Payments to LLC members for services.

• Author: Owen, Sheila
• Position: Limited liability companies

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Limited Liability Companies topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).

Other than guaranteed payments under Sec. 707(c), when members receive payments for services performed for a limited liability company (LLC) that is classified as a partnership for federal income tax purposes, the first issue is to determine whether the member is performing the services in the capacity as a member or as a third party. When services are performed outside the member's capacity as a member, the transaction is treated for tax purposes as occurring between the LLC and a third party (Sec. 707(a)). Payments (other than guaranteed payments) received for services performed in the member's capacity as a member are generally treated as a distribution of the member's share of LLC income.

When payments made to a member acting in the capacity as a member are treated as distributions of LLC income, the payment is a current distribution under Sec. 731 (income is generally recognized only to the extent the distribution exceeds the member's basis in the LLC). However, the member reports the distributive share of income (whether distributed or not) in its tax year that includes the LLC's year end. This may result in the member's reporting income before payment is received. The timing rule for recognizing guaranteed payments is similar. Alternatively, if payments are made to a member acting outside the capacity as a member (i.e., treated as made to a third party), a cash-basis member does not report income until the payments are received.

In addition to the member's timing for income recognition, whether services are performed as a member or as a third party affects the LLC. For example, consider an LLC formed to design and construct an office building. Assume one of the original members is an architect who contributed $50,000 cash (10% of all contributed capital) for a 10% interest in all LLC items. If this member provides the necessary architectural services for the project in his capacity as a member and receives no payment (other than his allocable share of LLC income and cash flow), the value of his services is not capitalized to the cost of the building or deducted by the LLC. If the same individual had been paid a fee in addition to his distributive share of LLC profits (acted outside his capacity as a member) to perform the architectural services, the LLC would be required to capitalize the fee paid as part of the cost of the building.

At times it is difficult to determine whether a member performing services for the LLC is acting as a member or a nonmember. The...