The Department of Treasury (Treasury) recently reaffirmed the rule that an individual cannot be both an employee and a partner of the same partnership. Under Temporary Regulation § 301.7701-2T, partners in a partnership that owns a disregarded entity (DRE) cannot be employees of the DRE for employment tax purposes. Rather, they are subject to self-employment tax.
The IRS views these temporary regulations as a clarification of existing law. The new regulations are designed to end the practice of inserting a DRE between the individual and the partnership in an attempt to change the individual’s self-employment tax treatment or to allow them to participate in various employee benefit plans.
Impact on benefit plan participation
According to the preamble to the new regulations, “some taxpayers may have read the current regulations to permit the treatment of individual partners in a partnership that owns a DRE as employees of the disregarded entity.” The Treasury wrote that such a reading “was not intended” and has enabled some partners “to participate in certain tax-favored employee benefit plans.” Since partners cannot be treated as employees of the DRE, the proposed regulations make clear they are not eligible to participate in various employee benefit plans. Partnerships may have also used this structure to allow partners to pay taxes via W-2 withholding, rather than quarterly estimated payments.
Possible exceptions? The IRS is requesting comments
- The government is requesting comments on the application of these rules to tiered partnership situations, including:
- circumstances in which it may be appropriate to permit partners to also be employees of the partnership;
- the impact on employee benefit plans (including qualified retirement plans, health and welfare plans, and fringe benefit plans), and
- the effect on employment taxes if existing rules were modified to permit partners to also be employees in certain circumstances.
- The IRS may also be willing to look at situations where an employee of a partnership obtains a small ownership interest (undefined) in the partnership.
In general, a business entity with a single owner that is not a corporation is disregarded as an entity separate from its owner. An exception to this rule provides that a DRE is treated as a corporation for purposes of federal employment taxes. Under this exception, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for federal employment tax purposes. However, this rule does not apply for self-employment tax purposes. Prior to these new rules, the regulations did not include a separate example in which a DRE was owned by a partnership. The absence of a separate example where the DRE was owned by a partnership led some practitioners to conclude (incorrectly) that partners could also be employees of the DRE.
The temporary regulations clarify that self-employment tax also applies when a DRE is owned by the partnership. The new temporary regulations clarify that partners in a partnership that owns a DRE are subject to self-employment tax. Thus:
- The rule that a DRE is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a DRE; and
- A partner of a partnership that owns an entity that is disregarded as an entity separate from its owner for any purpose is subject to the same self-employment tax rules as a partner of a partnership that does not own an entity that is disregarded as an entity separate from its owner for any purpose.
In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the temporary regulations will apply on the later of:
- Aug. 1, 2016, or
- the first day of the latest-starting plan year following May 4, 2016, of an affected plan (based on the plans adopted before, and the plan years in effect as of May 4, 2016) sponsored by an entity that is disregarded as an entity separate from its owner for any purpose.
For these purposes, an affected plan includes any qualified plan, health plan, or section 125 cafeteria plan if the plan benefits participants whose employment status is affected by the regulations. A qualified plan means a plan, contract, pension, or trust described in section 219(g)(5)(A) or section 219(g)(5)(B) (other than section 219(g)(5)(A)(iii)). A health plan means an arrangement described under Regulation section 1.105-5.
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