In light of the new final and temporary regulations issued by the IRS and the U.S. Department of Treasury (Reg. 301.7701-2T), partnerships that have been using wholly-owned disregarded entities to “employ” partners (in order to provide access to various tax benefits, including cafeteria plans, parking and transit benefits, and other employee benefit plans) will need to reevaluate their structure and treatment of partner/employee classification. In the new rules, which were published on May 4th, 2016, the IRS moved to halt this practice, providing that where partners of a partnership are separately working for a second (disregarded) subsidiary legal entity, such individuals may not be treated as employees of the subsidiary. Instead, they are considered self-employed individuals for both self-employment and employment benefit plan purposes.

Current regulations provide that an entity that has a single owner and is treated as a disregarded entity is not disregarded for purposes of employment tax, meaning that the entity (not its owner) is treated as the employer and is responsible for withholding FICA, FUTA and federal income taxes on behalf of its employees. The regulations provide an example, however, noting that the owner of a disregarded entity is subject to self-employment tax on the net earnings from the entities’ activities. The example did not explicitly address a scenario in which a partnership is the owner of the disregarded entity, which has led some taxpayers to take the position that partners of a partnership may be treated as employees of the partnership’s disregarded subsidiary entity (and thus allowed to participate in employee benefit plans).

The new regulations clearly address (and eliminate) this strategy. Reaffirming the holding of Revenue Ruling 69-184 (which stated that members of a partnership are not employees for tax purposes, and that any partner who devotes time and energy in conducting the partnership’s trade or business or who provides services to the partnership as an independent contractor, is self-employed, and cannot be an employee), the preamble clarifies that there is no exception to the general regulatory rule for partnerships owning disregarded entities, and states that “the rule that a 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 a partnership that owns a disregarded entity.”

As a result, compensation paid to a partner (whether by the partnership or its disregarded subsidiary) is not wages with respect to employment, and therefore not subject to FICA or FUTA tax or federal income tax withholding. The IRS has not ruled out the possibility that tiered partnerships may treat partners as employees in particular circumstances, and has requested comments on this issue – so while taxpayers can no longer utilize disregarded subsidiaries to “employ” partners of a parent partnership, there may be future authority that provides planning opportunities for taxpayers. In the meantime, taxpayers can look to Revenue Ruling 69-184 and the final and temporary regulations for guidance in correctly reporting partner compensation (and make any necessary benefit plan and payroll changes). The new regulations require all “affected plans” (any qualified plan, health plan, or Section 125 cafeteria plan with participants affected by the regulations) to conform to the clarified rules as of the later of (1) August 1st, 2016, or (2) the first day of the latest-starting plan year following May 4, 2016, of an affected plan sponsored by a disregarded entity.