On May 4, 2016 the Internal Revenue Service (the “IRS”) issued final and temporary regulations, Treasury Regulation § 301.7701-2T (the “Regulation”), to clarify the employment tax treatment of partners in a partnership that owns a disregarded entity. The Regulation provides that such partners cannot be treated as employees of the disregarded entity owned by the partnership, are subject to self-employment taxes and cannot participate in certain tax-favored employee benefit plans that exclude partners, such as a Section 125 cafeteria plan.
Treasury Regulation § 301.7701-2, which defines various business entities for purposes of federal tax classifications, provides that a business entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner (a “disregarded entity”). However, a disregarded entity is treated as a corporation and an employer for purposes of the rules regarding withholding and reporting of employment taxes. As an employer, the disregarded entity is responsible for withholding taxes from employee wages and reporting those wages on a Form W-2. Even though the disregarded entity can be considered an employer for employment tax purposes, there is no analogous rule for self-employment tax. Therefore, the owner or owners of the disregarded entity are subject to self-employment taxes similar to the owner of a sole proprietorship. The total payments made to partners (1) are reported on a Form K-1, rather than a Form W-2, (2) are not subject to tax withholding, (3) require estimated tax payments and (4) are subject to self-employment tax. While these prior regulations provided examples for the employment tax and self-employment tax treatment of employees and owners of a disregarded entity, the regulations did not provide an example of a partnership that owns a disregarded entity.
Final and Temporary Regulations
Underscoring the need to issue the Regulation, the IRS noted in the preamble that it had “come to the attention of the Treasury Department and the IRS that even though the regulations set forth a general rule that an entity is disregarded as a separate entity from the owner for self-employment tax purposes, 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 because the regulations did not include a specific example applying the general rule in the partnership context.” Under this reading, which the IRS stated was not intended, some taxpayers treated partners of the partnership that owned the disregarded entity as employees of that entity and thus permitted these partners to participate in certain tax-favored employee benefit plans that do not allow for partner participation.
Thus, the IRS issued the Regulation to clarify that partners of a partnership cannot be treated as employees of a disregarded entity owned by the partnership. Therefore, a partner in a partnership that owns a disregarded entity is subject to self-employment tax in the same manner as a partner of a partnership that does not own a disregarded entity and cannot be treated as an employee of the disregarded entity. The IRS believes that the Regulation is consistent with the holding in Revenue Ruling 69-184, which provided that a partner cannot be an employee of the partnership, even if, based on his or her services provided for the partnership, the individual would normally have had the status of an employee under a common law employee analysis.
Additionally, in the preamble to the Regulation, the IRS addressed commentators’ request to revise Revenue Ruling 69-184 to allow partnerships to classify partners as employees in certain circumstances, specifically those circumstances in which an employee acquired an ownership interest in the partnership through an equity incentive award. The IRS suggests that several issues, including employment tax and employee benefits plan implications, would need to be resolved before the IRS is willing to allow a partner to be treated as an employee. At this time, there is no de minimis ownership rule whereby an owner of a small percentage of the partnership could continue to be treated as an employee. Therefore, once an employee of a partnership or a disregarded entity owned by the partnership receives an ownership interest in the partnership, such employee is treated as a partner, regardless of the percentage of ownership.
The Regulation is effective as of the later of (1) August 1, 2016 or (2) the first day of the latest-starting plan year following May 4, 2016 of an affected plan. An affected plan would include any employee benefit plan adopted before and in effect as of May 4, 2016, which is sponsored by a disregarded entity.
In light of the Regulation, partnerships should review whether they have been treating partners in the partnership as employees of a disregarded entity owned by the partnership. As a part of this review, all partners—no matter the ownership percentage—should be treated as partners and not as employees. If the partners have been considered employees for purposes of employment taxes, then changes with regard to tax withholding and reporting will need to be implemented by the applicable effective date described above to treat these partners as owners who are subject to self-employment taxes. Additionally, partnerships should review the participants in the employee benefit plans sponsored by the disregarded entity, such as qualified retirement plans, health plans and Section 125 cafeteria plans. If partners are participating in the qualified retirement plans or the health plans, the relevant plan documents should be reviewed to ensure that partners are eligible to participate in those plans and these plans may be amended as necessary to provide for partners to be eligible to participate. Partners are not able to participate in Section 125 cafeteria plans and any partner that is currently participating in such plan should be removed from the plan.