A federal tax issue frequently arises when key employees of an operating business are given the opportunity to become equity holders. Despite the well-established rule that partners of a partnership are not permitted to be treated as employees of the partnership, many partnerships have been treating partners as employees of a disregarded entity owned by the partnership. However, a little over six months ago, the Internal Revenue Service ("IRS") and Treasury released temporary regulations clarifying that partners of a partnership may not be treated as employees of a disregarded subsidiary of the partnership. The practical consequences of this rule are to subject a partner to self-employment taxes on the compensation the partner had been receiving as an employee rather than the normal payroll and income tax withholdings and, more severely, disrupt the individual's participation in employee benefit plans. Practitioners are beginning to propose workarounds, but some carry significant risks.

A disregarded entity is an unincorporated business entity, usually an LLC, with a single owner and is disregarded as separate from its owner for federal income tax purposes, meaning that the entity's income, assets and liabilities are treated as those of the owner.¹ On May 4, 2016, the IRS released Temporary Treasury Regulation § 301.7701-2T which specifically states that a "partner of a partnership that owns an entity that is disregarded as an entity separate from its owner for any purpose under § 301.7701-2 is subject to the same self-employment tax rules as a partner of a partnership that does not own an entity that is disregarded."²

In Revenue Ruling 69-184,³ the IRS held that partners are not employees for purposes of payroll taxes and partners who devote time and energy in the conduct of the trade or business of the partnership or who provide services to the partnership are self-employed individuals. The income distributed to such partners is, therefore, subject to self-employment taxes rather than payroll taxes. 

Why did partnerships conclude that treating partners as employees of their disregarded subsidiaries was permissible? While Revenue Ruling 69-184 is very clear with respect to partnerships, it did not address self-employment concerning disregarded entities. Generally, an entity that is disregarded for federal income tax purposes is treated as a corporation for payroll tax purposes. A disregarded entity must, therefore, remit and report payroll taxes to the IRS in its own name with respect to its employees - this is the reason many disregarded entities obtain EINs.⁴ For self-employment tax purposes, though, an entity with a single owner is still treated as disregarded. The Treasury Regulations provide an example of these rules where an entity wholly-owned by an individual must remit and report payroll taxes with respect to its employees but not with respect to its owner. With respect to the owner, the entity is disregarded and the owner is treated as self-employed and subject to self-employment taxes.⁵ Taxpayers have read this example narrowly as not applying to disregarded entities owned by other entities, such as partnerships, and permitting the treatment of partners as employees of disregarded subsidiaries of a partnership.

So, why do businesses want to treat partners as employees of a disregarded entity owned by the partnership? Compensation paid to an employee is subject to payroll taxes, including Social Security and Medicare taxes. These payroll taxes are withheld and remitted to the IRS by the employer and reported on IRS Form W-2. The employee has little to no administrative burden. A self-employed individual, on the other hand, must calculate and pay self-employment taxes to the IRS. While the aggregate amount of tax paid is generally the same, the administrative burden on the self-employed individual is much greater. In addition, individuals often prefer to be treated as employees to continue participating in tax-advantaged retirement or health plans that may not be available to equity holders.

It is clear from the preamble of the temporary regulation that the IRS does not view the temporary regulation as a new rule but rather a clarification of existing principles. Taxpayers not in compliance with these rules should quickly make arrangements to correct the issue. In some cases, having to treat the "employee-partner" solely as a partner may be acceptable. The result is that the compensation reported on the "employee-partner's" IRS Form W-2 would now be reported on the IRS Form K-1 that the "employee-partner" receives from the partnership as a guaranteed payment and subject to self-employment taxes. In many cases, however, retaining employee treatment with respect to the affected individuals may be desirable so as not to disrupt the individuals' participation in benefit plans.

Practitioners are beginning to propose alternative structures in an effort to retain employee treatment. Some of these structures involve tiered partnerships or LLCs. The IRS and Treasury have expressed skepticism about such structures and suggested that they may be the subject of future regulations.⁶ A more robust solution would involve employee-partners holding their equity through S corporations. These proposals should be carefully vetted however; S corporations add complexity and additional reporting burdens and may not be right for all employee-partners.

¹ See Treas. Reg. § 301.7701-2(c)(2)(i).  

² The effective date of this rule is the later of August 1, 2016 or the first day of the latest-starting plan year following May 4, 2016 of an affected plan (i.e., a retirement plan, health plan, or cafeteria plan) sponsored by an entity that is disregarded. 

³ 1969-1 C.B. 256.

⁴ See Treas. Reg. § 301.7701-2(c)(2)(iv). 

⁵ Treas. Reg. § 301.7701-2(c)(2)(iv)(D).  

⁶ Preamble to Treas. Reg. § 301.7701-2T,T.D. 9766 (May 4, 2016).