Proposed Regulations Would, as a General Matter, Prevent Partners from Participating in Employee Benefit Plans Established for Employees of a Disregarded Entity Owned by the Partnership
Today, the Treasury Department issued proposed and temporary regulations clarifying that partners providing services to a disregarded entity owned by the partnership are not treated as employees of the disregarded entity, but rather, are treated as self-employed. Consequentially, those partners are generally not eligible to participate in benefit plans that are limited to employees and are sponsored by a disregarded entity owned by the partnership.
The Treasury Department requests comments as to (i) whether it may be appropriate to treat partners as employees in tiered partnership structures or in certain other circumstances, including when employees receive relatively small partnership interests as compensation, and (ii) the potential impact on employee benefit plans and self-employment taxes if partners were permitted to be treated as employees.
Under current Treasury regulations, an entity that is disregarded as separate from its owner for most federal income tax purposes is treated as a corporation for purposes of employment taxes, and is responsible for matters such as withholding and remitting employment taxes. This rule does not apply, however, with respect to an individual that operates the disregarded entity as a sole proprietorship. In such a case, the current Treasury regulations make clear that the individual is treated as self-employed, rather than as an employee of the disregarded entity.
PROPOSED AND TEMPORARY REGULATIONS
In the preamble to the proposed regulations, the Treasury Department states that, although it did not intend to create a distinction between a disregarded entity owned by an individual (i.e., a sole proprietorship) and a disregarded entity owned by a partnership, the Treasury Department believes that some taxpayers may have read the current regulations to permit the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity. To address this misconception, the Treasury Department has issued proposed and temporary regulations clarifying that partners providing services to a disregarded entity are nevertheless subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.
With this clarification, the Treasury Department has made clear that partners in a partnership that owns a disregarded entity are generally not eligible to participate in certain tax-favored employee benefit plans sponsored by the disregarded entity. The Treasury Department also reaffirmed its view, based on long-standing IRS Revenue Rulings that: (i) bona fide members of a partnership are not employees of the partnership for purposes of FICA, FUTA, and income tax withholding, and (ii) a partner who devotes time and energy in the conduct of a trade or business of the partnership, or in providing services to the partnership as an independent contractor, is a self-employed individual rather than an employee.
The temporary regulations will apply on the later of: (i) August 1, 2016 or (ii) the first day of the lateststarting plan year following May 4, 2019, of an affected plan (i.e., any qualified plan, health plan, or section 125 cafeteria plan) if the plan is sponsored by a disregarded entity. A plan is considered “affected” for these purposes if it benefits participants whose employment status is affected by the temporary regulation.
In the preamble, the Treasury Department notes that the regulations do not address these rules in the context of tiered partnerships and further, the preamble requests comments on the appropriate application of the proposed rule to tiered partnership situations, the circumstances in which it may be appropriate to permit partners to also be employees of the partnership (including when employees receive relatively small partnership interests as compensation), and the impact on employee benefit plans and on employment taxes in such cases.