Last week, the Internal Revenue Service and the Department of the Treasury released new regulations regarding the tax treatment of partners of a partnership (or members of a limited liability company taxed as a partnership) that owns an entity that is disregarded for federal income tax purposes (e.g., a single member limited liability company). These regulations may significantly affect how these partners (or members) report their self-employment taxes as well as how benefit plans and executive compensation arrangements are handled.
As background, the IRS has historically held the position, as set forth in Revenue Ruling 69-184, that a partner of a partnership cannot also be an employee of the partnership for employment tax purposes. Rather, partners who provide services to the partnership are subject to self-employment taxes on compensation for those services and are prohibited from participating in certain tax-favored employee benefit plans.
The new regulations:
- Extend the IRS’ position to situations in which a partnership owns a disregarded entity (which is, as a general rule, treated as a corporation for employment tax purposes).
- Provide that a partner of the partnership who provides services to the disregarded entity may not be treated as an employee of the disregarded entity. Rather, he or she is considered an owner of the partnership only (and is compensated for any services in that capacity).
Practically speaking, this means the partner:
- will receive only an IRS Schedule K-1 from the partnership (and not a Form W-2 from the disregarded entity);
- will pay self-employment tax instead of employment tax; and
- may be excluded from certain benefit plans, or participate as an owner instead of an employee.
Treasury did, however, request comments on whether it may be appropriate to treat partners as employees in tiered partnership structures, and also whether employees who receive relatively small partnership interests as compensation can maintain employee status in certain cases. Such comments may or may not ultimately affect the implementation of the new regulations.
These new rules are effective 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 sponsored by a disregarded entity (i.e., any qualified plan, health plan, or section 125 cafeteria plan).