Self Employment Income determination

We have a client that is an LLC taxed as a partnership that also issues a Form W-2 to the partners. This year the partner's have large losses on the K-1 box 14a.  We would normally add the W-2 income and the K-1 income together for plan compensation (after the appropriate SE tax calculation when K-1 is positive) but someone in our office thought they remembered reading that the negative K-1 income could be disregarded and only the W-2 income used.  Does that sound familiar? I do not remember reading anything about that so wanted to see if anyone else was familiar with it.  The negative K-1 amounts are slightly less than the W-2 income so the partners will have a small amount of income for the year.  

No it doesn't sound familiar because LLCs with pass through SE taxation are not supposed to issue W-2s. Period. 

The only time I see that is when an existing employee is becoming a partner mid-year. 

See Revenue Rulings 69-184, 81-300, and 81-301. An individual cannot be both an employee and a partner for employment tax purposes. 

I would confirm with the CPA that the LLC does not have an S-Corp election. If they confirm then have them tell you want to use as compensation. It's their issue. 

17 hours ago, justanotheradmin said:

No it doesn't sound familiar because LLCs with pass through SE taxation are not supposed to issue W-2s. Period. 

It's done - a lot. I agree it is not supposed to be that way. Accountants and clients like it since withholding is easier than quarterly tax payments, I think. 

We always add (or net) the W-2 and net SEI. 

7 minutes ago, Bird said:

It's done - a lot. I agree it is not supposed to be that way. Accountants and clients like it since withholding is easier than quarterly tax payments, I think. 

We always add (or net) the W-2 and net SEI. 

I'll also add that there are long articles and whitepapers out there on this issue, which goes back to the 1930s. These usually include situations far more complicated than we normally see in our practice, which are usually a pretty easy to decipher.   For those of us with a taste for the finer things in life like the Code, ambiguous court rulings, and guidance that prompts more questions than it answers, its a gold mine!

1 hour ago, Bird said:

It's done - a lot. I agree it is not supposed to be that way. 

I agree its done a lot more than it should be.

19 hours ago, Rose said:

but someone in our office thought they remembered reading that the negative K-1 income could be disregarded and only the W-2 income used.  Does that sound familiar? I do not remember reading anything about that so wanted to see if anyone else was familiar with it.  

How to address it the way Rose proposes isn't something I'm familiar with because I refuse to entertain the idea and whenever it comes up I send it back to the CPA and have them tell me what to use because I refuse to figure that calculation out. 

I was told once by a client maybe 15 years ago that the K1/W2 combo was appropriate for a business in New York (state).  I don't remember the whole deal other than it did add only a few thousand dollars from the K1 to the partners' wage amounts.

As justanotheradmin noted, the only situation where we expect to see an individual with W2 and K1 income in the same year is when the individual's status changes between a common law employee and a self-employed employee.  When we see a W2 and K1 in the same year under other than these circumstances, we push back on the client and the accountant.  We have been successful in getting revised reporting from them.

One topic of particular interest and is fairly common is when an individual who becomes a partner during the year has Guaranteed Income for their services performed during the year and are treated much like a salary.

We familiarized ourselves with Schedule K-1s and it made the conversations with the client and accountants is easier by speaking their language.  We also educate them on retirement plans assuming all earnings from self-employment are considered earned as of the last day of the plan year and use the 415 definition of compensation.

Yes, it can be messy.  See https://www.irs.gov/retirement-plans/calculation-of-plan-compensation-for-partnerships .  In the end almost always results on a mutual agreement and understanding of plan compensation, and the conversation rarely has to be repeated from year to year.

I don't think state has anything to do with it, and agree with Just. Below are excerpts from IRS website. I have seen people use W2 inappropriately as an easy avenue for payroll taxes and income tax withholding because they don't want the hassle of doing correctly. Also agree you should "punt" to accountant to give you plan compensation.

Reporting Partnership Income
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" profits or losses to its partners. Each partner reports their share of the partnership's income or loss on their personal tax return.

Partners are not employees and shouldn't be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partner. For deadlines, see About Form 1065, U.S. Return of Partnership Income.

Is a partner considered an employee?
Are partners considered employees of a partnership or are they considered self-employed? Partners in a partnership (including certain members of a limited liability company (LLC)) are considered to be self-employed, not employees, when performing services for the partnership.  (Jun 15, 2023)

I was wondering if a plan that has two 50% owners with employees and also the same two owners have an affiliated service group with no employees, would this be another situation where the owners can use both W-2 for the one entity and K-1 for the other and combine them to determine plan compensation?