The Treasury Department (Treasury) and the Internal Revenue Service (Service) have issued temporary regulations (Regulations) clarifying the federal employment tax treatment of the owners of partnerships and other entities classified as partnerships for federal tax purposes. In general, the Regulations clarify that, where a partnership owns a disregarded entity (such as a single member LLC that has not elected to be treated as a corporation), the partners of that partnership are not permitted to be treated as employees of the disregarded entity for federal employment tax purposes (i.e., for FICA, FUTA, and income tax withholding purposes and reporting purposes). Rather, the partners are subject to self-employment tax on net earnings from self-employment resulting from the partnership’s activities, including the activities of the disregarded entity.
While the Regulations apply to only a limited subset of partnerships – specifically, partnerships that own a disregarded entity – the Regulations nonetheless are meaningful to all partnerships engaged in a trade or business. First and foremost, the Regulations reaffirm the Service’s long-standing position, as set forth in Rev. Rul. 69-184, 1969-1 CB 256, that a partner of a partnership is not permitted to be treated as an employee of the partnership for federal employment tax purposes but is instead considered self-employed and thus subject to federal self-employment tax. Moreover, the preamble (Preamble) to the Regulations includes requests for comments concerning, among other things, how the principles of Rev. Rul. 69-184 should be applied in tiered partnership structures and, more generally, whether there are circumstances in which it may be appropriate to limit the principles of Rev. Rul. 69-184 so as to permit partners to be treated as employees.
Sutherland Observation. The Service has historically taken the somewhat rigid position that an individual who works for a partnership and holds an equity interest in the partnership is not permitted to be treated as both an employee and a partner of that partnership, apparently even in circumstances in which the individual has only a relatively small equity interest, e.g., as a result of holding equity compensation. An employee is subject to FICA and income tax withholding, and W-2 reporting, on wages received as an employee. In contrast, a partner generally is required to pay self-employment taxes and estimated tax payments on the partner’s distributive share of partnership income and any guaranteed payments, which are reported by the partnership to the partner on Schedule K-1. Also, the tax rules for participation in an employer-sponsored retirement or health plan are different for employees and partners; in particular, a partner cannot participate in a cafeteria plan permitting the payment of pre-tax health insurance premiums. A partnership’s treatment of a person as having dual status – i.e., as both a partner and an employee – may result in adverse tax consequences to the partnership and its partners.
In general, a business entity is disregarded as an entity separate from its owner (i.e., is a disregarded entity) for federal tax purposes if (1) the entity has a single owner and (2) is neither required nor elects to be classified as a corporation. This general rule does not apply for federal employment tax purposes; rather, for such purposes, the entity is treated as a corporation and thus the entity (and not its sole owner) is considered to be the employer of the entity’s employees. However, the general rule treating the entity as a disregarded entity does apply for self-employment tax purposes.
The regulations (Prior Regulations) as in effect prior to the issuance of the Regulations include a single example illustrating the application of these rules. In the example, the entity has a single individual owner who is a sole proprietor, and the entity also has employees. The example concludes that the entity is considered a corporation (i.e., a separate entity) for federal employment tax purposes with respect to its employees but is treated as a disregarded entity for purposes of applying the self-employment tax to the entity’s individual owner. Thus, the example concludes that the individual owner is not treated as an employee of the entity for federal employment tax purposes but is instead subject to self-employment tax on the net earnings from self-employment resulting from the entity’s activities.
According to the Preamble, the Treasury and the Service are aware that some taxpayers may have read the Prior Regulations to permit the partners of a partnership that owns a disregarded entity to be treated as employees of the disregarded entity and on that basis to permit such partners to participate in certain tax-favored employee benefit plans. The Preamble notes, however, that the Prior Regulations did not create a distinction between a disregarded entity owned by an individual and a disregarded entity owned by a partnership. Further, the Preamble acknowledges that the Treasury and the Service do not believe that the Prior Regulations altered the holding of Rev. Rul. 69-184 (i.e., that a partner of a partnership is not permitted to be treated as an employee of the partnership for federal employment tax purposes but is instead considered self-employed and thus subject to self-employment tax).
Explanation of Regulations
The Regulations clarify that, where a partnership owns a disregarded entity, the rule that the disregarded entity is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in the partnership. Accordingly, the Regulations make it clear that the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.
Requests for Comments
The Preamble acknowledges that the Regulations apply only to partnerships owning a disregarded entity and that the Regulations do not apply to tiered partnership structures. The Preamble indicates that several commenters have requested the Service to provide additional guidance on the application of Rev. Rul. 69-184 to tiered partnership structures (which have also been used as a method to allow a person to hold a partnership interest and simultaneously serve as an employee), and to modify the holding of Rev. Rul. 69-184 to allow partnerships to treat partners as employees in certain circumstances, such as, for example, an employee in a partnership who obtains a small ownership interest in the partnership as an employee compensatory award or incentive. Accordingly, the Preamble requests comments on the appropriate application of Rev. Rul. 69-184 to tiered partnerships, 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 Rev. Rul. 69-184 were to be modified to permit partners to also be employees in certain circumstances.
The Regulations apply on the later of (1) August 1, 2016, or (2) 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 plans in effect as of, May 4, 2016) sponsored by a disregarded entity. For this purpose, 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. The Preamble indicates that the effective date of the Regulations is intended to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments.