May 05, 2016
Tax Flash - IRS Issues New Regulations on Partnership Treatment of Employees
By Michael D'Addio, Principal, Tax & Business Services
The Internal Revenue Service has issued new temporary regulations and proposed regulations providing that where a partnership owns 100% of the interests of a disregarded entity, a partner of the partnership cannot be treated as an employee of the disregarded entity. The Service believes that this is a clarification of the current rules. Additionally, the Service is requesting comments discussing situations where it would be appropriate to treat a partner performing such service for the disregarded entity or the partnership itself as an employee.
The question of whether a partner can be treated as an employee of his or her partnership has been an ongoing issue. Some partners prefer to be subject to regular income tax and payroll tax withholding as an employee to assure that these funds are turned over to the IRS and state tax authorities. They are concerned that they will not budget appropriately to pay quarterly estimated taxes. Others recognize that payroll taxes of employees are borne by both the employer and employee while self-employment taxes on partnership earnings are the sole responsibility of the partner. Many employees who receive equity interests in partnerships as an incentive are surprised to find that they may be required to be treated as partners and no longer receive a Form W-2 and may no longer qualify for certain tax-free employee fringe benefits.
While the law does not define the term "employee," the case law generally holds that a partner cannot wear a dual hat as an employee of the partnership. IRS confirmed this in Revenue Ruling 69-184. This ruling provides that bona fide members of a partnership are not employees for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and Income Tax withholding. It further holds that a partner providing service in the partnership business, even as a consultant, is a self-employed individual rather than a common law employee.
Some taxpayers have used a quirk in certain regulatory language to claim employee treatment is appropriate where the partner does not provide service to the partnership itself but provides it to a disregarded entity owned by the partnership.
- It is clear that for income tax purposes, a business entity formed under state law (other than a corporation) which is wholly owned by a partnership is treated as a disregarded entity. Under this rule, the operations, assets and liabilities of the disregarded entity are treated as part of the partnership for tax purposes.
- The current regulations arguably provided for a different result for employment tax purposes. They appear to treat the disregarded entity as separate from its partnership-parent, as if it were a separate corporation. Some argue that the service provider should be considered as working for the disregarded entity and not the partnership. Many consider this position to be a stretch. IRS states that the current regulations do not support this conclusion since self-employment tax treatment is determined at the level of the owner of the disregarded entity.
In the Preamble to the new regulations, IRS notes that some partnership-owned disregarded entities have allowed partners to participate in employee benefit programs which would not be allowed for partners.
As a "clarification," the Service amends regulations to expressly provide that "...if a partnership is the owner of an entity that is disregarded as an entity separate from its owner for any purpose... the entity is not treated as a corporation for purposes of employing a partner of the partnership that owns the entity; instead the entity is disregarded as an entity separate from the partnership for this purpose and is not the employer of any partner of the partnership that owns the entity." This puts a partner working for the wholly-owned disregarded entity in the same position as a partner working directly for the partnership and subject to self-employment tax.
The new temporary regulations contain a prospective effective date for this rule to permit partnerships to make payroll and benefit plan adjustments. It is 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 for plan years in effect as of May 4, 2016. An "affected plan" includes a qualified plan, health plan, or section 125 cafeteria plan.
These regulations offer no guidance in situations involving tiered-partnerships (i.e., where a partner performs services for a subsidiary partnership not owned 100% by the parent partnership of which he or she is a partner). IRS is requesting comments on this situation. IRS also seems to be open to considering relaxing the basic no-employee rule for partners in certain circumstances and requests comments in this area, as well.
It is important to immediately review the employment status of anyone who can be covered under this new rule. The analysis must consider not only the employment tax issues but potential consequences to employee benefit plans.
Contact your Marcum tax professional if you have any questions related to how the new regulations may affect you.