IRS Says No, Not for Now, But Asks for Comments

In Northern California, and especially in Silicon Valley, it has become more and more common for a startup business to be organized as a Limited Liability Corporation. The LLC format provides simplicity and flow-through tax treatment, as well as fairly easy future conversion to a corporate form when and if such a conversion might prove helpful.

Startup companies in any form rely heavily on equity compensation as part of their opening business plans. Such companies are normally cash poor but have a pristine capital structure, permitting them to offer ownership rights to keep their workers motivated. Since the mid-1990s, LLCs and other companies taxable as partnerships have been able to issue equity compensation in the form of profits interests without triggering immediate taxable income for the recipient. A profits interest grants a worker a right to future appreciation and income but does not provide an immediate capital stake in the issuing company.

Are there any collateral consequences when an employee receives a profits interest in an LLC or a partnership? Most businesses do not treat the grant as anything more than a normal equity award. The worker will receive a Form K-1 each year, reflecting the worker’s share of the employer’s profits. But shouldn’t the worker continue to be subject to wage withholding, employment taxes, and annual Form W-2 reporting of compensation income?

The technical answer is no. The IRS ruled, in Revenue Ruling 69-184, that an individual who is a “bona fide” partner in a partnership for tax purposes cannot be considered an employee for tax purposes. The worker would still be subject to self-employment taxes, but wage income should be reported as a “guaranteed payment” to the worker from the LLC or partnership, being reflected on the worker’s annual K-1. There should be no wage withholding or employment tax withholding at the entity level.

This often comes as an unwelcome surprise to the recipient of a profits interest award. In many cases, workers grow accustomed to paying their taxes through the wage withholding mechanism. They take comfort in having their current-year tax compliance handled by institutional withholding administrators. Withholding also provides forced spendthrift protection, devoting wages to tax payments before the wages ever hit the worker’s bank account. Departing from the wage withholding system requires workers to navigate the complex world of quarterly estimated tax payments, which many of them had never previously encountered during their business careers.

Many businesses simply ignore the mandate of Revenue Ruling 69-184, and continue to report wages to their profits interest holders under the wage withholding system. Neither the IRS nor the FTB appears to have made this issue an enforcement priority; indeed, receiving tax payments via wage withholding, instead through estimated tax payments, tends to make governmental tax collections faster and more certain.

The IRS recently addressed the continued viability of Revenue Ruling 69-184. This summer, new temporary and proposed regulations were issued that considered the employment status of the owner of a single-member LLC. The new rules provide that such a single-member LLC is simply disregarded for tax purposes, and that the owner is treated as a self-employed individual with respect to any compensation derived form the LLC. Interestingly, though, the preamble to the new regulations confirmed the ongoing application of the holding of Revenue Ruling 69-184, but asked for public comment on instances in which the holder of a small equity grant might appropriately remain an “employee” for wage withholding purposes. This suggests that the IRS is at least considering a modification of the rule that a partner cannot be an employee – though we may not have the definitive answer to this question for months to come.

By Thomas A. Maier, Futterman Dupree Dodd Croley Maier LLP. Tom Maier’s practice emphasizes tax planning and general business matters for start-up to mid-sized businesses, particularly tech enterprises and service organizations. Throughout his career, he has worked extensively with growth companies and investors to structure favorable equity and debt financing transactions and sound employee stock plans. He regularly represents U.S. and foreign companies in the planning and negotiation of international business transactions. Tom is the Vice-Chair of the ACBA Business Section’s Executive Committee.