Members of LLCs taxed as partnerships cannot also be employees of the LLC for tax purposes. This means LLC members must report and pay self-employment taxes (including quarterly estimated taxes), rather than sharing payroll taxes with their employer and having applicable taxes withheld. These requirements complicate equity compensation plans, particularly when grants are small and grantees are acclimated to employee treatment. In some cases, start-up founders avoid the LLC structure entirely for this reason.
In past years, some LLC businesses have managed this prohibition by granting equity in a parent LLC (which issues a K-1), forming an LLC subsidiary (a “disregarded entity” for tax purposes), and characterizing equity grantees as employees of the subsidiary (which issues a W-2). Most tax professionals avoided this structure as a strained interpretation of the regulations, and the IRS made frequent, but informal, statements condemning the practice. Apparently, however, quite a few tax practitioners signed-off on the structure.
Last week, the IRS issued regulations formally denouncing the structure, but providing a deferred effective date (in certain situations) to allow affected businesses to become compliant.
Some well-advised LLC businesses have instead employed a variant of that structure where a corporate subsidiary holds a nominal interest in the LLC subsidiary, making it a “regarded” entity (typically taxed as a partnership). The new regulations appear to leave this structure unaffected.
For start-ups, these tax issues can be frustrating, and illustrate the importance of a careful choice-of-entity analysis from the company’s onset.