United States

IRS issues guidance relating to partners as employees

TAX ALERT  | 

The IRS has issued important guidance, and asked for public comments, on the question of whether a partner may be treated as an employee of a disregarded entity owned by his or her partnership. The release confirms that the IRS continues to hold to a ruling and litigating position that partners in a partnership that provide services to the partnership may not be treated as partnership employees. The regulations clarify that this position cannot be avoided by making the partners employees, for state law purposes, of a single-member limited liability company (LLC) owned by the partnership.  

Partnerships that were uncertain on the basic issue but drew comfort from the use of a tiered structure (where the partner was an employee of a separate legal entity that was disregarded for income tax purposes but respected for employment tax purposes) may need to reconsider their positions. The regulations provide that a single-member LLC is disregarded in determining whether a partner is subject to self-employment taxes. That is, payments from the partnership’s disregarded entity to the partner, will be viewed as if they were payments directly from the partnership.

Interestingly, the IRS has not definitively addressed the question of whether (even without interposing a disregarded entity) a partner may be an employee of his or her partnership in certain cases but has asked for public comment on whether it should modify its position. Some courts and commentators have suggested that the IRS position should not apply to payments that are made to a partner in a non-partner capacity, which under another set of recently proposed regulations would include any essentially fixed payment as to which there was no entrepreneurial risk. See our Nov. 24, 2015, article, RSM comments on 'fee waiver' regulations address employment tax issues.

Finally, the IRS has indicated that it may address the treatment of a person who is an employee of a lower-tier or ‘operating’ partnership that is largely owned by another upper-tier partnership, if the person is a partner in the upper-tier partnership. Many commentators believe that a two-tiered structure involving two partnerships (not a partnership and a disregarded entity) would not be subject to challenge.

The new rules may require partnerships that use one or more single-member LLCs as operating entities (that employ some of their partners) to revise their payroll and benefit plan practices. Before the issuance of these regulations, under the belief that a disregarded entity was a separate employer (and, thus, that Rev. Rul. 69-184 that states that partners are not employees did not apply to the disregarded entity), an increasingly common practice was for partners of the partnership to enter into employment contracts with the lower-tier disregarded entity. In the preamble to the updated regulations, the IRS stated that this belief was not the intent of the rules and the new regulations provide that the separate employment tax treatment does not apply to partners of a partnership that owns the disregarded entity.

Therefore, although the new regulations preclude taxpayers from taking the position that a partner of a partnership can be an employee of a disregarded entity owned by the partnership, they do not add any clarity to whether a partnership can treat, in some cases, an individual as both a partner and an employee with respect to a single entity. The request for comments on these issues suggests that the IRS is considering the opportunity for dual status as partners and employees, but in the meantime, entities must consider what these final regulations mean to their tax positions.

The regulations apply on the later of (1) Aug. 1, 2016, or (2) the first day of the latest-starting plan year following May 4, 2016, of an affected plan sponsored by a disregarded entity. (Our understanding is that the original reference in the announcement to May 4, 2019, was erroneous.) For a calendar-year taxpayer that operates its benefits plans on the calendar-year, this would mean Jan. 1, 2017. Therefore, partnerships that own disregarded entities must act quickly to revise their payroll practices and benefit plan arrangements to apply the regulations.

If partners are currently being treated as employees of a disregarded entity of the partnership they own, this employment status should now be viewed from the perspective of the partnership itself, and entities must consider whether there is a supportable position that the partners can be treated as employees of the partnership. While some believe Rev. Rul. 69-184 stands for the complete disallowance of such a position, others believe this view is contrary to other authority and certain facts may support a dual status position.

Beyond employment tax issues (and the question of whether to issue a Form W-2 as well as a Schedule K-1 or only a Schedule K-1) this issue has implications for employee benefit plans. Partners are generally treated as employees for purposes of participation in qualified retirement plans, but compensation is calculated differently if it is considered earnings from self-employment as opposed to wages. While this difference may be minimal, a larger issue lingers with respect to certain fringe benefits. Partners are not considered employees for fringe benefit purposes, and thus, cannot participate in section 125 cafeteria plans. Therefore, in the case of a calendar-year arrangement, to the extent a partner of a partnership is participating in a cafeteria plan of a disregarded entity owned by the partnership, these regulations require that participation cease as of Jan. 1, 2017. In addition, such partners would not properly be considered employees for purposes of receiving tax-free employer-paid accident and health plan benefits. However, a partner may qualify for the self-employed health insurance deduction on his or her personal return for health insurance premiums paid by the partnership.

In summary, these regulations remove any supportable position that a partner of a partnership can be an employee of a disregarded entity owned by the partnership, based on the regulations governing employment tax treatment of such entities. However, the regulations do not address tiered structures with regarded entities or the possible argument that dual status is permissible even in the case of a single tax law entity. Partnerships should carefully review their structures with respect to the final regulations and stay current with this issue as the IRS gathers comments and considers further changes.

The regulations provide that in order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, these temporary regulations will apply on the later of:

  1. Aug. 1, 2016, or
  2. The first day of the latest-starting plan year following May 4, 2016, of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2016, sponsored by an entity that is disregarded as an entity separate from its owner for any purpose under Reg. section 301.7701-2).

This means, for example, if a partnership’s benefit plans operate with a June 30 year end, the regulation goes into effect on Aug. 1, 2016. The following table, provides the effective date of the regulation determined based on the benefit plan years.

Latest plan year start date Regulation effective date

Jan. 1, 2016

Feb. 1, 2016

March 1, 2016

April 1, 2016

May 1, 2016

June 1, 2016

July 1, 2016

Aug. 1, 2016

Sept. 1, 2016

Oct. 1, 2016

Nov. 1, 2016

Dec. 1, 2016

Jan. 1, 2017

Jan. 1, 2017

Jan. 1, 2017

Jan. 1, 2017

Jan. 1, 2016

Aug. 1, 2016

Aug. 1, 2016

Aug. 1, 2016

Sept. 1, 2016

Oct. 1, 2016

Nov. 1, 2016

Dec. 1, 2016


Therefore, partnerships whose benefit plans operate on a fiscal year basis that ends after May 31, 2016, will need to react very quickly to these regulations.

 

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