The IRS has issued final and temporary regulations that potentially impact the treatment of individuals who have been granted profits interests in a partnership or an entity (such as a LLC) taxed as a partnership for purposes of employment taxes and eligibility for certain types of benefit plans.
Unlike a traditional company stock option, which represents a right to buy into the company at a future time, a profits interest represents an ownership interest only in the future profits and growth of the company and not an interest in the current value of the company. When designed to follow the Internal Revenue Service “safe harbors,” a profits interest can be tax free to the recipient at the time of grant.
The question, though, has been whether that profits interest recipient is to be treated as a "partner" or as an "employee." With the new regulations, the IRS loudly confirms that a profits interest granted to an employee of the LLC/partnership converts that employee from W-2 status to K-1 status. With that K-1 status comes the following:
- Application of self-employment taxes for FICA and FUTA (i.e., self-employed individual pays both the employee and the employer share)
- Quarterly estimated tax filings
- Application of state income taxes in states in which the partnership does business
- Ineligibility to make pre-tax contributions for group health plan premiums (only after-tax contributions are permitted) and taxation of employer-paid group health, life and other benefit plan premiums (although an above-the-line deduction may be possible on the partner's Form 1040)
- Ineligibility to participate in healthcare and dependent care flexible spending account plans
- A need to have the employer's 401(k) plan define "compensation" for plan purposes to include "earned income" and not be limited to W-2 income only
In the past, some companies have tried to address the long-standing IRS prohibition against dual-status as a partner and an employee by forming lower tier C-Corporation or sister S-Corporation management companies to hold the profits interests, or by forming a subsidiary LLC (wholly-owned by the partnership and disregarded for tax purposes) to serve as the operating company which employs the employees with profits interests being granted out of the parent partnership holding company. The new IRS regulations clearly throw water on these designs by providing that self-employment taxes do apply to partners of a partnership that owns a disregarded entity and that those same partners cannot be treated as "employees" of the disregarded entity.
For new profits interests granted on or after August 1, 2016, the new rules apply. For previously issued profits interests, companies that have been treating partners as employees of disregarded entity subsidiaries must adjust their payroll by August 1, 2016 to cease such treatment (i.e., start applying K-1 treatment). For existing benefit plans affected by these regulations, the new rules are effective as of the later of August 1, 2016 or the first day of the plan year that begins after May 4, 2016 if the plan includes participants whose employment status is affected by the regulations.