Recently the IRS issued guidance in the form of temporary and proposed regulations clarifying that individuals who are partners in a partnership that itself owns a disregarded entity are not to be treated as employees of the disregarded entity for various tax law purposes. As a consequence, such individuals are responsible for self-employment taxes and are not eligible to participate in (or may have their benefits affected under) certain types of employee benefit plans.

Partnership as Owner of Disregarded Entity

Generally, an entity that is a "disregarded entity" for purposes of the Internal Revenue Code (having a single owner and is not a corporation) is treated as the employer of its employees for purposes of employment taxes. However, the disregarded entity is not considered the employer of any individual owner providing services to it, and the owner is subject to self-employment tax on income from the entity.

In the new guidance the IRS clarified that this principle applies regardless of whether the owner is a single individual or a partnership with individual partners. Even if the owner of the disregarded entity is a partnership, the entity is disregarded and not treated as the employer of the partners of the partnership. As a result, partners of the partnership providing services to the entity are not considered employees and are subject to the same self-employment tax treatment that is imposed on a single individual owner.

The regulations are applicable on the later of (i) August 1, 2016 or (ii) the first day of the latest starting plan year following May 4, 2016 (and not 2019 as was originally published) for an "affected plan" that is sponsored by a disregarded entity. An "affected plan" is defined as any qualified plan, health plan or Section 125 cafeteria plan if the plan benefits participants whose employment status is affected by these regulations. The effective date of the regulations will also be applicable to the individual partners who are providing services to a disregarded entity, with respect to their filing of self-employment taxes.

Should Partners Be Treated as Employees?

Granting equity interests is a popular form of incentive compensation. However, under the current IRS interpretation of applicable law, an individual having even a small equity interest in an entity taxable as a partnership is subject to self-employment taxes on any compensation income from the partnership and may be precluded from participation in (or have benefits affected under) certain types of employee benefit plans.

In the introduction to the recently published guidance, the IRS requested comments on the long-standing IRS ruling that partners of a partnership are not employees. Under the existing ruling (Rev. Rul. 69-184), members of a partnership who provide services to the partnership are not employees of the partnership for purposes of employment and self-employment taxes and income tax withholding. However, the IRS has indicated that it may consider modifying this ruling and allow partnerships to treat partners as employees in certain circumstances. Specifically, the IRS invited comments on the appropriate treatment of "employees in a partnership who obtain a small ownership interest in the partnership as an employee compensatory award or incentive." The IRS requested input on when it would be appropriate to consider partners to be employees of the partnership for employment tax purposes and for purposes of employee benefit plans, such as qualified retirement plans, health and welfare plans and fringe welfare benefit plans, and the impact of such a change on both employee benefit plans and on employment taxes.