On May 4, 2016, the IRS issued final and temporary regulations clarifying the self-employment tax treatment of partners in a partnership that owns a disregarded entity (Treasury Decision 9766, 81 FR 26693-26695, May 4, 2016). The final and temporary regulations provide that where an individual is both an employee of a disregarded entity and a partner in the partnership that owns the disregarded entity, the individual will not be treated, for employment tax purposes, as an employee of the disregarded entity but only as a partner of the partnership.
In general, a business entity that has a single owner and is not a corporation is treated as a disregarded entity for tax purposes. Treasury Regulations provide an exception for employment tax purposes, such that an entity that is otherwise treated as a disregarded entity is treated as a corporation with respect to employment taxes, with the result that the entity, rather than its owner, is considered the employer of the entity’s common law employees. However, this special employment tax exception does not apply for self-employment tax purposes. The Treasury Regulations illustrate this rule in the context of a single individual owner, providing that the owner of an entity is treated in the same manner as a sole proprietorship and thus is subject to self-employment tax on the taxable income of the disregarded entity.
The IRS has long taken the position, set forth in Rev. Rul. 69-184, 1969-1 CB 256, that (i) bona fide members of a partnership are not employees of the partnership and (ii) partners who devote time and energy in the conduct of the trade or business of the partnership are treated as self-employed regardless of whether the individual would be treated as an employee under the usual common law rules.
The IRS noted that some taxpayers are taking the position that the disregarded entity rule for employment taxes trumps Rev. Rul. 69-184’s conclusion that a partner in a partnership cannot also be an employee of the partnership. In particular, some taxpayers were taking the position that, notwithstanding Rev. Rul. 69184, an individual partner in a partnership that owns a disregarded entity also may be an employee of the disregarded entity because the regulations did not include a specific example applying the self-employment tax rule in the partnership context. This has led some taxpayers to permit partners to participate in certain tax-favored employee benefit plans of a subsidiary disregarded entity.
Partners Employed at a Disregarded Entity Owned by Partnership Are Self-Employed for Employment Tax Purposes
The new regulations clarify that there is no distinction between a disregarded entity owned by an individual (i.e., a sole proprietorship) and one owned by a partnership in the application of the self-employment tax rule, and that the general tax rule for disregarded entities applies for self-employment tax purposes to any owner of a disregarded entity.
Effect on Disregarded Entities Owned by Partnerships
The new regulations have several implications for a partner of a partnership who historically has been treated as an employee of a disregarded entity owned by the partnership:
- Compensation Reporting – Compensation paid to the individual for services rendered to the disregarded entity may no longer be reported on a Form W-2 and must be reported on a Schedule K-1 delivered by the partnership.
- Self-Employment Taxes – Compensation paid to the individual in consideration for services rendered to the disregarded entity will be subject to self-employment taxes. However, an individual can generally deduct the employer-equivalent portion of self-employment tax in computing the individual’s adjusted gross income.
- Health Insurance – Health benefits may not be excluded from the individual’s income and are treated as taxable income to the individual. However, self-employed individuals can generally deduct the cost of health insurance in calculating net earnings from self-employment.
- 401(k) Plans; Cafeteria Plans – The final and temporary regulations do not affect an individual partner’s ability to participate in a tax-qualified Section 401(k) retirement plan. However, the individual will no longer be able to participate in cafeteria plans, such as flexible spending accounts and dependent care accounts, and certain other tax-favored employee benefit plans, such as qualified transportation benefits.
- State Taxes – The final and temporary regulations will likely have implications for the state tax filing obligations of the partnership and may also affect the state tax liabilities of the partnership’s partners.
To allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the temporary regulations will apply on the later of (i) August 1, 2016, or (ii) the first day of the latest-starting plan year following May 4, 2016, of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2016) sponsored by a disregarded entity. An affected plan includes any qualified plan, health plan, or section 125 cafeteria plan if the plan benefits participants whose employment status is affected by the regulations.
Impact on Tiered Partner Structures Remains Open
The IRS does not believe that the regulations alter its long-standing position that partners in a partnership may not be treated as employees of that partnership in accordance with Rev. Rul. 69-184. However, the IRS noted that the regulations do not address the application of Rev. Rul. 69-184 to tiered partnership situations and has requested comments on the appropriate application, the circumstances in which it may be appropriate to permit partners also to be employees of the partnership (e.g., if an employee obtains a small compensatory ownership interest in the partnership), and the impact on employee benefit plans and employment taxes if Rev. Rul. 69-184 were modified to permit partners also to be employees in certain circumstances.