LLC Payroll Madness with the Employment Development Department

By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP

Per the California CPA Magazine, May 2009 with some editorial comments by Ron Cohen:

Managing Vs. Non-managing Members of an LLC

A booby trap in LLC taxation is that California's Employment Development Department differentiates between "managing members" and " non-managing" members.

The EDD considers managing members to be similar to partners and therefore follows the federal practice of reporting everything on Schedule K-1.  Non-managing members, however, usually are considered employees under common-law tests, and the EDD considers their "wages" (or rather, guaranteed payments and distributions, since a member in a multi-member LLC is treated like a partner in a partnership)   reportable on Form W-2, and subject to California payroll taxes.

The EDD takes this position irrespective of whether the LLC is taxed as a partnership or as a corporation (if the multi-member LLC elected to be treated as a corporation, rather than the default classification of a partnership), which can lead to some strange looking W-2 forms for California LLC members, as well as difference between federal and California wages on the payroll tax reporting forms.

This is a serious problem.  This means non-managing members of a multi-member LLC are subject to California Income tax withholding, CA State Disability Insurance,  CA Employee Training Tax, and CA State Unemployment Insurance....but are Schedule K-1 partners for federal purposes. What a mess!

Does this mean each time a multi-member LLC makes a payment to a non-managing member, that California payroll penalty and interest start running for failure to register as an California employer, Failure to report new employees, failure to deposit payroll taxes and failure to file DE-88, DE-6 and later, DE-7 and W-2s at year end?

I suspect that a LLC non-management member who is a mere investor and performs no services for the LLC could not be viewed as a common law employee, and therefore, payments to them should escape California payroll tax treatment.  But that is just an assumption on my part.

Taxpayers and our Firm need to determine how we will approach this issue asap.

Payroll tax nonconformity gets worse for LLCs
EDD stands firm: A nonmanaging member is an employee.
Source: Spidell Publishing Inc.

By: Lynn Freer
Tuesday, July 01, 2008

There are two big nonconformity problems for LLCs when it comes to payroll taxes. The result of this nonconformity is that some LLC managing members who are treated as employees for federal purposes are not treated as employees for California, and some nonmanaging members are not federal employees but are California employees. Sounds like nonconformity gone wild — well, it has! Here is more information about the two problems and how to prepare the income tax returns.

Managing member nonconformity

First, according to the EDD, California does not conform to the federal check-the-box rules for payroll purposes. So, an LLC that elects to be taxed as a corporation is treated as such for federal and state income tax purposes, but the owners are taxed as partners for EDD purposes.

As such, a managing member who performs services and is treated as an employee for federal purposes is not an employee for California payroll tax purposes and does not receive a Form W-2 for California.

The reason is that managing members are treated as shareholders for income tax purposes, but legally, they are still LLC members. As a result, the managing member has control and does not fit the definition of “employee.” See the August and September 2005 issues of Spidell’s California Taxletter^® for more information.

Nonmanaging members in LLCs taxed as corporations are employees for California purposes, just like they are for federal purposes.

Nonmanaging member nonconformity

Recently, a more difficult problem has come to our attention. According to the EDD, a nonmanaging member performing services for an LLC that does not elect to be treated as a corporation is an employee for California income and payroll tax purposes. The EDD states that, in this case, the member should receive a W-2 reporting:

• Wages subject to California Personal Income Tax (PIT wages);
• State income tax withholding;
• Wages subject to California payroll taxes (subject wages); and
• State Disability Insurance (SDI) withholding

In addition, the LLC must include these wages in the computation of state unemployment tax.

For federal purposes, the member receives no W-2 and the income taxable to the worker is reported on the federal K-1. The income is subject to self-employment tax based on IRS proposed regulations.¹

Per EDD requirements, guaranteed payments made by an LLC taxable as a partnership to nonmanaging members for services are reported on a W-2 as California state wages, but are not reported on a W-2 as federal wages.

For federal and California income tax purposes, the member’s share of income and guaranteed payments must be reported on Schedule K-1.

Preparing the 540

When preparing the individual’s California income tax return, begin with federal AGI, which includes no W-2 income from the LLC but includes the member’s guaranteed payments.

There will be a W-2 for California only, which will not include any amount in the federal boxes. Include the wages on the California-only W-2 on line 12 of Form 540.

Do not make an adjustment on schedule CA for the wages.

EDD’s reasoning

When considering whether a worker is an employee or an independent contractor, the EDD applies a 10-factor test. The most important factor is that of control or the right to control.

Although cases throughout the years have set forth criteria used to determine whether a worker is an employee or an independent contractor, the most common test is the right to control the work. In Empire Star Mines v. California Employment Commission,² the Supreme Court held that the most important factor is whether your client has the right to control the manner and means by which the work is done.

If the nonmanaging member is paid for services rendered on behalf of the LLC, and takes direction and is controlled by the managing member, he or she would be classified as a common law employee. Thus, payments received would be considered both subject wages and PIT wages.

According to the EDD, this factor alone is what creates an employer/employee relationship for the nonmanaging member. What is missing in this analysis is the concept of risk of loss and return of capital.

In many situations, the LLC nonmanaging member has contributed capital to the operation and, although the individual is performing services, some or all of the profit could be a return of capital or a result of capital generating profits, not services.

Which payments go on the W-2?

Although the EDD agrees that some payments may not be wages, their position seems to be that if any services are performed, all payments are wages. The following are some examples that the EDD has provided us to illustrate their position.

If no guaranteed payment is made, the EDD expects the LLC to report wages for the period and the employee will be taxed on his draw from the LLC, plus wages, even though he received no cash or other assets from the LLC.

If the nonmanaging member receives no payments or draws throughout the year for services rendered, there is no distinguishing between wages and draws from the member’s percentage of net income; it is all considered subject/PIT wages. In effect, the EDD is putting the cash basis taxpayer on the accrual basis and requiring them to report wages in a year before they received them. We disagree with the EDD on this point because an employee should not have to report wages that were not paid.

According to the EDD, if a nonmanaging member does not receive a guaranteed payment or draw in a given year (no remuneration for services rendered), there would be no subject wages; however, there would be “wages legally due but unpaid” that should be reported to EDD.

In other words, the EDD expects wages to be reported in the year the services were performed, if the payment is not made until a later year, that’s the LLC member’s problem.

¹ Prop. Treas. Regs. §1.1402(a)
² Empire Star Mines v. California Employment Commission , 28 Cal. 2d 33 (1946)