United States

RSM submits comments on treatment of partners as employees

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The IRS has recently signaled that it is open to reconsidering its 1969 position on the question of whether partners may be treated as employees of their partnership. To help in that process, RSM's Washington National Tax office has submitted comments to the IRS and Treasury explaining the importance of the issue to many of RSM's clients and providing insights into the underlying technical issues.

By way of background, the IRS in 1969 issued Rev. Rul. 69-184, which has been interpreted as holding that a partner may never be treated as an employee of the partnership. For many years, this was little more than an inconvenience for the relatively small number of service partners who wanted to receive a portion of their compensation as Form W-2 wages rather than as guaranteed payments. Most of the substantive federal legal rules applicable to employee compensation and guaranteed payments were and remain substantially similar.

In the years since 1986, the significance of the issue of administrative convenience has been magnified by the veritable explosion in the amount of business activity conducted through partnerships (including limited liability companies treated as partnerships for tax purposes),  making the issue important to many more individuals. In addition, partnerships are increasingly offering relatively modest profits interests to their full-time employees, making them partners in the partnership, and arguably preventing those employees from continuing to receive their normal salaries as Form W-2 wages. Indeed, denying these workers the ability to be both partners with respect to their profits interests and employees with respect to their salaries could result in their losing such benefits as unemployment insurance or coverage under the Affordable Care Act. 

RSM's comment letter makes two important technical points that we hope will be carefully considered by the Treasury and IRS and perhaps factor into a future decision to reverse or limit the scope of the 1969 position. First, contrary to the apparent but unstated theory underlying the 1969 ruling, the IRS has in fact traditionally allowed individuals to maintain dual capacity as both an employee and a self-employed individual with respect to different types of payments from the same service recipient. For example, court reporters who received salaries as court employees were permitted by the IRS to be simultaneously treated as self-employed individuals for purposes of the additional fees they received from the court when it ordered supplemental transcripts. Accordingly, as the letter explains, there is nothing in the employment tax rules that precludes an individual from having a dual status as both an employee of a partnership and a self-employed individual with respect to the same partnership. 

Second, moving from employment taxes to income taxes, the letter explains that the 1969 ruling, which has been interpreted as prohibiting partners from being treated as employees with respect to any portion of their compensation for services, was apparently based on the then position of the IRS that services provided to a partnership by its partners in the partnership's core business (such as a law firm partner providing legal services, or a physician partner in a medical group providing patient care) were necessarily provided in a partner capacity (under section 707). To the extent that was correct, the result was that any fixed payments for those services were required to be treated as guaranteed payments and not permitted to be treated as wages or salaries. The letter observes that, while this may have been a reasonable IRS position for many years, many observers believe that the law defining the difference between partner capacity and non-partner capacity payments has changed since 1969. Accordingly, the letter explains, if the 1969 ruling is based on an obsolete definition of partner capacity that is no longer good law, the 1969 ruling itself may no longer be good law.

Based on these technical observations, the letter recommends that the IRS issue a notice or ruling (1) confirming that dual status is permitted for employment tax purposes, (2) clarifying that the definition of partner capacity payments has changed, and (3) explaining that partnerships may accordingly enter into employment agreements with their partners (outside of the partnership agreement itself) and treat any fixed wages or salaries paid pursuant to such employment agreements as wages, and not as guaranteed payments.

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