On May 3, 2016, the IRS released temporary and proposed regulations under section 7701 of the Internal Revenue Code of 1986, as amended (the “Code”), which address certain self-employment tax issues regarding partners in a partnership which is the sole owner of a disregarded entity.  The regulations clarify that where the partners are working for the disregarded entity in such a circumstance, they may not be treated as employees of the disregarded entity.   Although the general rule for disregarded entities is that they are disregarded as separate entities from their owners, there is an exception to this rule in Treasury Regulations section 301.7701-2(c)(2)(iv)(B) which provides that, for employment tax purposes, disregarded entities are treated as a corporation.  There is a carveout from this exception, however, which provides that, in the self-employment context, the general rule (that a disregarded entity will be disregarded) is applied instead.  The regulations providing this carveout include an example illustrating that an individual owning a disregarded entity is not considered an employee of that entity for employment tax purposes.  The regulations did not, however, include an example in which a partnership owns a disregarded entity.  

It is the IRS’s view that the lack of a specific example addressing partnerships has caused confusion and led some taxpayers to take the position that a partner in a partnership which owns a disregarded entity can be considered an employee of that disregarded entity.  Because the characterization as an “employee” grants access to various employee benefit plans which are unavailable to self-employed individuals, this has been an attractive position for some taxpayers.  The IRS disagrees with this position, and the temporary and proposed regulations make clear that disregarded entities remain disregarded in the self-employment context even when owned by a partnership.  

In the preamble to the regulations, the IRS reiterates its support of Rev. Rul. 69-184, which stands for the general proposition that a bona-fide partner in a partnership cannot be an employee of that same partnership (but will, instead, be treated as self-employed to the extent performing services for the partnership outside of his/her capacity as partner).  The IRS notes, however, that these regulations do not address the applicability of Rev. Rul. 69-184 in the tiered-partnership context.  Instead, the IRS requests comments on this issue as well as circumstances in which it might be appropriate to permit partners to also be employees of the partnership (e.g., when employees receive small incentive grants of ownership interests).  

Because the IRS views these regulations as a clarification, rather than as a new rule, it is unclear whether taxpayers who have taken a contrary position on past returns will be at risk for adjustment.  The fact that the IRS has endeavored to “allow adequate time for partnerships to make necessary payroll and benefit plan adjustments” before the regulations become applicable, however, may suggest that these regulations are meant to be forward-looking.  The regulations will generally begin to apply on August 1, 2016, though their applicability may be delayed to the first day of the latest-starting plan year following May 4, 2016, of an “affected plan”.