LLCs are governed by the tax provisions that apply to partnerships, and LLC members are taxed as partners. As a general rule, partners are treated as self-employed individuals rather than employees, and they must make quarterly payments of estimated income and self-employment taxes, rather than having these taxes withheld by their employer. General partners are subject to self-employment taxes on their compensation and their share of the partnership's income.
They are also taxed on the value of certain fringe benefits that they receive, such as life and health insurance. Limited partners are subject to self-employment taxes on their wages and (probably) fringe benefits, but not on their share of the partnership's income. Employees who become partners of an LLC when they receive a compensatory membership interest must deal with the tax regime to which partners are subject; they can no longer rely on the employer to withhold the necessary amounts.
There are many unresolved questions about the "partner" status of an employee who receives an LLC membership interest. Is an employee who receives a restricted membership interest treated as a partner immediately upon receipt of the interest even though he or she might forfeit the entire interest? Is the new member a general partner or a limited partner?
Regulations proposed in 1997 that provide guidance on the status of LLC members as general or limited have a narrow definition of "limited member," subjecting many employees who receive compensatory LLC membership to treatment as general partners. However, the regulations were subject to intense criticism when they came out and have never been finalized, leaving the open questions unanswered. General advice in this area cannot be given; each type of issuance must be examined separately in its context by an advisor who fully understands the issues. (Is it profits interest or capital interest or both? Is it restricted or unrestricted?)
As LLCs continue to be a popular entity for closely held businesses, uncertainty about the tax consequences of issuing membership interests to employees will create pressure on the IRS and Congress to provide the necessary guidance. In the meantime, LLCs must consult with their tax advisors before issuing membership interests to their employees.