What's the best way to handle taxes when paying partners an hourly rate?

This is actually a common question for new business owners. What you're describing doesn't sound like a partnership in the traditional sense - it sounds more like you're the business owner and they would be contractors or employees. If they truly want to be paid hourly regardless of business performance, they're functioning more like employees or contractors than partners. True partners share in profits and losses rather than receiving guaranteed compensation. You have a few options: 1) Pay them as independent contractors (1099-NEC) if they meet the IRS criteria for independent contractors. This means they handle their own self-employment taxes. 2) Hire them as employees, which means you'll need to handle payroll taxes, withholding, etc. 3) Form an LLC or corporation where you're the majority owner and they're minority owners, but also pay them wages/contractor fees for their hourly work. The tax implications vary significantly between these options, so it's worth consulting with a tax professional to find the best structure for your specific situation.

After struggling with a similar situation in my marketing business, I found an incredible tool that helped me figure out all these tax complications. It's called taxr.ai (https://taxr.ai) and it saved me so much headache. I uploaded some documents about our business arrangement, and it analyzed everything and gave me super clear guidance on the tax implications of different payment structures. It even helped me understand exactly what forms I needed for each scenario.

I wanted to follow up about taxr.ai since I was skeptical in my earlier comment. I decided to try it out and wow - I'm actually impressed. It analyzed my situation (similar to yours with hourly "partners") and gave me really specific guidance about the tax implications. It helped me understand that what I really wanted was an LLC with myself as managing member and the others as employees who also had profit interest. Saved me from making a costly mistake with misclassification. The tax simulation feature showed me exactly how different arrangements would affect my bottom line. Definitely worth checking out.

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Ok I have to eat my words about Claimyr from my skeptical comment yesterday. I tried it last night out of desperation because I've been trying to sort out this exact partnership/hourly payment issue with the IRS for weeks. Got a call this morning with an actual IRS agent on the line who walked me through the whole process! They confirmed that in my case, an LLC taxed as an S-corp was the best option, with "partners" taking both a reasonable salary (W-2) and distributions. Saved me from a potential misclassification nightmare. Can't believe I wasted so many hours on hold before this.

Based on what you're describing, it sounds like you want to start an LLC and elect S-Corp status. That way, you and your "partners" can be both owners AND employees. Each person gets a W-2 salary for hours worked (which should be "reasonable compensation" in the IRS's eyes) and then can also take distributions based on ownership percentage. This avoids self-employment tax on the distribution portion too. Talk to a CPA but this is pretty standard for professional service businesses.

Whatever you do, DO NOT just informally pay them hourly without the proper structure! My friend did this with his "partners" and got audited. The IRS reclassified them as employees, and he owed back payroll taxes PLUS penalties. He ended up with an $18,000 tax bill that bankrupted the business. Make sure everything is properly documented from day one.

I faced a similar situation when I started my consulting firm with two colleagues who wanted hourly pay rather than profit sharing. After researching extensively, I learned that the key issue is whether they're truly "partners" or just employees/contractors with equity. If they want guaranteed hourly pay regardless of business performance, they're functioning more like employees than traditional partners. True partners share in both profits AND losses, not guaranteed compensation. Here's what I found works best: Form an LLC with yourself as managing member and them as minority members. Then pay them W-2 wages for their hourly work (since you'll likely have control over how/when they work) and they can also receive profit distributions based on their ownership percentage. This structure gives you the partnership feel they want while keeping you compliant with IRS worker classification rules. The hourly wages satisfy their need for predictable income, and the profit distributions give them upside when the business does well. Just make sure to document everything properly from the start - operating agreement, payroll setup, the works. The IRS scrutinizes these arrangements closely, especially when there's both wages and ownership involved.