Partner or Employee?

It has long been the position of the IRS that a bona fide member of a partnership is not an employee of the partnership. Such a partner, who devotes his or her time and energies to the conduct of the trade or business of the partnership, or in providing services to the partnership, is a self-employed individual.

According to the IRS, however, it appears that some taxpayers have been misreading the so-called “entity classification” rules so as to permit the treatment of individual partners, in a partnership that owns a disregarded entity, as employees of the disregarded entity. Under this reading, some partnerships have permitted partners to participate in certain tax-favored employee benefit plans.

In order to address this issue, the IRS recently proposed regulations to clarify that such partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. [TD 9766]

Before reviewing the proposed regulations, it may be helpful to describe the tax treatment of “partner compensation.”

Payments for Services

The rules that govern the tax treatment of transactions between partners and their partnerships are among the most complex rules in the Code. The treatment of a particular transaction will depend, in part, upon the capacity in which the partner is acting and upon the nature of the transaction.

For example, payments made by a partnership to a partner for services rendered in his or capacity as such, are considered as made to a person who is not a partner, if such payments are determined without regard to the income of the partnership. [IRC Sec. 707(c)]

However, such a “guaranteed payment” is considered as made to a non-partner only for certain enumerated purposes.

Specifically, the partner must include the amount of the payment in his or her gross income [IRC Sec. 61; https://www.law.cornell.edu/uscode/text/26/61 ], even if the partnership has a loss for the year in which the payment is made. Moreover, because the payment is made in respect of services rendered, the income is taxed as ordinary income regardless of the character of the income, if any, realized by the partnership.

Similarly, the partnership may deduct the payment [IRC Sec. 162], provided it constitutes an ordinary and necessary trade or business expense , is reasonable for the services rendered, and does not have to be capitalized under the rules relating to capital expenditures. [IRC Sec. 263]

The impact of this rule is limited to these enumerated purposes. For purposes of other provisions of the tax law, guaranteed payments are regarded as a partner’s share of the partnership’s income. Thus, as in the case of a partner’s distributive share of partnership income, the partner must include such payments in gross income for his or her taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments under its method of accounting. [Reg. Sec. 1.707-1(c)]

For purposes of other provisions of the Code, guaranteed payments are regarded as a partner’s distributive share of ordinary income. Thus, a partner who receives guaranteed payments for a period during which he or she is absent from work because of personal injuries or sickness is not entitled to exclude such payments from his gross income. [IRC Sec. 105] Similarly, a partner who receives guaranteed payments is not regarded as an employee of the partnership for the purposes of income or employment tax withholding, deferred compensation plans, etc. [Reg. Sec. 1.707-1(c)] Instead, guaranteed payments received by a partner, from a partnership that is engaged in a trade or business, for services rendered to the partnership are treated as “net earnings from self-employment” and are subject to self-employment tax. [1.1402(a)-1(b)]

The Entity Classification Rules

A business entity (typically, an LLC) that has a single owner, and that is not a corporation, is disregarded as an entity separate from its owner for purposes of the income tax. The single owner is treated, for example, as owning all of the entity’s assets and as receiving all of its income.

However, such a “disregarded entity” is treated as a corporation for purposes of the employment taxes imposed under the Code. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of the employment taxes.

While a disregarded entity is, thus, treated as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes. Rather, the general rule applies, and the entity will be disregarded as an entity separate from its owner for purposes of the self-employment tax.

The applicable regulation illustrates this rule in the context of a single individual owner (not a partnership) by stating that the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on self-employment income. However, the regulation includes an example in which the disregarded entity is subject to employment tax with respect to employees of the disregarded entity, while the individual owner is subject to self-employment tax on the net earnings from self-employment resulting from the disregarded entity’s activities.

Because the regulation does not include a specific example applying the general rule in the context of a partnership, many taxpayers believed – unreasonably, you might say – that an individual partner, in a partnership that owns a disregarded entity, could be treated as an employee of the disregarded entity. Consequently, they decided to pay wages to partners through a disregarded entity, like a wholly-owned LLC, in order to qualify the partners as “employees” for purposes of certain tax-advantaged benefit plans.

The Proposed Regulation

The IRS noted that the regulation did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rules. Rather, the regulation applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity.

The regulations proposed by the IRS apply the existing general rule to illustrate that, if a partnership is the owner of a disregarded entity, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. In other words, the rule that treats the entity as disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. A disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, or for purposes of employing an individual that is a partner in a partnership that owns the disregarded entity.

Where Is This Leading?

In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the proposed regulations, which were also issued as temporary regulations, will apply no earlier than August 1, 2016.

Between now and then, any partnership that has been treating its partners as employees of an LLC wholly-owned by the partnership will have to stop doing so.

A the same time, however, it should be noted that the IRS has indicated that it will consider whether it should allow partnerships to treat partners as employees in certain circumstances; for example, in the case of employees of a partnership who obtain a small ownership interest in the partnership as a compensatory award or incentive.

In connection therewith, the IRS will have to analyze, among other things, the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if partners were to be treated as employees in certain circumstances.

Stay tuned – the IRS may eventually change its position.