United States: IRS Regulations Clarify Treatment Of Self-Employment Tax Of Partners

In recently issued final and temporary regulations, the IRS has clarified the tax treatment of partners in a partnership that owns a disregarded entity for which the partners work as employees. The regulations, issued on May 4, 2016, clarify that the IRS did not intend to create a distinction between a disregarded entity owned by an individual and a disregarded entity owned by a partnership in the application of the self-employment tax rules. As a result, partners must pay self-employment tax, even if they work for a business entity with a single owner that is "disregarded" as an entity separate from its owner for federal income tax purposes.

Treatment of Partners as Employees

The Internal Revenue Service's (IRS) long-standing position is that an individual cannot for federal income tax purposes be both an employee and a partner of an entity that is taxed as a partnership.

Under the IRS's long-standing view, the compensation paid to any individual who is a partner in a partnership in his or her capacity as an employee of the partnership should not be reported by the partnership as salary subject to withholding taxes and reported on a Form W-2. Instead, the compensation should be reported as a guaranteed payment on the Form K-1 given to the individual in connection with the filing of the partnership's federal income tax return, and the partner must pay self-employment taxes on the amount of his or her compensation.

But disregarded entities present special issues under this rule. For example, where a multi-member limited liability company owns all the equity of another limited liability company (the Subsidiary LLC), and unless an election is filed to treat the Subsidiary LLC as a corporation for federal income tax purposes, the Subsidiary LLC is generally treated as a disregarded entity. However a disregarded entity is still treated as a corporation for employment tax purposes with respect to its employees. IRS regulations provide, however, that the exception for treating the Subsidiary LLC as a corporation for employment tax purposes does not apply for self-employment tax purposes with respect to the owner of the Subsidiary LLC.

After setting forth this general rule, IRS regulations apply this rule in the context of a single individual owner, stating that the individual owner of the entity should be treated in the same manner as a sole proprietorship that is subject to self-employment income.

The IRS regulations also contain an example that specifically illustrates the mechanics of the rule. In the example, the disregarded entity is subject to employment tax reporting with respect to employees of the disregarded entity. The individual owner, however, is subject to self-employment tax on the net earnings resulting from the disregarded entity's activities. The IRS regulations did not contain an example that addressed the situation where the disregarded entity was owned by a multi-member partnership or limited liability company and certain partners or members of the partnership or limited liability company were employees of the disregarded entity.

Due to the lack of direct authority or an example in the IRS regulations that addressed the ownership of a disregarded entity by a partnership, some partnerships took the position that individual partners in the partnership who were employees of the disregarded entity could be treated as employees of the disregarded entity for income tax purposes and as such:

  • Compensation the partners received from the disregarded entity would be subject to standard employment tax withholding;
  • The compensation would be reportable by the disregarded entity on a Form W-2; and
  • These individuals would be eligible to participate in tax-favored employee benefit plans.

New Regs Extend Self-Employment Income Treatment

The IRS did not intend to carve out an exception regarding a partnership that owns a disregarded entity, and the new regulations now make it clear that the partners in a partnership that are employees of a disregarded entity owned by the partnership are subject to the same self-employment tax rules that have applied to an individual that owned all the equity of the disregarded entity. Accordingly, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

In order to allow adequate time for partnerships to make the necessary payroll and benefit plan adjustments, the regulations will apply on the later of:

  • August 1, 2016; or
  • If the regulations affect benefit plans sponsored by the disregarded entity, the first day of the latest starting plan year, following May 4, 2016, of an affected plan (based on plans adopted before, and the plan years in effect as of May 4, 2016) sponsored by an entity that is otherwise disregarded as an entity separate from its owner.

For these purposes, an affected plan includes any qualified plan, heath plan or an Internal Revenue Code Section 125 cafeteria plan if the plan benefits participants whose employment status is affected by these regulations.

Not the Last Word

Subsequent to the issuance of these regulations, the IRS announced that it is considering the impact the regulations will have on prior years.

The IRS noted in the preamble to the regulations that a number of commentators had suggested the current rule that a partner in a partnership is a partner and not an employee for employment tax purposes should be modified to allow partners to be treated as employees in certain circumstances. Such a situation would cover, for example, employees in a partnership who obtain a small ownership interest in the partnership as part of an employee compensatory award or incentive. However, these commentators did not provide any detailed analyses or suggestions as to how employee benefit plans and employment tax rules would apply in such situations.

Therefore the IRS has requested comments concerning the circumstances in which it may be appropriate to permit partners to also be employees of the partnership, and the impact on employee benefit plans and on employment taxes if the current rules were to be modified to permit partners to also be employees in certain circumstances.

Bottom Line

Recently issued IRS regulations now clarify that partners in a partnership who are employees of a disregarded entity owned by the partnership should not be treated as employees, and self-employment taxes apply to the income paid to them by the disregarded entity. This is an important clarification that partnerships and limited liability companies should review with tax counsel. Entities that have treated such individuals as employees in the past will now be required to make adjustments to both payroll and possibly benefit plans.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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