Community organizations often sponsor seasonal events that require the use of short term labor. When volunteer labor is not available, there may be tax implications of paid services. Even though the dollar amount per worker is small, the total cost can be a significant portion of the organization’s overall budget.
A single-member LLC is managed by a nonprofit corporation acting as the LLC’s non-member authorized representative elects to recruit additional young members to perform small tasks for a seasonal event for compensation in amounts totaling under $300 for the year. Other than for this specific task (where volunteer labor was unavailable), the workers are uncompensated volunteers to the nonprofit organization. The LLC rejected the idea of hiring the workers as employees due to the state requirement to carry worker’s compensation insurance on employees as well as the liability to handle wage taxes on these small amounts. How are the payments taxed?
For the LLC:
The correct treatment of compensation for services rendered in this case is to pay them a “guaranteed payment.” This amount is governed by IRC Section 707. Guaranteed payments are considered first-priority distributions and will be paid out even if the partnership is losing money. This is important because guaranteed payments are not dependent on actual profits of the business. In this case, the business is not expected to be profitable, yet guaranteed payments are deductible by the LLC. as an ordinary business expense.
For the member:
A multi-member LLC is treated either as a partnership or as a subchapter S corporation. In this case, the LLC made a subchapter S election that was denied by the IRS as untimely. So, by default, this LLC is taxed as a partnership. The additional members are treated as limited partners.
Revenue Ruling 69-184 states that “members of a partnership are not employees of the partnership”. No W2 forms will be issued.
IRC Section 1402 provides that a partner’s distributive share of partnership income is included in self-employment income. IRS reaffirmed that the distributive share of partnership income allocated to members of an LLC was subject to self-employment tax in CCA 201436049. IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner– other than guaranteed payments–is not included in self-employment income. In this case, the payments are self-employment income.
Since is is estimated that self-employment income will be less than $400 and the workers are generally not engaged in other self-employment activity, we do not anticipate that the payments will trigger the need for a Schedule C self-employment tax return.
If the LLC makes a Subchapter S election then Revenue Ruling 59-221 says that each shareholder’s distributive share of the S corporation’s income is not subject to self-employment income, regardless of the shareholder’s level of participation or services rendered. It would likely be more efficient for tax reporting if the LLC made a timely subchapter S election but in this case the application for election was denied by the IRS.
It remains unclear to me how the payments will be reported on the Form 1065 partnership tax return and whether the workers will need to report income since the LLC (and its members) will not have any reportable taxable income.
This Mstreetlegal article by Andy Mirsky includes links to additional information
Forbes’ Tony Nitti covers the inherent controversy in 2014