Answer: You are correct that a Limited Liability Company (LLC) with only one member, which does not elect to be taxed as a corporation, is disregarded as a separate entity for tax purposes. What does that mean? That may be easiest to understand with an example or two. Each LLC in these examples has only one member and has not elected to be taxed as a corporation.
- Example 1. Suppose I, as an individual, set up an LLC. I would report all of the income and expenses from that LLC on Schedule C of my tax return, just as though it were a sole proprietorship. I would pay self-employment taxes on that income.
- Example 2. Suppose XYZ corporation sets up an LLC. It would report all of the income and expenses from that LLC on its form 1120, just as though the LLC were a division or department of the corporation.
So, how does this apply to a limited partnership as the sole member of an LLC? Much as with the corporation, it is as though the LLC did not exist, and the LLC business was a division of the partnership's general business. All income and expenses are reported on the partnership's 1065 just as though the LLC did not exist and the partnership were operating its business directly.
How are partners treated for payroll tax purposes? Revenue Ruling 69-184 is very explicit:
Bona fide members of a partnership are not employees of the partnership within the meaning of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24, respectively, subtitle C, Internal Revenue Code of 1954). 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. Sections 1402(a) and 3121(d)(2) of the Code.
Remuneration received by a partner from the partnership is not "wages" with respect to "employment" and therefore is not subject to the taxes imposed by the Federal Insurance Contributions Act and the Federal Unemployment Tax Act. Such remuneration also is not subject to Federal income tax withholding.
Moving specifically to the issue of limited partners, we have Revenue Ruling 70-411. It is important to note that this is a pre-ERISA ruling, in a day when partners were not eligible to be in a standard qualified plan. But, while the conclusion of the ruling is no longer valid, the ruling is still important because of its reasoning that a partner is a partner -- and not an employee -- even if he is a limited partner:
Advice has been requested whether a partnership's profit-sharing plan may qualify under section 401(a) of the Internal Revenue Code of 1954 if it permits "special partners" to participate under the circumstances described below.
The partnership adopted a profit-sharing plan intended to meet the requirements of section 401(a) of the Code. The plan, which is not designed to include self-employed individuals, provides for annual contributions of six percent of compensation on behalf of all employees, including "special partners." The term "special partner" is defined in the partnership agreement to mean a limited partner who is employed by the partnership to perform such services as would be performed by a regular common-law employee of the partnership. These special partners are intended to have the dual status of employees and partners, and to receive compensation with respect to their services performed as employees while also receiving a share of the partnership profits with respect to their investment in the partnership.
Revenue Ruling 69-493, C.B. 1969-2, 88, holds that a plan covering persons who are not employees of the employer does not meet the qualification requirements of section 401 of the Code. Revenue Ruling 69-144, C.B. 1969-1, 115, holds that, except to the limited extent applicable to the participation of self-employed individuals after December 31, 1962, partners are not employees and, therefore, are not eligible to participate in a qualified plan.
Once an individual's status is established as a bona fide partner of a partnership, it is immaterial, for purposes of his participation in a qualified plan of the partnership, how his partnership interest is defined.
Accordingly, it is held that the partnership's profit-sharing plan does not qualify under section 401(a) of the Code since it permits "special partners" to participate.
So, with this in mind, it seems clear that the limited partners should be treated as limited partners for employment tax purposes. The fact that there is a disregarded LLC in the middle is irrelevant.
IRS Publication 533 makes it clear that limited partners who receive guaranteed payments are subject to self-employment tax:
Limited partner. If you are a limited partner, your partnership earnings are generally not subject to SE tax. However, guaranteed payments you receive for services you perform for the partnership are subject to SE tax and should be reported to you on line 15a or in box 9 of your Schedule K-1.
Thus, these limited partners are partners, not employees. They should not receive a W-2 form. Because they are receiving regular payments for services, they are treated as self-employed individuals and they pay self-employment tax accordingly.
Notice 99-6 while acknowledging that the a disregarded entity is disregarded for employment tax purposes, allows the disregarded entity to file and pay employment taxes for its employees as though it were the employer. I do not believe this affects my conclusions, and discuss why in Q&A 155.
This brings us to your second question: whether these limited partners should participate in retirement plans. By saying that they are subject to self-employment tax, we are also saying that they have earned income from their work for purposes of IRC 401(c). That means that they are self-employed individuals under that section and hence are treated as employees. The ultimate holding of Revenue Ruling 70-411 is no longer applicable, because partners (general and limited) who have earned income and other self-employed individuals are now eligible to participate in qualified retirement plans.
Of course, the situation is different for limited partners who do not have earned income from the business (i.e., they are not performing services for the business for which they receive guaranteed payments). These partners are not self-employed individuals and are not treated as employees. If they participate, it is a violation of the exclusive benefit rule and the plan would be disqualified.
Issues relating to entity status and self-employed individuals are addressed in Chapter 1 of my book, Who's the Employer.