Nevada
LLCs And The Fee
Percentage for The Manager
In some
Nevada limited liability companies (LLC), the managing member will be
a corporation while the rest of the members will be individuals. Some
will use this device in order to push as much income to the managing
corporation as possible. This can be accomplished through paying the
manager a fee for its services. This raises the question, what is an
acceptable fee for a manager of an LLC? A review of the law leads to
the conclusion that almost any amount agreed to by the parties is acceptable.
First,
a review of the pertinent Nevada LLC statutes is in order. An LLC "manager"
is designated in or selected pursuant to the articles of organization
or an operating agreement of the LLC to manage the company. NRS 86.071.
An "operating agreement" is any valid written agreement of
the members as to the affairs of the LLC and the conduct of its business.
NRS 86.101. The articles of organization may set forth any provision,
not inconsistent with law, which the members elect to set out for the
regulation of the internal affairs of the LLC. NRS 86.161 (2). Thus,
whether the members designate the manager through an operating agreement
or the articles of organization, they have the statutory authority to
regulate the affairs of the LLC, so long as the terms of the contract
do not violate the law. The amount that the members wish to pay the
manager cannot possibly be of concern to the state as a matter of public
policy.
Another
statute supports this interpretation. NRS 86.291 is entitled "management."
It holds that the management of an LLC is vested in its members in proportion
to their contributions to the LLC's capital, unless the articles of
organization or the operating agreement provides otherwise. Further,
the members have the power to vest the managing power in a single manager,
if they so choose. Thus, even if the manager does not contribute the
lion's share of the capital, the other members can anoint him with full
management powers. Since they can do this, what they decide to pay the
manager is of no one's concern but the members.
A review
of the pertinent Nevada statutes leaves little doubt that the state
legislature wished to leave issues concerning the internal affairs of
an LLC to the members of the LLC. Another area of the law which is pertinent
to the issue under discussion is federal tax law. An LLC which wishes
to pay its corporate manager a large fee is desirous of shifting income
away from the members and to the corporation. Fortunately, federal tax
law can assist in this endeavor.
As we know,
a multi-party LLC is likely to be taxed as a partnership since the advent
of the IRS' "check-the-box" regulations which took effect
on January 1, 1997. A partnership is not subject to federal income tax.
Rather, the entity is disregarded and the partners are responsible for
the tax in their separate or individual capacities. Internal Revenue
Code (IRC) §§ 701, 702. Furthermore, a partner's share of
income, gain, loss, deductions or credits is determined by the partnership
agreement. IRC § 704(a).
A few other
code sections are pertinent here. IRC § 707(a) reads, in part:
If a partner
engages in a transaction with a partnership other than in his capacity
as a member of such partner-ship, the transaction shall, except as otherwise
provided in this section, be considered as occurring between the partnership
and one who is not a partner.
IRC §
707(c) reads:
To the
extent determined without regard to the income of the partnership, payments
to a partner for services or the use of capital shall be considered
as made to one who is not a member of the partnership, but only for
the purposes of section 61(a) (relating to gross income) and, subject
to section 263, for purposes of section 162(a) (relating to trade or
business expenses).
Lastly,
IRC § 162(a)(1) reads:
There shall
be allowed as a deduction all the ordinary and necessary expenses paid
or incurred during the taxable year in carrying on any trade or business,
including--
(1) a reasonable allowance for salaries or other compensation for personal
services actually rendered[.]
The importance
of these sections to the issue under discussion was pointed out by David
Walters:
To deduct
as a business expense payments to a promoter/ organizer or managing
member for goods and services, the LLC must be able to show, first,
that the payments are deductible business expenses under section 162(a).
Don't assume the deductibility of amounts paid to promoter/ organizers
and managing members for services rendered under section 162.
In addition,
LLC payments to a promoter/organizer or managing member for goods and
services must be deductible under section 707(a) or section 707(c) ("guaranteed
payments").
As a general
rule, payments from an LLC to a member for services or goods provided
to an LLC are deductible under section 707(a) and 707(c) to the extent
they are determined without regard to the income of the LLC. According
to section 707(c), guaranteed payments must be reported as ordinary
income by members, and limited liability companies must deduct the payments
as trade or business expenses (if they otherwise qualify as "business
expenses").
David W.
Walters, "Drafting Limited Liability Company Operating Agreements,
Part 2," 10 no.3 Prac. Tax Lawyer 29, 33 (Sp. 1996).
Thus, so
long as the payment to the corporate manager of an LLC is a guaranteed
payment, that is, it is not determined by the income of the LLC, and
the payment meets the test of an ordinary and necessary business expense
and is a reasonable amount, the LLC can deduct the manager's fee. By
so doing, the amount attributed to the other LLC members is lowered,
and the goal of shifting income to the manager is accomplished.
To be a
guaranteed payment, the operating agreement needs to state that the
payments are to be made without regard to the income of the LLC. See
Thomas M. Fahey, T.C. Memo. 1979-20, 38 T.C.M. 62 (1979); Foster v.
Commn'r, 42 T.C. 974 (1964); cf. Rev. Rul. 66-95, 1966-1 C.B. 169. The
rules determining whether a business expense is deductible are more
complicated.
Even a
properly documented guaranteed payment is not deductible if it fails
to meet the requirements of IRC § 162. See e.g., United States
v. Pacheco, 912 F.2d 297 (9th Cir. 1990); Cagle v. Commn'r, 539 F.2d
409 (5th Cir. 1976). The determination of what is reasonable compensation
is a question of fact. See RTS Invest., Corp. v. Commn'r, 877 F.2d 647
(8th Cir. 1989); Atlas Plaster & Fuel Co. v. Commn'r, 55 F.2d 802
(6th Cir. 1932). The burden of proving reasonableness is on the taxpayer.
See RTS Invest., supra; Clinton Co. v. Commn'r, 159 F.2d 102 (7th Cir.
1946); Long Island Drug Co. v. Commn'r, 111 F.2d 593 (2nd Cir. 1940).
The courts
use various tests to determine whether compensation is reasonable under
IRC § 162(a), and thus deductible. In general, there must be considered
the type and extent of services rendered, the scarcity of qualified
employees, the qualifications and prior earning capacity of the employee,
the prevailing compensation paid to employees with comparable jobs,
and the peculiar characteristics of the taxpayer's business. See, e.g..
Edwin's, Inc. v. United States, 501 F.2d 675 (7th Cir. 1974); RAPCO,
Inc. v. Commn'r, 85 F.3d 950 (2nd Cir. 1996). Overall, reasonableness
is judged from the perspective of whether an independent investor would
have been willing to pay such an amount of compensation. See, e.g.,
RAPCO, supra; Donald Palmer Co. v. Commn'r, 77 A.F.T.R. 2d 96-1808 (5th
Cir. 1996). The amount paid to similar employees concerned in similar
industries is probably one of the most important factors in determining
reasonableness. See, e.g., Patton v. Commn'r, 168 F.2d 28 (6th Cir.
1948); Griffin & Co. v. United States, 182 Ct. Cl. 436 (1968). However,
the court can take into consideration the recipient's foresightedness
and business acumen, and his success in managing the business. See Gordy
Tire Co. v. United States, 155 Ct. Cl. 759 (1961). Cf. John L. Ginger
Masonry v. Commn'r, T.C. Memo. 1997-251 (1997)(compensation of owner-employee
of a closely-held business in excess of $1 million is reasonable where
employee served multiple roles of C.E.O., C.F.O. and C.O.O., and the
employee frequently worked more than 12 hour days in his multiple roles).
Lastly, the fact that compensation payments are made in accordance with
an agreement of the parties does not necessarily render them reasonable.
See J.D. Van Hooser & Co. v. Glenn, 50 F. Supp. 279 (W.D. Ky. 1943).
If a compensation
arrangement with a corporate manager of an LLC is reasonable, and made
without regard to the income of the LLC, the corporate manager recognizes
ordinary income, and the desire to shift income is fulfilled. On the
other hand, if the payments to the corporate manager do not qualify
as business expenses and are thus not deductible, the intent to shift
income is not defeated. In such a situation, the payments are deemed
a "distribution" to the recipient. The effect of this is to
leave less money available to the LLC for the non-managing members.
See Walters, supra, at 33. This results in the corporate manager having
to recognize the distribution for tax purposes, but the compensation
arrangement has fulfilled the desire to shift as much LLC income as
possible to the corporate manager and away from the other members.
Given all
of the above, neither state nor federal law truly stands in the way
of an LLC paying its corporate manager a large fee. It can be accomplished,
with the only difference being whether the corporate manager recognizes
the receipt of ordinary income, or a taxable "distribution"
from the LLC. See IRC § 702(c).
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