LLC Distribution/Commission Issue

[bbrownatl]

Once again, I need a thought checkup here on a new client that you have already given me insight. Thanks again in advance. Again, new client, two guys set up an LLC as 50/50 partners and obtained the distributorship rights to sell certain medical products. They hire independent sales reps to go forth and sell. For all sales, the LLC gets a 20% commission of which 10% is passed down to the independent sales rep. My question is the following. The owners will obviously split the overall profits 50/50. However, how do I handle the specific sales of the two owners as they too will be out there selling? Just consider it a draw? Pay them just like the other independent sales reps (via A/P and give 1099)?

Now one further twist, consideration is being given to electing S-Corp status. The main issue that I see here is the distribution issue discussed above. I know that treatment as a regular LLC would provide more flexibility on that front. Again, the question comes down to how to address the commissions that will due to the two owners from their specific sales.

Any insight appreciated.

Thanks,
Brian

[Bees Knees]

For your first issue, the answer is treat the sales commissions for the individual owners as guaranteed payments, rather than as distributions. See Guaranteed Payments on page SB4-6 in TTB Small Business edition, or page 20-4 in TTB Deluxe edition.

For the second issue, the commission for an S corp shareholder MUST be added to his/her W-2 wage. You cannot treat an S corp shareholder as a 1099 independent contractor, nor can you distribute earnings as distributions because distributions must be based on the 50/50 ownership rather than as a percentage of profits.

[bbrownatl]

Run commission through W2

Bees, thanks for the insight. I did see this guaranteed payments guidance on page 20-4 in TTB Deluxe edition. I was a little uncertain if the commission would fall into this category but upon second thought I do see where that would apply. Ok, I’m clear on the first item regarding an LLC.

For the second item, I see what you are saying regarding showing the commission on the W2. Even though the two partners split the profits 50/50, they may also get different salary amounts given their commissions, i.e. salary of $90K and the other $110K Though, this drives one further question as to the need to even elect S-Corp status. They would save on self-employment taxes. Makes it a little more complicated and the flexibility with distributions and retirement savings is limited with the S-Corp. Any thoughts as to S-Corp vs. LLC in such a situation?

Thanks again.

[bbrownatl]

Go Twins

Bees, are you a baseball fan? The Minnesota Twins won a classic last night. Wow, what a game. Sorry for the diversion from tax discussions. Thanks again for the insight.

[Bees Knees]

The Twins got into the payoffs, AND Brett Favre helped the Vikings beat the Green Bay Packers. Good week for Minnesota sports.

As to the LLC vs S corp status, I always talk my clients into being an LLC taxed as a partnership (or sole prop for single members). MN does not have any extra fees for being an LLC vs S corp. So in the interest of not having to do payroll taxes (assuming their are no other employees), I say the LLC thing is the way to go.

BTW, being an LLC gives you the same tax savings for SE/FICA taxes as an S corp. Under current law, the LLC member's distributive share of profits is not subject to SE tax, so long as you are paying guaranteed payments similar to the way an S corp would pay wages to shareholders. Both the LLC and S corp receive similar treatment as far as SE/FICA taxes go.

[bbrownatl]

LLC same tax savings as S-Corp??

BTW, being an LLC gives you the same tax savings for SE/FICA taxes as an S corp. Under current law, the LLC member's distributive share of profits is not subject to SE tax, so long as you are paying guaranteed payments similar to the way an S corp would pay wages to shareholders. Both the LLC and S corp receive similar treatment as far as SE/FICA taxes go.

Bees, I need some clarification here. Both distributive share and guarantee payments flow through via the K-1 to Schedule SE as self employment income. Thus, I don't see the SE/FICA savings here. What am I missing here or not considering? Again, thanks for your insight. Go Twins!!

[Nashville]

Partnership vs. S Corp

I've been reading this thread, and I'm not sure you are aware that an LLC is a disregarded entity. There is, for example, no "LLC treatment" because this entity must choose between being an S corp or a partnership. [reference form 8832] If it fails to choose, it files as a partnership by default.

ALL of partnerships regular earnings are subject to self-employment tax, whether in the form on Guaranteed payments or simply partnership earnings after Guaranteed Payments. Not so with an S corp. Creating an example: The entity earns $150,000 including what the partners make in commissions. A makes $50,000 and B makes $40,000 in commissions.

Partnership files a total of $90,000 in guaranteed payments split as above, then another $60,000 in ordinary income, since guaranteed payments are regarded as an expense. The $60,000 is split 50-50. The K-1 for A is $80,000 and for B $70,000, but only $30,000 is distributed to each as "partnership earnings." ALL of it is subject to SE tax, as you have noted.

S Corp files a total of $90,000 as "Salary Expense" on W-2s. There is no SE tax on this, but both A and B have W-2 withholdings for social security/medicare, and the corporation must match those withholdings. The income for the S Corp is only $60,000, and each shareholder receives a K-1 for $30,000 which is NOT subject to SE tax under current law.
The rest of the income for the partners appears on their respective W-2s.

So the S Corp bails out of PART of the FICA/Medicare/SE tax. However, Bees' made a point for the partnership in that the guaranteed payment commission scheme can be performed without the fuss and bother of payroll tax reporting, so as long as the partnership has no other compensated people, you don't have to have a payroll. Not so with the S corp, you will have at least 2 W-2s, with all the grief that comes with quarterly and annual reporting.

Also, there is a good discussion in TTB about what the IRS will do if it appears the S corp is contriving to lower FICA/Medicare taxes by reporting salaries that are unreasonably low. And "unreasonably low" is by the IRS definition and not the shareholders' definition.

[bbrownatl]

Taxed as partnership yet SE tax savings?

However, Bees' made a point for the partnership in that the guaranteed payment commission scheme can be performed without the fuss and bother of payroll tax reporting, so as long as the partnership has no other compensated people, you don't have to have a payroll. Not so with the S corp, you will have at least 2 W-2s, with all the grief that comes with quarterly and annual reporting.

I understand the LLC being a disregarded entity and the chosing between the S-Corp election or the default partnership. My objective is to assist with the setup so as to the extent possible save on SE taxes. My understanding was that I would do it under the traditional S-Corp/reasonable salary scenario as you detail above. However, yours and Bees responses indicate being able to achieve the same objective without electing S-Corp treatment and thus being taxed as a partnership. In my situation, the two owner members of the LLC are only compensated ones. I realize via Rev. Ruling 69-184 that they can't be compensated via payroll rather only via their distributive share and guaranteed payments. Sorry for the confusion and again, I appreciate your insight.

Thanks,
Brian

[bbrownatl]

Point of Clarification

Ok, I think what you are both saying is that the commissions could be paid as guaranteed payments with the LLC as a default partnership but no SE savings. With the S-Corp election and resonable salary, they could obviously save on the SE taxes. Right or am I still missing something? Thanks for the clarification.

[Nashville]

Hope I haven't misled

I have always maintained that partnership earnings (ordinary income from K-1) is subject to self-employment tax in addition to guaranteed payments also being subject to SE tax.

After re-reading BBrown and Bees' dialogue above, I notice Bees implies that if the partnership is an LLC election, the earnings in excess of guaranteed payments may be exempt.

I post an opposing view to Bees very rarely, and didn't realize I was doing so until re-reading the thread. I'm still not aware that K-1 ordinary income could be exempt from SE tax, but now want to throw this up for grabs. Anyone care to jump in and clear this up?

[WhiteOleander]

I think the point Bee's is making is that Congress has not clarified that the profit from a LLC is subject to SE tax. The IRS said it was, but, in 1997, Congress told the IRS to back off. Congress said it had not made that determination. And they have not addressed the issue since.

So, if it is an "old fashioned" partnership, then all business income passed through on the K-1 would be subject to SE tax. But, if it is a LLC filing as a partnership, then it can be argued that only the guaranteed payments are subject to SE tax because Congress has not said the business income passed through on the K-1 by a LLC is subject to SE tax.

This should be explained to the client and let them make the call. IMO

[bbrownatl]

LLC w/ guaranteed pymts (w/SE tax) & profit dist. (w/no SE tax)

So essentially the conservative route is electing S-Corp status, paying a reasonable salary, and taking the profit distribution not subject to SE. However, the more aggressive route is having the LLC taxed as a partnership and make guaranteed payments (subject to SE) and the remaining profit distribution (Not subject to SE). The TTB shows those profit distributions as being subject to SE tax. However, it seems that in practice this is a gray area of varying treatments regarding SE tax on the profit distributions where the LLC has also made guaranteed payments. Again, I like the LLC route better for the ease of not having the S-Corp do payroll. However, I'm somewhat nervous to even recommend the LLC route w/guaranteed pymts (subject to SE tax) and w/profit distbutions (not subject to SE tax).

Thanks for your insight. Other feedback is welcomed regarding how you are treating this matter and/or how you are presenting this option to your clients.

[BHoffman]

http://www.nysscpa.org/cpajournal/2006/606/essentials/p32.htm

I found this very interesting article that talks all about this topic. Since it was written in 2006, not sure if some of the discussion is still relevant, but the source (nysscpa) is usually very reliable.

"Bifurcation" seems to be one of the key elements.

[Snaggletoof]

Bifurcate?

Really Beth. Joins a long list of words such as "bloviate" "emulsify" that I'll have to learn.

No idea. Doesn't sound very nice.

Seriously, good research BHoffman. Sounds like there hasn't been anything conclusive like a court decision or final regs on this issue.

[BHoffman]

Bifurcation. I thought it sounded kinda dirty