Final Regulations Issued for Partners Providing Services; Treatment as Employee
By Michael D'Addio, Principal, Tax & Business Services
The IRS finalized regulations stating that a partner providing services to a disregarded entity owned by a partnership cannot be treated as an employee but will be subject to self-employment tax.
IRS has just adopted, in final form, temporary and proposed regulations which were issued in May 2016, denying employee status to a person who provides services to a disregarded entity owned by a partnership of which he or she is a partner.
The Internal Revenue Code does not define the term “employee” for employment tax purposes. Early cases determined that a partner cannot be the employee of a partnership under an “Aggregate Theory” of partnerships – effectively providing that the partnership is not an entity separate from its partners. The Internal Revenue Service has ruled that a partner is not considered to be an employee of his/her partnership for employment tax purposes in two General Counsel Memos, 34001 and 34173, issued in 1968 and 1969, respectively. The Service in Rev. Rul. 69-184 ruled 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.
Prior to the May 2016 temporary and proposed regulations, some practitioners used a quirk in existing regulations, discussing income tax and payroll taxes, to get around this problem by creating a single member limited liability company (SMLLC), 100% owned by the partnership for which the partner can perform services. The SMLLC is a separate entity for state law purposes but is disregarded for income tax purposes.
However, there was some language in the regulations that could be interpreted to treat the disregarded entity as a separate corporation for employment tax purposes. This would arguably make the disregarded entity (and not its partnership owner) the employer of the service provider.
The temporary and proposed regulations issued in 2016, and now adopted in final form, state that employee treatment is not appropriate under existing regulations for this situation. They state 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 the partner working for the disregarded entity in the same situation as a partner working directly for the partnership and subject to self-employment tax.
The temporary and proposed regulations contain a prospective effective date for this rule, to permit partnerships to make payroll and benefit plan adjustments. The rule is effective on the later of (1) August 1, 2016; or (2) the first day of the latest starting plan year following May 4, 2016, and on or before May 4, 2017, 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.
Impact of the Regulations
A number of tax issues can arise from improperly categorizing a partner as an employee, including (but not limited to):
- Cafeteria plans and other employee benefit plans may potentially be disqualified.
- Payment of FICA taxes by the entity may constitute additional guaranteed payments to the partner.
- Section 199A Qualified Business Deduction may be overstated where the limitation based on wages applies.
- State taxes based on employee wages may be improperly apportioned (if the state does not include partner payments as wages).
- Rev. Proc. 2001-43, which involves the treatment of unvested partnership profits interests taxed at current zero value (where a section 83(b) is not made) may be inapplicable. One condition is the treatment of the service provider as a partner.
- Amounts paid after year-end may actually be taxable to a cash-basis partner in the current tax year (as a guaranteed payment or income allocation).
- Penalties may apply to both the partnership and the tax preparer since there is no substantial authority for treating an individual both as a partner and an employee.
The regulations do not address a tiered partnership situation, i.e., where a partner of a partnership performs services for a subsidiary partnership entity. Additionally, the regulations do not consider the application of this rule to publicly traded partnerships.
If you have any questions concerning these issues, do not hesitate to contact your Marcum tax professional.