On May 4, 2016, the federal government issued new temporary and proposed regulations that address employment taxes with respect to certain workers who both own equity interests in a partnership or LLC (taxed as a partnership and referred to as a “tax partnership”) and are employed by an LLC that is wholly-owned (a “disregarded entity” for tax purposes) by that tax partnership.
Though described by the IRS as merely clarifying existing federal tax law, the new regulations will likely require many businesses to alter their employment tax treatment of workers of their subsidiaries. In addition to changing how and who must remit taxes for that worker’s earnings, the altered tax treatment may preclude or otherwise impact a worker’s participation in certain employee benefit arrangements.
Joe owns 1% of Parent LLC, which is a tax partnership. Parent LLC owns 100% of Operating LLC, which is a disregarded entity of Parent LLC. Joe receives a salary from Operating LLC, which has been reported as wages on a Form W-2 for federal tax purposes, and with respect to which Operating LLC withholds taxes as required for employee wages. Operating LLC’s profits (after expenses, which include Joe’s wages) are reported as partnership income of Parent LLC. Joe receives a Schedule K-1 each year from Parent LLC reflecting his share of those profits, which is reported on his personal tax return. He does not treat those profits as self-employment income (i.e., he is only reporting his salary from Operating LLC as subject to federal employment taxes).
Under the new regulations, Joe should no longer receive a Form W-2 or have taxes withheld as an employee for tax purposes; rather, any salary or compensation Operating LLC pays him should be included as part of his share of Parent LLC income on his Schedule K-1. Benefit plan differences will also result from this reporting change.
Background on Tax Partners and Employment Taxes and Benefit Plans
1969 IRS administrative guidance provides that tax partners are not “employees” of the tax partnership for federal employment tax purposes. Instead, tax partners are “self-employed” for tax purposes, and their Schedule K-1 income and other compensation is subject to self-employment taxes.
Classification of a worker as a tax partner versus tax employee is significant for several reasons.
First, a tax partnership does not withhold and remit any federal tax (including federal employment tax) from tax partner payments, even payments that relate to personal services rendered. Rather, the individual partner is responsible for paying all taxes, including employment taxes on “self-employment income” (known as SECA) from the partnership. While SECA tax rates have, for some time, been the same as the combined employer and employee FICA and Medicare tax rates, the combined taxes are remitted entirely by the tax partner - not half by the worker and half by the employer as is the case for tax employees. Also, since there is no federal wage withholding for income or other tax purposes, a tax partner will generally need to remit quarterly estimated tax payments.
Second, a tax partner’s income is allocable to various states in which the tax partnership does business, which often means the tax partner must file tax returns in multiple states. In many states, a tax employee is deemed to earn wages and owe taxes in only the state in which he or she works (or resides, depending on state reciprocity agreements).
Third, a tax partner generally cannot participate in employee benefit arrangements established by the tax partnership on the same basis as tax employees, and will be completely precluded from participating in certain types of benefit plans. The most significant differences are as follows:
- Medical Benefits. Unlike employees who can exclude from income the cost of employer-provided medical (including dental and vision) coverage as a fringe benefit, tax partners must include those benefits in income or treat the amounts as a distribution from the tax partnership. Similar treatment applies to health savings account contributions made by the tax partnership on behalf of a tax partner. Tax partners can participate in employer-sponsored health plans like employees do, and may be entitled to a deduction on their personal return for the value of that coverage (generally only if other employer-sponsored coverage is not available to them through a family member).
- Cafeteria Plans. Tax partners cannot participate in cafeteria plans (also known as Internal Revenue Code section 125 plans). A cafeteria plan is a benefit arrangement that provides employees with the option to pay their share of medical or other qualified benefit plan costs on a pre-tax basis, or participate in a medical flexible spending or dependent care account benefits on a pre-income and employment tax basis.
- Group Term Life or Disability Insurance. Employer-provided group term life or disability insurance is not deductible or excludible from income by a tax partner. Normally, employees can exclude premiums on up to $50,000 of employer-provided group term life insurance from income, and pay the entire cost of long-term disability coverage pre-tax, or exclude premiums that the employer pays toward such coverage from their income.
Undoubtedly to avoid the perceived undesirable federal tax consequences of being treated as self-employed, some taxpayers took the position that existing federal tax regulations permitted a tax partnership to treat tax partners as employees of a disregarded subsidiary entity owned entirely by the tax partnership. Consistent with that reporting position, the disregarded entity would generally withhold tax (including federal employment tax) from the individual tax partner-employee’s compensation, issue Form W-2s to the tax partner-employee, and permit tax partner-employees to participate in tax-favored employee benefit plans established by the disregarded entity. Simply put, some businesses and their tax advisors adopted the disregarded entity structure as a planning strategy to rationalize a means for tax partners to simultaneously enjoy “partner” and “employee” status within the same controlled business enterprise. The federal government published the new regulations to “clarify” that such a structure is impermissible.
The new regulations essentially provide that a tax partner who performs services for a disregarded entity owned by the tax partnership cannot be treated as a tax employee of the disregarded entity for federal employment tax purposes.
Notably, the new regulations do not address other tiered partnerships arrangements. Thus, if LLC I (taxed as a partnership) owns a portion of the outstanding equity interests of LLC II (taxed as a partnership), which in turn wholly-owns LLC III (a disregarded entity with respect to LLC II), LLC III can presumably still employ and treat as tax employees, persons who are tax partners of LLC I. Because LLC II is not 100% owned by LLC I, LLC III is not deemed 100% owned by LLC I.
Also, the new regulations do not contain an exception from partner tax treatment for tax partners who are issued a nominal amount of equity in a tax partnership in exchange for personal services rendered.
Despite the IRS reciting that the new regulations merely clarify existing law, they are not effective until the later of (i) August 1, 2016, or (ii) for affected benefits plans, the first day of the plan year that begins after May 4, 2016. An affected plan includes a qualified plan, health plan, or cafeteria plan that include persons whose federal employment tax status is impacted by the new regulations.
All tax partnerships should evaluate whether their tax partner ranks include individuals who are also treated as employees of subsidiaries disregarded for tax purposes. If those tax partners-employees exist, then the tax partnership should consult with appropriate legal advisors regarding compliance with the new regulations.