IRS Giving New Attention to Partnerships and Salaries

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As an avid reader, I can tell you that recently I have seen article after article about how the IRS is beginning to scrutinize companies that are giving W-2s to partners and single-member LLCs that are disregarded entities. 

For example, I have a client who gets a W-2 from Company A. Company A is a disregarded entity with its income flowing to Company B, which is taxed as a partnership. On the K-1 of Company B, my client is listed as a limited partner and then the income is listed as self-employment income. 

Firstly, a limited partner requires that the taxpayer spend less than 500 hours working with the company and is, therefore, not a material or active participant. The income should be treated as passive. 

I brought this up to the tax preparer and finally made my way up the chain to the person who created this structure. The tax code does not define the term “employee.” However, if you read Reg. Section 31.3401(c)-1, it states:

The term employee includes every individual performing services if the relationship between him and the person for whom he performs such services is the legal relationship of employer and employee. The term includes officers and employees, whether elected or appointed, of the United States, a State, Territory, Puerto Rico, or any political subdivision thereof, or the District of Columbia, or any agency or instrumentality of any one or more of the foregoing.

So, what this comes down to is control. There is no doubt that my client materially and actively participates in Company A, but not Company B. Furthermore, if we are going to say that he materially and actively participates in Company B, then the only way that he can be compensated is through guaranteed payments to partners or distributions, not with a W-2.

Revenue Ruling 87-41 provides a 20-part test to determine if someone is an employee for federal employment tax purposes. In 1959, the 3rd Circuit determined in Robinson that partners could not be employees. In fact, when an overhaul of the tax code was done in 1954, the code stated that partners could not be treated as employees.

Let’s talk about payroll companies for a second because they are usually responsible for creating this mess. They sell payroll services to LLCs that have yet to make a tax election. I can understand that, but what I don’t understand is why I am going back and forth with a CPA for two weeks about what is basically Partnership Taxation 101, Day 1.

The end result in this case was the CPA telling me that I could take a contrary opinion on the tax return and answer IRS notice after IRS notice. Then she ended with, “Since the IRS is scrutinizing payments to partners, we will be looking over our methods on how we pay them.”

This is nothing new, I tell her, and I can’t wait to see what this veritable brain trust comes up with next.

What I like about LLCs is their flexibility: their legal flexibility and when it comes to taxation. For instance, let’s say you meet with a client and they have an LLC for which they have yet to make a tax election. You can change their tax election to an S corporation if their profit is so high that it is causing a lot in self-employment tax. You do this by filing Form 2553, Election by a Small Business Corporation, under Revenue Procedure 2013-30 and attach it to the 1120S for the year that you want the S corporation to be in effect.

The problem comes in when a single-member LLC or multimember LLC is a disregarded entity and has done payroll for the year. Because of profit, it will cost more for them to pay you than it will save them in taxes to elect S status. Do you elect S status anyway, or do you do the return incorrectly, adding their salaries as a deduction and explaining to them that they can’t do payroll?

In that respect, the CPA whom I was arguing with was right. However, if you are specializing in tax, you should already know this.

About Craig W. Smalley, EA

Craig Smalley

Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.


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