BILL ANALYSIS
Senate Committee on Labor and Industrial Relations
Mark DeSaulnier, Chair
Date of Hearing: April 14, 2010 2009-2010 Regular
Session
Consultant: Gideon L. Baum Fiscal: Yes
Urgency: No
Bill No: SB 1244
Author: Walters
Version: As Amended April 5, 2010
SUBJECT
Employment: taxes and contributions: limited liability company.
KEY ISSUE
Should the Legislature conform the Unemployment Insurance Code
to existing federal regulations on Limited Liability Companies
(LLCs)?
PURPOSE
To conform Unemployment Insurance Code to federal regulations on
Limited Liability Companies (LLCs) so LLCs may offset federal
unemployment insurance tax (FUTA) costs.
ANALYSIS
Existing law defines, for the purposes of Unemployment Insurance
taxation, an employer as an employing unit, which for some
portion of a day, has within the current calendar year or had
within the preceding calendar year employed one or more
employees and pays wages for employment in excess of one hundred
dollars ($100) during any calendar quarter.
Existing law requires employer contributions to the Unemployment
Fund shall accrue and become payable by every employer for each
calendar year with respect to wages paid for employment. The
contributions cannot be deducted in whole or in part from the
wages of individuals in his employ.
Existing law defines wages, for the purposes of Unemployment
Insurance taxation, as all remuneration payable to an employee
for personal services, whether by private agreement or consent
or by force of statute, including commissions and bonuses, and
the reasonable cash value of all remuneration payable to an
employee in any medium other than cash.
This bill would treat "reasonable compensation" paid to a
managing member of a limited liability company or "S"
corporation as wages for the purposes of unemployment insurance
taxation.
This bill would exclude guaranteed payments to non-managing
members of a limited liability company or "S" corporation as
wages for the purposes of unemployment insurance taxation.
COMMENTS
1. Need for this bill?
The unemployment insurance system is a hybrid federal-state
system, both in terms of policy and administrative statutes
and regulations, as well as in taxation structure. This bill
seeks to conform the state's unemployment tax structure to
federal regulations from 1997 which allowed business entities
to classify themselves as corporate or non-corporate entities
for tax purposes. This regulatory change was primarily done
to clarify tax law surrounding limited liability companies
(LLCs).
Limited liability companies are a business structure that
combines elements of partnerships and corporate business
structures. The LLC is well structured for single owner
business entities, and, as the name suggests, serves to limit
liability. From a federal taxation perspective, LLCs are
treated as pass-through or "disregarded entities" - a single
owner would treat profits as their own income, or multiple
owners would file as a partnership, but the LLC itself does
not file taxes.
Hearing Date: April 14, 2010 SB 1244
Consultant: Gideon L. Baum Page 2
Senate Committee on Labor and Industrial Relations
Instead, an LLC elects how they wish to be taxed with the IRS
by depending on the ownership structure in place. One of
these possible elections is as an "S" corporation. An "S"
corporation can have 1-100 shareholders, and all profits and
losses are passed on directly to these individuals. With both
"S" corporations and LLCs, the Internal Revenue Service (IRS)
requires that a "reasonable compensation" be paid to all
shareholders - the assumption is that no one works for free.
From a state unemployment insurance taxation perspective, all
of the above is basically inapplicable. Current unemployment
taxation law does not address the existence of LLCs directly,
and therefore does not deal with "S" corporations. Due to
existing law, the Employment Development Department is not
able to view an LLC as a corporation. Therefore, they are not
an employer, and therefore they do not have employees, and
therefore they do not pay unemployment insurance taxes.
This can pose significant challenges for LLCs, as this opens
them up to full federal unemployment insurance tax (FUTA)
liability, whereas in other states LLCs are able to offset
FUTA liability through the payment of their state unemployment
insurance taxes. Most business accounting software assumes
that such an offset occurs, also placing California's LLCs in
a difficult position.
NOTE: SB 1244 has been double-referred to the committee on
Revenue and Taxation.
2. Questions for the Committee to Consider:
In communications between the author's office and the
Committee, the author's office has made a commitment to
continue to work with the Employment Development Department
(EDD) and the Committee to clarify and strengthen the
technical provisions in the bill. While this is an ongoing
process, the Committee may wish to seek additional clarity on
the following issues:
Hearing Date: April 14, 2010 SB 1244
Consultant: Gideon L. Baum Page 3
Senate Committee on Labor and Industrial Relations
1) Wages for Managing and non-Managing LLC and "S"
Corporation Members:
As currently written, compensation to managing members of
a LLC or "S" corporation are counted as wages for the
purposes of UI taxation, but not non-managing members.
Why was this approach taken? What guarantees are there
in the legislation to ensure the avoidance of a perverse
outcome where managers are eligible for unemployment
insurance benefits, but stockholder-employees are not?
2) "S" Corporations and LLCs:
Since many "S" corporations are a taxation election by a
LLC, it is unclear why addition mention of the "S"
corporation is necessary. Why do "S" corporations need
specific mention in Unemployment Insurance Code?
3) Defining "Reasonable Compensation":
Currently, the unemployment insurance code does not
contain a definition of "reasonable compensation" for
LLCs and "S" corporations. While this is a commonly used
term in the federal business tax world, this term in not
defined in the bill and may need to be.
3. Committee Amendments:
Currently, while SB 1244 defines the earnings of LLCs and "S"
corporations' members as wages for the purposes of
unemployment insurance taxation, it does not define members as
"employees". Therefore, the Committee may wish to suggest an
amendment to define an employee as "Any member of a limited
liability company that is treated as a corporation for federal
tax purposes."
4. Proponent Arguments :
The sponsor of this measure believes that SB 1244 would
Hearing Date: April 14, 2010 SB 1244
Consultant: Gideon L. Baum Page 4
Senate Committee on Labor and Industrial Relations
conform Unemployment Insurance Code to existing federal
regulations. The sponsor notes that this was done in 1997 and
1998 with the Revenue and Taxation Code and the Corporations
Code. The sponsor believes that this will improve the
business climate for LLCs and "S" corporations, and make their
tax filings simpler.
5. Opponent Arguments :
None received.
6. Prior Legislation :
AB 1704 (Leach), Statutes of 1998, Chapter 243, conformed the
Corporations Code to federal regulations regarding Limited
Liability Companies.
SB 1234 (Alpert), Statutes of 1997, Chapter 608, conformed
Revenue and Taxation Code to federal regulations regarding
Limited Liability Companies.
SUPPORT
California Society of Enrolled Agents
OPPOSITION
None received.
* * *
Hearing Date: April 14, 2010 SB 1244
Consultant: Gideon L. Baum Page 5
Senate Committee on Labor and Industrial Relations