Potential tax traps for employees who become partners

Recently proposed regulations have renewed discussions regarding the IRS position that a partner in a partnership cannot also be an employee of that partnership.

While some question the validity of that view, if it is deemed to be correct, a partner receiving fixed payments as compensation for services must treat them as guaranteed payments reported on Schedule K-1 and not as a salary reported on Form W-2.

If an existing employee’s wages are converted into partner guaranteed payments, more will change than the tax forms. A partner receiving such a payment may seek an increase in gross compensation to make up for the fact that they will now be responsible for a greater share of their Social Security taxes under the self-employment tax rules.

In addition, there will be changes to the tax treatment of certain fringe benefits. For example, a partner who is eligible to participate in a spouse’s health care plan, but chooses not to, will likely not qualify for a deduction for self-employed health insurance premium deductions and will also not enjoy the ability to receive tax-free health insurance from the partnership.

Before making any changes, employers should consider discussing the tax and other consequences with their workers.