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likely acting as a member if he or she
does not receive any payment (other The courts generally have held that
than distributions of income allocated to
the determination of whether a partner
him or her under the Sec. 704 rules) for
services performed for the LLC. is acting in a nonpartner/nonmember
Caution: In certain situations, Sec.
capacity is based on the facts and
707(a)(2)(A) provides a disguised-
payment-for-services rule requiring circumstances.
payments that would otherwise be
treated as distributions of the member’s
share of LLC income to be treated success; (2) payments were not in accor- in an LLC obtain a membership interest
as a payment for services made to a dance with the partnership agreement as an employee compensatory award
nonmember (see below). regarding distributions of profits to or incentive. However, until further
The courts generally have held that partners; and (3) payments were dispro- guidance is issued, the IRS will continue
the determination of whether a partner portionate to the partner’s ownership to follow the conclusion set forth in Rev.
is acting in a nonpartner/nonmember share of the partnership. Rul. 69-184 that an individual cannot be
capacity is based on the facts and cir- both a member and an employee.
cumstances. The Fifth Circuit in Pratt, LLC members as employees
550 F.2d 1023 (5th Cir. 1977), held According to Rev. Rul. 69-184, an in- Services provided by
that a partner who performs incidental dividual cannot be both a member and a member acting as a
services generally acts as a nonpart- an employee of an LLC classified as a nonmember — Sec. 707(a)
ner, whereas a partner who performs partnership for employment tax (Social Members who provide services to the
continuing services, such as ongoing Security, Medicare, and unemployment LLC other than in their capacity as a
management services, generally acts in tax) purposes. This ruling provides no member recognize income under the
the capacity of a partner, especially if analysis, authority, or other discussion general income recognition rules, based
the services are integral to the business other than its conclusion. The con- on their tax accounting method. Like-
activities for which the partnership was sequences of this prohibition against wise, the LLC deducts or capitalizes
formed and in which it is engaged. The employee status can be far-reaching. the payment based on its tax accounting
court also held that services addressed For example, an LLC member’s cash methods (Sec. 707(a)(1)). However,
in the partnership agreement generally compensation is not considered wages or accrual-method LLCs generally cannot
are provided by partners in their capacity salary for federal income tax withhold- deduct a payment before the year a cash-
as partners. ing or Federal Insurance Contributions method member includes it in income.
The IRS has indicated that the Act tax purposes but is instead generally
circumstances surrounding the services, treated as a guaranteed payment under Example 1. Payment for services to
such as whether partners are required to Sec. 707(c), or as nonemployee com- a member acting as a third party: L
pay their own expenses in performing pensation if the member is not acting in Inc. is a member in H Investors LLC,
the services and whether they perform his or her capacity as a member (see the which is classified as a partnership.
similar services for others, are also rel- next section). Therefore, LLC members L provides property management
evant (Rev. Rul. 81-301). The structure are generally subject to self-employment services and acts as a leasing agent
and documentation of the arrangement tax on compensation received from the for commercial properties owned by
are also important. LLC. Also, many fringe benefits can be H. L also renders similar services to
In Herrmann, 132 Fed. Cl. 459 provided tax-free only to employees (not other third-party real estate owners.
(2017), the court disagreed with the LLC members). During the year, in accordance with
IRS’s contention that a partnership’s Note: In the preamble to T.D. a management fee agreement, H pays
payment to a partner was a distribution 9766, the IRS reaffirmed its position in $78,500 to L for management ser-
of partnership income. Instead, the court Rev. Rul. 69-184. The IRS noted that vices. This fee is based on the same
found that the payment was in exchange several commentators have suggested rates that L charges other third-party
for services performed as a nonpartner. modifying Rev. Rul. 69-184 to allow owners for similar services. The fee
Key factors cited by the court were LLCs classified as partnerships to does not affect L’s allocation of LLC
(1) the payment was based on a bonus treat members as employees in certain income. Both H and L are accrual-
formula and not tied to the partnership’s circumstances, such as when employees basis taxpayers.

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