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Update on Proposed Revised Uniform Limited Liability Act

By time this article is issued, we may be close to seeing the California Revised Uniform LLC Act (Vargas – SB 323) adopted.  The good news is that this Act may not have any major impact.  However, we came very close last month to a terrible situation with respect to compliance with LLC reporting, as proposed by the EDD.

It may not feel like fair play, but on August 23, 2012, one day before the last day for amending bills, the EDD asked the sponsor of SB 323 to remove the last sentence of CUIC Section 623.  That sentence was an exemption from employee status, and required the EDD to follow the IRS/FTB check-the-box regulations, by mandating that members in pass-through LLCs were in fact partners, not employees under all circumstances.

What the sponsor did not know (and was not told) was why that sentence was there in the first place.  Prior to the exemption, enacted January 1, 2011, the EDD could reclassify certain pass-through LLC member Form K-1 income as wage income, if the Articles was marked that the LLC had managers.  The EDD argued that marking “managers”, even if all members were managers, resulted in the treatment of those members as employees.

On the other hand, because the IRS and FTB, however, did not follow that position, tax practitioners, tax software companies and tax leaders for nearly two decades told the EDD that their inconsistent position with the IRS and FTB made it impossible to comply.  It is impossible to treat income from an LLC as partner income on a Schedule K-1 for income tax purposes, but wage income subject to withholding for EDD purposes at the same time.  Furthermore, it forced LLC members into a “Catch 22” as to which agency to comply with.

Gina Rodriguez, of the California Taxpayer’s Association (previously with Spidells) fortunately alerted the State Bar sponsors, Vargas to the problem with the EDD change and its major harm.  In addition to lodging a grass roots campaign to oppose the legislation with the insertion, Vargas, the bill sponsor, personally took the extraordinary act of asking that the Assembly Judiciary Committee meet in an extra evening session the evening of August 28, 2012, to allow the correction so the bill could go to the floor by month end for a vote.  The Judiciary Committee agreed that the EDD was less than forthcoming and the circumstances supported a waiver of rules to allow the bill to be corrected in time to go to the floor for a vote in August.

While the bill is ready for a vote, the EDD’s strategy to come in last minute has been seen to be less than forthcoming in explaining the removal and allowing public comment.  There is a real concern that the EDD may try again in the future to remove the exemption.  To understand the implications of loss of this exemption, an example will illustrate.

Example:

Able Helper and Betty Smith are members in Better Helpers LLC.  Each earned $50,000 for 2013.  The Articles state that the company has two managers (i.e., it is not member managed), but Able and Better are the sole managers.  For income tax purposes, the LLC is treated as a partnership.

If the Revised Uniform LLC Act was passed with the EDD amendment, Able and Betty will be deemed employees.  Therefore, the $50,000 in Schedule K-1 income reported to them should have been reported to the EDD as wages on a California only W-2 for EDD filing purposes, and those earnings should have been subject to withholding taxes.  However, for income tax purposes, the same income must be reported as partner income.  Because the rules conflict, Able and Betty must decide to follow the EDD, or the IRS/FTB laws as they cannot consistently comply with both.  If reported as wages solely for EDD purposes, this may not make sense to the FTB which will require said income to be reported on a Schedule K-1 instead.  If not reported as wages, the EDD may assess taxes, interest and penalties for both failure to file payroll tax returns and for failure to pay employer/employee state employment taxes (SDI, SUI, ETT, SIT).

Finally, having avoided this problem, tax practitioners can come to understand the California RULLC Act upon passage.  Because these provisions are very detailed as to what they change, it is best saved for another day.

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