The IRS recently released new temporary and proposed regulations to address employment tax treatment in certain limited liability company ("LLC") and partnership structures where an individual is both a partner and an employee.

The IRS Rule on Employees as Partners

The IRS has a longstanding position reflected in a 1969 ruling that an individual cannot be both an employee and a partner of a partnership, even if his or her partnership interest is extremely small.  Despite no change in this position, industry practice has adapted to reflect the significant changes that have occurred since the IRS issued formal guidance on this issue.  In particular, with the evolution of LLCs as a preferred choice of entity, the number of businesses treated as partnerships for tax purposes has increased dramatically.  Additionally, issuing partnership equity to key employees has become increasingly common as a way to incentivize key employees.

Changing from employee to partner status carries some consequences that may not be desirable or intended.  As a partner, instead of receiving wage income reported on a W-2 subject to withholding, the individual would be subject to self-employment tax.  The change of status also affects employee benefit eligibility; for example, a partner cannot participate in Section 125 cafeteria plans.  Because of these issues, many LLCs and partnerships have sought arrangements to allow partners to remain employees as well.

Past Workarounds and New Limitations

One way that businesses have worked around the IRS's rule is by adopting a structure with an LLC treated as a partnership owning an LLC treated as a disregarded entity.  The employees and other partners hold ownership interests in the partnership, but employment agreements are made between the employees and the disregarded entity.  This arrangement has allowed businesses to take the position that the affected individuals are employees of one entity, but partners of another entity.

The new regulations provide clarification to the self-employment tax rules, and effectively rule out this type of arrangement as a way to treat partners as employees.  The regulations state that if a partnership owns a disregarded entity, the partners are subject to the same self-employment tax as they would be if the partnership did not own the disregarded entity.  The result is that the disregarded entity is ignored for self-employment tax purposes as well as income tax purposes.

The new regulations also confirm that the IRS still maintains its original ruling that a partner in a partnership cannot also be an employee of that partnership.  However, comments have been requested by the IRS as to whether its rule should be narrowed to allow partners to be employees as well in some circumstances. 

The regulations apply on the later of August 1, 2016, or the first day of the latest-starting plan year following May 4, 2016, of a qualified plan, health plan, or cafeteria plan sponsored by a disregarded entity subject to the new regulations.

Next Steps for LLCs and Partnerships

Further developments in this area are expected.  In the meantime, partnerships should take the opportunity to assess their situation and consider what risks may be present if partners are being treated as employees, and whether changes should be made.  Prospective buyers of partnerships should also evaluate these issues as part of their diligence.  We will be monitoring these issues closely, and provide updates as further information is available.

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