Preface: Courts are finding that minority partners, are in an employment relationship for purposes of Unemployment Compensation tax assessments. Therefore, if a business has minority partners who receive K-1 income statements, they may be in danger of audits, citations, and penalties.
Is Your Partnership Legal?
Converting a General Partnership to a Limited Liability Company (LLC)
Credits: Tyler W. Hochstetler, Esq
For many years, Anabaptist business owners have often chosen the General Partnership as their business model of choice. The primary incentive for choosing the General Partnership is avoiding employee payroll, and thereby avoiding regulations, taxes, and workman’s compensation premiums.
After enjoying many years of relatively few legal challenges, some partnerships are now facing withering attacks. Pennsylvania regulatory agencies have charged Anabaptist partnerships with stretching the definition of “partnership” too far, and have imposed staggering penalties on these businesses.
In an effort to be wise stewards of business resources, many business owners have operated with 1% partners or minority partners instead of employees. These minority partners have typically been young men, sometimes minors, who exercise very little discretion and control over the activities of the business. They are often added to the partnership at a low capital investment amount, such as $100. They are often paid based on an hourly wage, and are rarely given a significant profit-sharing check.
These minority partners tend to view their work much like employment, and there is often a revolving door of turnover in these businesses. As minority partners exit, they are often repaid at the same or similar rates as when they “bought into” the partnership, rather than receiving a share of the fair market value of the company.
In many cases, one or two majority partners own the majority of the business, and the remaining partners have low ownership interests and low capital investments in the company. The majority partners often make partnership decisions without input from the minority partners, and they often set the compensation rates for everyone, including themselves. In some cases, these partnerships do not hold regular partnership meetings with all partners, they do not allow equal voting rights among partners, and they do not maintain adequate documentation of partnership activities.
As a result of these practices and government budget deficits, certain regulatory authorities have begun to challenge the validity of these partnerships. The Pennsylvania Department of Labor & Industry and Pennsylvania OSHA offices are examples of agencies which have begun to enforce a more liberal interpretation of what constitutes “employment.” These authorities have evaluated the relationship between majority and minority partners, and have often determined that the relationship is more like an employment relationship than a legitimate partnership. Fines and penalties are assessed accordingly.
Frustratingly, these authorities rarely give concrete guidance as to the definition of who is a legitimate “partner.” These authorities determine who is an “employee” based on vague standards such as a “totality of the circumstances.” They enjoy nearly unfettered discretion in determining who should be classified as an employee.
In an Unemployment Compensation audit, the agency will often audit a partnership for multiple years of business activities. These audits are stressful and expensive. Auditors sometimes paint with a broad brush in ruling that one or two partners are the “employers” and everyone else is an “employee.” They then assess unemployment taxes for several years at once, and add on penalties and interest payments. Subcontractors can also become entangled in the web of the auditor’s review, adding another layer of complexity. The burden of proof then tends to shift onto the partnership to prove that the auditor erred in classifying everyone as employees.
In an OSHA examination, roofing partnerships are especially vulnerable. Often a competing contractor or concerned citizen complains to OSHA when young men are roofing without harnesses and safety equipment. OSHA seizes the opportunity to interview young, minority partners. When those partners do not answer questions to their satisfaction, OSHA can levy punitive penalties on the partnership. Many minority partners are not prepared to answer questions regarding their ownership interests or the partnership structure.
Several partnerships have challenged the assessments by Unemployment Compensation and OSHA. Several recent Anabaptist cases which were appealed in Pennsylvania courts (by other attorneys) have failed. Courts are finding that minority partners, as described above, are in an employment relationship for purposes of Unemployment Compensation tax assessments. The Pennsylvania legislature has also contributed to this discussion with the 2011 passage of the Construction Workplace Misclassification Act (Act 72). This law addresses the misclassification of independent contractors, but it appears to have emboldened regulators in evaluating partnerships.
It is important to note that both General Partnerships and LLC’s taxed as partnerships are affected by these changing interpretations to partnership law. Consequently, if a business has minority partners who receive K-1 income statements, they may be in danger of audits, citations, and penalties. As one solution, some General Partnerships and LLC partnerships have elected to place all of their minority partners on payroll to protect themselves from audits and assessments.
When making this conversion, partnerships may begin looking for an alternative business structure. The LLC is a recommended option because of its protection from legal liability, its pass-through tax status, and the low amount of legal paperwork required. There are several steps involved in converting a General Partnership to an LLC.
In Pennsylvania, converting a General Partnership to an LLC requires filing a Statement of Conversion (Form DSCB: 15-355) with the Pennsylvania Department of State. A Docketing Statement must also accompany this form. A registered address will be required, which should match any existing registered address that the partnership may have filed with the state in order to conduct business under a fictitious name.
Further, when converting from a General Partnership to an LLC, a corporate designator is required. This means that your business name must include the letters “LLC” or a similar designator in the name.
After you have filed the appropriate forms with the state, and they are approved and returned to you, your entity should consider several other steps to effectuate the conversion. Depending on the circumstances, the business may also want to consider updating its vehicle titling, transportation licenses, sales tax registrations, real property deeds, bank accounts, and other paperwork which remains in the old partnership name.
Every LLC should generally have an LLC Operating Agreement. You should consult with legal counsel in drafting an LLC Operating Agreement for the converted partnership. This Operating Agreement will contain information such as who will manage the LLC, who owns the LLC, and how the LLC will continue or cease if one member passes away or withdraws.
The LLC should also consult with a competent accountant throughout the conversion process to ensure that the appropriate tax paperwork and payroll information is established and filed in a timely manner. Workman’s compensation coverage should be purchased in most cases, although some states (including Pennsylvania) have religious exemptions for certain employees. Unemployment compensation registration should be completed with the state as well.
Partnerships should also recognize that employee tax withholdings will increase the tax burden of the business. Compensation adjustments should be considered in order to reconcile the cost increase. Once employees understand that the employer is now paying a portion of their tax burden, and withholding and remitting the remainder of their tax burden, they will often be appreciative.
One of the biggest liabilities for a partnership is an unhappy minority partner that files a workman’s compensation claim or unemployment compensation claim. Having employees on payroll can result in happier employees, more peace of mind, and a better testimony of compliance and living in peace with our authorities. May God grant you wisdom in discerning the best course of action for your business in this changing legal climate.
Tyler W. Hochstetler, Esq. is an Anabaptist attorney who is licensed in Pennsylvania and Virginia. He serves as in-house counsel for Anabaptist Financial, and also has a private law practice, representing Amish and Mennonite clients.