors can bill by the hour but it usually becomes obvious if the person really is an independent contractor. Gburns' second question is another key one.

Now in this situation of having "partners" in the LLC, I'm guessing that each "partner" is going to eat what eat or she kills. That would make me question if it's a true partnership; what, exactly, would be the point of the partnership as a mutual venture, other than tax avoidance? But the fact that expenses are not reimbursed is a factor on the side of being an independent contractor. That makes me wonder if someone has already considered the "independent contractor" route and concluded "no" and that makes me think that if the individuals are not independent contractors, then they're not likely legitimate partners either.

Just thinking out loud and I could be way off base.

[Guest forohonek]

Good questions...

Who will be the employees of the LLC who will provide the labor and services required for Company "A" ?

The LLC would not have any employees

The LLC would provide all labor and services that Company "A" retained the LLC to do. The members of the LLC would actually perform the work. When a LLC member performs the work normally performed by "an employee" then, by law, he is not an employee receiving employee's wages, rather he is receiving "guaranteed payments to partners."

Who sets their hours and working conditions etc ?

The LLC would make all such decisions

Who will be the employess of the LLC who will provide the services necessary to operate the LLC ?

The LLC would not have any employees

The LLC members would provide all services to operate the LLC, or the LLC could hire an accounting form to handle office work, including preparing tax returns and other gov't forms.

Who pays the expenses of the LLC ? Rent, telephone, licensing, bookkeeping, insurance etc ?

Expenses could be minimal. Office? operated out of the managing member's home at his own expense. telephone? the managing member's cell phone at his own expense, is all that's needed. bookkeeping? the LLC would need to retain an accounting firm. insurance? NONE paid by the LLC, that's the whole point here!

Where are the expenses reported ? You said that the 1065 only has 2 entries.

okay, I over simplified. All LLC income and any expenses paid for by the LLC are reported on form 1065 and the related Schedule K-1's Other unreimbursed operating expenses, would be the responsibility of each individual member, and generally I'd expect them to deduct those expenses on form 1040, Schedule E, page 2.

What happens in the LLC when either a member leaves or more are needed ?

Same as is standard practice for other LLCs taxed as partnerships. A final K-1 is issued to exiting members. When new people wish to join the LLC, they pay $100 to become a member.

Being "heads up with eyes open" is irrelevant, if there is a miscalculation of employment status. IMHO these people very likely will be regarded as employees by regulators.

THAT'S the trick. Where is the problem with this set up? Can the Dept of Labor tell an LLC that its members are employees of a Company "A" who has never supervised any of the members? never written a check to any of the members? If so, then what would the "employees" wages be when there are no checks payable by Company "A" to any individual, and Company "A" has no knowlkedge of how many LLC members there are, what their compensation is, or the names and addresses of any of the individual LLC members is? (all checks from Company "A" are made out to the LLC when the LLC renders an invoice.

[GMK]

Maybe this can work, but I agree with GBurns that these people look like employees ...

unless they perform services for more than one unrelated firm at the same time.

I'd also worry about the part that says that a worker is generally an employee if the employer has the right to discharge the worker and/or the worker can quit without incurring liability.

Just some thoughts. I'm no expert.

[GBurns]

As Bird points out your scheme seems to serve no other purpose than tax avoidance. There is no economic substance and no business purpose for either the LLC or its members.

As also pointed out there is the issue of employment status. If the LLC is setting the hours and working conditions etc the the members are employees. I would check the rules regarding Independent Contractor status.

Receiving wages is not the sole determinant of employee status.

It is ot being an employee of Company "A" that is the issue, it is being an employee of the LLC. And YES the DoL and the IRS does and can tell you with severe penalties that the so-called members are also employees of the LLC etc. So might your state regulators.

Regardless of how fancy a structure might be, substance will always trump form.

I have not looked it up, but your scheme seems very much like one of the schemes that was tried unsuccessfully in the Microsoft case.

[Guest TPA Licensing]

The post by "bird" above regarding the IRS 20 factor test appears to be the main issue. The IRS has a test it uses to determine whether someone is an independent contractor or an employee subject to withholding. It is generally based on whether the person controls their own work like subcontractor, or whether they are at the direction and control of the employer. Otherwise, lots of employers would try to call all their employees subcontractors and set them up as LLCs for the reasons you describe. Check out http://www.crscorpservices.com/ for more info on corporate issues, including LLCs.

[Moe Howard]

GBurns is correct ..... no economic substance.

It would probably work if each partner's guaranteed payment was based on his production.

[Guest Mr. Kite]

It seems that one of the benefits you are banking on is the deductibility of expenses by an LLC partner that would not be deductible by an employee. This is not correct. Automobile expenses incurred in going to work are generally nondeductible unless specifically allowed (see RR 99-7). Meal expenses are also generally nondeductible unless there is a specific exception, and even if deductible they would be subject to the 50% limitation of IRC 274(n).

Additionally, I believe that the deductiblity of expenses under IRC 212 (expenses related to the production of income) are more limited than deductions under IRC 162 (trade or business expenses).

Another problem that could arise regarding these expenses is that they could be classified as capital contributions to the LLC. If the idea here is that the LLC is doing the "work," and the "partners" are acting as agents of the LLC in performing the work, then the expenses incurred by the partners on behalf of the LLC, and it is the LLC that is entitled to the deductions. Of course, the deductions would pass-thru to the partners, but I believe the pass-thru must be made according to the partners' interests in the LLC rather than to each individual partner that incurred the expense.

Finally, if the IRS became aware of this situation and applies the substance-over-form and 20-factor test to determine that the "partners" are employees -- and probably employees of the employer rather than the LLC, not only would the partners be subject to the taxes they should have paid if properly classified as employees, as well as penalties and interest, the LLC and/or the employer will be liable for taxes (failure to withhold and FICA) and penalties. Also, because this arrangement is so transparently an attempt to avoid taxes there is a risk that this would be treated as tax fraud.

Several years back there was a case involving a professional basketball player that set up an LLC or corporation, which contracted with the team to provide basketball playing services, which were carried out by the individual. The court looked right through that to find that the service agreement was between the player and the team.

Also, state worker's comp law would probably treat the "partners" as employees of the employer -- there are a number of employee leasing cases in which the court held the company to be the employer for workers comp even though, on paper, the individuals were classified as employees of the leasing company. Any potential employer that signs up for this arrangement may find themselves on the hook for these costs, and would probably seek recompense from the promoter (i.e., you).

Additionally, what if a "partner" does not show up at work one day -- does this partner nevertheless receive his or her guaranteed payment? Any vacation days?

There are just too many risks here for heavy penalties (above and beyond the payment of taxes), and this risk clearly outweighs the $1,000/year savings you envision per "partner."

[QDROphile]

I assume that the sale of LLC membership interests will be incompliance with applicable securities law.