The IRS has released temporary and proposed regulations that bar partners from being treated as employees of a disregarded entity (DRE) owned by their partnership.

The temporary regulations (T.D. 9766) will require a relatively quick response from taxpayers regarding the employment tax treatment of certain partners, their eligibility for benefit plans and the qualifying status of the benefit plans themselves. They are effective on the first day of the latest-starting new employee benefit plan year following May 4, 2016, or by Aug. 1, 2016, if later. The temporary regulations were issued concurrently as proposed regulations (REG-114307-15) to allow taxpayers to comment.

Treatment of partners as employees

The question of whether an individual holding a partnership interest can ever be treated as an employee of the partnership has long been considered by taxpayers. The determination is important for various tax rules, and partners face significant restrictions on employee benefits.

Most of the case law and guidance generally provides that even a nominal partnership interest disqualifies an individual from employee treatment. In 1967, The U.S. Court of Claims in Wilson v. United States stated that a partnership is not a legal entity separate and apart from its partners, and "accordingly, a partnership cannot be regarded as the employer of a partner for the purposes of [the exclusion from income for meals and lodging]." The IRS followed with two general counsel memoranda in 1969 (GCM 34001 and GCM 34173), which generally found that a person cannot be both employer and employee and that it is therefore not possible to be an employee of a partnership in which one is a partner. In an isolated case from the Fifth Circuit, the Court of Appeals held in 1968 in Armstrong v. Phinney that a person could have dual status as an employee and partner for purposes of the exclusion of meals and lodging from income.

Most importantly, the IRS issued Rev. Rul. 69-184, concluding that, for purposes of employment tax provisions (Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA) and withholding from wages), a partner can be treated as an independent contractor for certain services under Section 707, but the partner can never be treated as an employee. The IRS has steadfastly continued to abide by Rev. Rul. 69-184.

Despite very little apparent support for the position in the record, some taxpayers have argued that a nominal interest in a partnership should not disqualify an individual from employee status. In addition, taxpayers have recently taken the more aggressive position that the regulations regarding DREs, which generally treat a DRE as a corporation for employment tax purposes, allow partners employed by a partnership's DRE to be treated as employees of the DRE.

DREs and the new regulations

The classification regulations under Section 7701 generally provide that a business entity that has a single owner and is not a corporation is disregarded, and not considered separate from its owner. However, in 2007, the regulations were amended to provide an exception for employment taxes. Under this rule, a DRE is respected and treated as a corporation for reporting and remitting employment taxes, but not for the application of self-employment taxes.

The IRS said in the preamble to the new temporary regulations that taxpayers have been using the 2007 employment tax regulations, including an example, to take the position that partners can be treated as employees of a DRE owned by a partnership even though the DRE is generally disregarded for federal tax purposes.

The new regulations clarify that a DRE cannot be treated as a corporation for purposes of employing any partner of a partnership. The rule that respects a DRE as a separate corporation for employment tax purposes does not apply to the self-employment tax treatment of partners. So a partnership's DRE is effectively disregarded for all partners under the new rules, and the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a DRE. The new regulations preclude the partners from participating as employees in any of the DRE's benefit plans, although the partners can still participate in their partner capacity as long as the plan is a type that allows participation by partners under federal income tax law.

The regulations expressly avoid addressing the application of Rev. Rul. 69-184 to tiered partnership structures, which will remain subject to some uncertainty. The IRS also noted that taxpayers have asked the IRS to modify Rev. Rul. 69-184 to allow employees of partnerships to receive nominal partnership interests as awards or incentives without losing their employee status. The IRS asked for comments on both of these issues.

Next steps

Any partnership that treats partners as employees through a DRE should immediately begin planning to correct this treatment by the effective date of the new regulations. Partners will no longer be permitted to receive W-2 wages from a DRE owned by their partnership under the new rules, and these DREs should no longer perform withholding. All payments should be treated and reported on a partner's Schedule K-1 as partnership distributions or guaranteed payments subject to estimated taxes and self-employment taxes to the extent those rules apply.

Partnerships should also immediately begin planning to make all affected benefit plans compliant after the recharacterization of affected employees as partners. This entails identifying plans in which partners are not permitted to participate under federal income tax law, such as Section 125 cafeteria plans, and ceasing partners' participation in the plans. In addition, it involves identifying plans in which partners are permitted to participate under federal income tax law and making sure the plan documents explicitly provide for participation by partners. These plans include any qualified retirement plans and health plans. The consequences of failing to comply with benefit plan compliance can be severe. 

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