The Role of a Member of an LLC
A Limited Liability Company (LLC) member is an individual or entity that has been granted an ownership interest in the company. Instead of stock, which is commonly issued to shareholders in a corporation, LLC members receive membership units or percentages of ownership in the LLC. LLCs are similar to S-Corps and C-Corps in that the business can be owned by two or more individuals (similar to shareholders). However, LLC members face far fewer restrictions than S-Corps and C-Corps in terms of who can own interests in the company (such as foreign individuals or entities, trusts, and even partnerships). This means that the ability of an LLC to be owned by only one or a few individuals as opposed to many shareholders is attractive to many.
Many LLC members are directly involved in the day-to-day operations of the business. Because limited liability companies often do not have a board of directors , the members of an LLC assume more responsibilities than many corporate shareholders. However, limited liability companies may have a board of managers or executives who handle the daily affairs of the business. In those cases where there are individuals handling day-to-day operations, members are usually responsible for the overall direction of the company and the actions of its managers and employees. For example, members typically vote on the appointment of managers along with critical operational issues. LLC managers do much of the "heavy lifting" when it comes to the day-to-day management of the business.
Some LLC members perform the same job duties as independent contractors. However, there are unique factors that distinguish between an LLC member and an independent contractor. If you have recently incorporated to form a new LLC or are an existing LLC that recently formed, legal advice from a qualified attorney may very well be invaluable to your business.
Understanding the Role of an Independent Contractor
In general, the term "independent contractor" refers to a person who contracts with another to perform a particular act. In the employment context, an independent contractor is viewed as being in business for himself/herself, rather than working for an employer or employer-entity.
If the general law of a state characterizes as an employee a person performing services for another person or entity, the general law will "trump" any term of an LLC operating agreement attempted to be used to characterize the status of an individual as an independent contractor (unless there is some basis for holding the term in the operating agreement enforceable in such regard).
According to the U.S. Department of Labor (DOL), factors to consider in determining whether a worker is an independent contractor from the standpoint of applicable federal minimum wage and overtime laws include, among other things, the degree of control exercised by the entity seeking to apply the law over the details or means of the work by the individual. As examples, if the individual providing labor services is subject to control or dictation of objectives, means or details by the individual seeking to apply the general law of the state or federal law, then the individual providing labor services may not be an independent contractor exempt from the application of the minimum wage or overtime laws.
Characteristics typically examined for purposes of determining whether the status of a worker is that of an employee or independent contractor include:
The exact determination of the status of a member of an LLC as an independent contractor or employee in a given case depends on the facts and circumstances involved, but should be made after undertaking a thorough factual analysis, possibly including a detailed review of the terms of an LLC operating agreement and the manner in which services were actually performed by the member seeking to be characterized as an independent contractor.
Individuals Working as Independent Contractors for an LLC
Just because an LLC member may also be an independent contractor does not mean that he or she must wind up working as an employee. Many LLC members find advantageous to work as independent contractors even if they are the owner of an LLC. For instance, it is possible to enter into a contract with an LLC where the LLC is hiring the member as a consultant. The arrangement can stipulate a set, agreed-to rate based on a number of hours worked per week. Alternatively, an LLC member may also want to consider doing work for another company not associated with the LLC. Often, LLC members will have particular skills where independent contractor work may be in demand by companies that do not offer the services in-house. In such cases, an LLC member has the option of providing services to clients. It is quite common for this type of arrangement to take place when the other company is benefiting from special skills and would not ordinarily be able to afford to hire a full-time, dedicated employee. An example would be a marketing firm mishiring a graphic designer as an independent contractor. The marketing firm benefits because the graphic designer will not have to charge an exorbitant sum for his or her services. Instead, they may invoice based on an hourly rate. The graphic designer benefits because they have the flexibility of being an independent contractor and can accept or reject assignments as needed. Moreover, there are many tax benefits of being hired as an independent contractor. While many of the benefits of working as an LLC employee are obvious (e.g. health coverage), it is possible that the LLC member may actually save money on taxes when filing if he or she is hired as an independent contractor.
Legal Aspects and IRS Regulations
The legal framework surrounding whether an LLC member can be an independent contractor hinges largely on their level of control. According to the IRS, the extent to which the individual must perform the services personally is a key criterion in determining whether the member is an employee or an independent contractor. If the LLC requires the individual to perform the services and does not allow a different person to perform those services, this indicates that there is an employer/employee relationship. Conversely, if the LLC merely requires them to produce a result – and allows them to determine how, when, where, and by whom those tasks are performed – then it is likely that an independent contractor relationship exists.
An additional factor that the IRS will consider is whether the LLC has the right to control when and where the work takes place. Control over the place of work strongly indicates that the individual is an employee. That said, if they have the freedom to choose in which states or locations they will perform the work, that would imply that an independent contractor relationship does exist. There are exceptions to the "right to control" rule, however, such as if the work location is an area subject to zoning regulations. In this case, the individual may not have the right to choose the area.
An important case to note with regard to these requirements is that of the U.S. Court of Appeals for the Ninth Circuit in the case of Donovan v. Sureway Cleaners & Laundry, Inc., 656 F.2d 1038 (9th Cir. 1981), in which the court examined the IRS’s wage determination process for deciding who constitutes an employer and who constitutes an employee for the purposes of wage withholding. This court held that "an assessment of economic reality is required under the Act." This means that the court examined the substance of the employment relationship in order to determine whether the relevant factors considered, such as "the degree to which the workers are economically dependent upon their employer", favor a finding that an employer/employee relationship exists.
Other statutes are relevant to the question of whether or not an LLC member can be classified as an independent contractor. For example, the Fair Labor Standards Act (FLSA) differs on its guidelines from the IRS, in that it protects only employees, not independent contractors. The legal considerations outlined by the IRS and the courts have helped shape relevant IRS guidelines on this issue. Only in more recent years have members of small, owner-managed LLCs been able to be hired as true independent contractors. This is good news for members of LLCs that want to establish an independent contractor working relationship with the company. The guidelines may be very nuanced, however, so any LLCs considering this arrangement may benefit from consulting with an experienced attorney to gain a full understanding of the implications and requirements in their particular situation.
Advantages and Disadvantages of Holding Both Roles
Even though an LLC member can also be an independent contractor, the logistics of this arrangement are not without problems. Let’s take a look at the pros and cons.
To help their LLCs optimize their management structures, members sometimes work as contractors. This set-up is beneficial for both parties. The LLC gets reliable help for its day-to-day operations, while the member continues to receive their usual compensation with a little bit of a boost.
Let’s look at the pros and cons of having an LLC member that also provides contracting services to their entity:
Financially, an independent member may earn more money from the LLC’s operation than through their member compensation, which could be considered a bonus. This could be a favorable development for the member if they’ve been undercompensated in the past. However, an LLC can still lose a lot of money as a result of this dual role, and this financial impact may not be taken into account when distributing funds among members . Therefore, profit-sharing needs to be based on the LLC’s LLC, not individual members’ finances.
In addition, it’s important that the service agreement provide sufficient protection from claims by the IRS. Sometimes, the IRS will completely ignore the member status of the contractor and view the independent contractor as an employee. Since LLC owners cannot collect unemployment or receive workers’ compensation benefits if they’ve been misclassified as employees, any actions for indemnification or other kinds of reparations will be very difficult, if not impossible.
Another negative outcome that might occur is double taxation. LLC members already pay self-employment tax, and receiving compensation for services provided can push the member into a higher tax bracket, which leads to a bigger burden in terms of taxation.
Creating Agreements and Documents
There is no statutory prohibition on LLC members entering into independent contractor agreements either with their own LLCS or with any other company. However, those agreements should clearly delineate the relationship between the member and the LLC. They should also make it clear that the independent contractor relationship exists between the member and the LLC (or between the member and another company), not between the member and the LLC and its other members and employees.
For example, the independent contractor agreement might state:
- The name of the LLC and of the member who will perform services.
- A "whereas" clause setting forth the member’s membership in the LLC and stating that the member is willing to perform services in return for the payments to be made by the LLC.
- The terms of the relationship, such as the hours to be worked, the nature of the services to be provided, the method of payment, and the term.
- The member’s responsibilities with respect to any tax reporting (for example, requiring the member to provide the LLC with an IRS Form W-9, if payment will be more than $600 in any year, and a certificate of insurance with regard to any required insurance coverage).
- An acknowledgement by the member that the LLC is not responsible for payment of unemployment compensation benefits with respect to the compensation paid under the agreement and the member is not entitled to any employer-sponsored benefits.
- The member’s agreement to indemnify and hold the LLC harmless if the member violates any law or agreement that results in the imposition of any liability on the LLC.
- The member’s acknowledgement that the independent contractor relationship is not exclusive and the member can perform similar services for other clients.
- The member’s agreement not to disclose at any time any confidential information of the LLC.
- Compliance by the member with any relevant policies of the LLC (for example, a code of conducts and/or a nondiscrimination policy).
- Required return of any LLC property and records upon termination or expiration of the agreement.
Examples and Case History
In examining real-life examples, there are several instances where LLC members have successfully worked as independent contractors without encountering any issues. One such case involves a web development company where all of its members served as independent contractors to clients. In this case, each member had their own personal network of clients and handled their own invoicing, while the LLC provided administrative and other support services. This structure allowed the LLC members to maintain autonomy while benefiting from the shared administrative resources. However, not all situations involving LLC members acting as independent contractors to the LLC have been trouble-free. There was a case in California involving a technology firm where three members carried out various IT and development projects for clients and operated as independent contractors to the company. While the work and day-to-day invoicing of clients were being handled by the members, little consideration was paid to the statutory and regulatory compliance for self-employment. Members were instead relying on their prior experiences with closely-held corporations in which the tax compliance handling fell under the ambit of the entity itself, rather than its individual members. When the company started to expand, the additional complexities of its multi-member LLC structure began to show, as the "above the line" tax nature of the complex LLC and its multi-member shared nature began to complicate matters. Filing for members’ self-employment taxes was the most troublesome aspect that caused issues for the company members. Because each LLC member owned an equal share of the company, their LLC profits were taxed as income at each individual’s level. In particular, the self-employment tax for all of the LLC’s income was assessed against each member, rather than being apportioned among its three members. The LLC was then held responsible for failing to issue 1099 forms to its members for that same tax year. In this case, the failure to file was filed as a deliberate action, and the LLC members were ultimately assessed for significant penalties that could have been avoided had the situation been prepared for and foreseen. Another example comes from a law firm in Texas, where the attorneys decided that the best route for their practice was to structure the group as an LLC, with each attorney serving as an independent contractor. In this firm, the legal representatives each had their own clients and managed their own billing practices and collections. However, they split the overhead and marketing costs among the group. This structure proved to be less of a tax problem, since each member of the LLC had already established their own business reputation and relationships. As such, problems with internal payment or allocations did not arise, since each member was essentially running their own practice within the larger LLC. Ultimately, the issue of whether or not an LLC member can serve as an independent contractor to the LLC has always been one to consider on an individual basis. The above examples show some of the considerations to weigh, but there are many other factors that must be weighed on an individual basis.
Consulting an Expert
Because the issue of classification as an independent contractor can be complex, it is highly advisable that an LLC member seeks the advice and counsel of a lawyer and/or other experts. From a legal perspective, a lawyer should be engaged to: (1) review the existing or proposed contract; (2) analyze whether the contract is consistent with the operating agreement (if one exists) , and whether any provisions may adversely impact the LLC; (3) determine whether the proposed arrangement requires any approvals from corporate authorities; (4) advise you whether there are other factors that may impact your desired status as an independent contractor; and (5) advise on how the structure of the arrangement impacts the LLC and the Members.
From a tax perspective, an accountant should be consulted, preferably one who has a great deal of experience with LLCs, to ensure that the LLC is following appropriate tax procedures in connection with an LLC Member acting as an independent contractor.