The IRS and Treasury have recently issued final regulations regarding the self-employment tax treatment with respect to partners in partnerships with wholly owned disregarded entities. Consistent with prior guidance laid out in a set of 2016 temporary regulations (see T.D. 9766), the final regulations provide that a partner cannot be an employee of a disregarded entity wholly owned by the partnership in which they are partners.
The IRS maintains a litigating position – established in Rev. Rul. 69-184 – that an individual providing services to a partnership cannot be both a partner in the partnership and an employee of the same partnership. Prior to the 2016 temporary regulations, the earlier version of the section 7701-2 regulations provided that a single member LLC was treated as a separate corporation for employment tax purposes. Based on this earlier regulation language, partnerships sometimes established a disregarded LLC below a partnership, transferred employees and partners of the regarded partnership to the disregarded entity, and treated individuals who were partners of the upper tier partner as employees, for state law purposes, of the wholly owned disregarded entity. The 2016 temporary regulations changed the language to clarify the earlier regulation, providing that a disregarded entity wholly owned by a regarded partnership would not be treated as a C corporation for purposes of employing a partner of the partnership owning the disregarded entity. The recently issued final regulations maintain this position.
In the final regulations, the IRS did not address certain areas raised by commentators, such as the application of the IRS’ positon in Rev. Rul. 69-184 to tiered partnerships and publicly traded partnerships. Commentators to both the previous proposed and temporary regulations had requested guidance on this matter, however, the final regulations do not address these issues other than to note that having a partner work as an employee for a different entity within a tiered group of entities (such as a corporation) “presents different issues, such as whether, under the facts and circumstances, the partner is an employee of the corporation.” The preamble to the final regulations notes that the tiered entity issues and PTP issues are beyond the scope of these regulations, the IRS has, however, asked for additional comments on such issues.