Under current federal income tax law, the IRS has firmly established its position that an individual cannot be both a “partner” and an “employee” of the same partnership (e.g., Rev. Rul. 69-184; Rev. Rul. 71-502; Rev. Rul. 81-300. Pratt (550 F. 2d 1023 Fifth Cir. 1977). However, for various reasons, a partnership may nevertheless be treating a partner as an employee by issuing a Form W-2 to a partner to report his/her compensation arising from the partner’s services to the partnership, rather than treating compensatory payments as “guaranteed payments”. In addition, the partnership may issue a Schedule K-1 to the partner to reflect his/her allocable share of items of partnership income that do not relate to the services provided. The IRS, recently supported by a district court decision, has made it clear that this treatment is not permitted.
Self-employment taxes must be paid via quarterly estimated payments, while regular income and payroll taxes are paid via withholding when treated as an employee. Additionally, partners are not allowed to participate in certain tax-favored employee benefit plans and also may not exclude from income certain employer-paid benefits which would ordinarily be nontaxable to employees. This issue is becoming more of a concern as the issuing of “profits interests” to employees as a means of incentive based compensation becomes more popular.
For partnerships that are currently treating partners as employees, proper attention should be given to the risks and exposure associated with this treatment. Partnerships should particularly note that if a partner participates in a tax beneficial Section 125 plan (also known as a cafeteria plan), the plan may be disqualified and thus create significant tax ramifications to all of the partnership’s employees. Cafeteria plans include Flexible Spending Accounts (FSA), Premium Only Plans (POP) and Health Savings Accounts (HSA).
Consequently, partnerships and their tax advisors have sought creative means to circumvent the general rule and allow their partners who provide services to the partnership to continue to be treated as employees under federal income tax law.
One method in which partnerships historically avoided the dual partner/employee issue, was by treating the service partners as employees of a disregarded entity (DRE) wholly owned by the partnership. Until the issuance of new Temporary Regulations in May of 2016, partnerships and some tax advisors took advantage of some ambiguity in the IRS Regulations. Under Regulation §301.7701-2(c)(2), a limited liability company with a single owner (i.e., a single member limited liability company) that is not treated as a corporation for income tax purposes is disregarded as an entity separate from its owner. However, the Regulations specified that the disregarded entityistreated as a corporation with respect to employment taxes. Nevertheless, the Regulations provided a specific example in the context of an individual who owns 100% of a DRE and clarified that the individual will still be treated as self-employed and not as an employee of the DRE. The Regulations do not include a specific example in which the DRE is owned by a partnership. The omission of an example specifically addressing the use of a partnership owned DRE created enough ambiguity for many partnerships and tax preparers to conclude that where a partnership is the sole owner of a DRE, partners in the partnership may be treated as employees of the DRE.
However, in May of 2016, the IRS issued temporary regulations with the intention of preventing the use of partnership-owned disregarded entities to circumvent the partner/employee issue. The new regulations clarify that if a partnership is the owner of a disregarded entity, the entity is NOT treated as a separate corporation for purposes of employing a partner of the partnership that owns the entity. A partner of a partnership that owns a DRE is subject to the same self- employment tax rules as a partner of any other partnership.
As a result of the newly issued temporary regulations, partners who have been treated as employees of a DRE will not be able to receive Form W-2s nor participate in the partnership’s tax favored employee benefit plans. The effective date of the temporary regulations is the later of August 1, 2016 or the first day of the latest-starting plan year following May 4, 2016 for an affected plan.
However, the IRS did indicate in its Preamble to the Temporary Regulations that they are open to comments on whether there should be specific circumstances in which it may be appropriate for partners to also be treated as employees of a partnership. Furthermore, the IRS did not specifically provide guidance on the use of tiered partnership structures (as opposed to disregarded entities) as a means of enabling an individual to be a partner in one partnership and an employee of another partnership.
With the issuance of the temporary regulation, the IRS has manifested a renewed interest on the treatment of partners who are also being treated as employees of partnerships. Partnerships, including limited liability companies, treating individuals as dual partners/members-employees need to revisit this treatment or run the risk of adverse ramifications.
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