Owners in a Partnership Business Cannot Be Treated as Employees
New rules clarify that partners and LLC members cannot be employees of the partnership/LLC for tax purposes.
On Tuesday, May 3, 2016, the IRS issued temporary regulations which are intended to end the practice some partnerships have adopted of treating partners as employees of a disregarded entity. These regulations are meant to clarify existing laws and provide guidance for partners in a partnership that own a disregarding entity.
The Tax Code states that a business entity with a single owner that is not a corporation is disregarded as an entity separate from its owner. However, an entity that is disregarded is treated as a corporation for purposes of employment taxes. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of employment taxes. While the Tax Code treats a disregarded entity as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes.
Some taxpayers have taken the position that where a partnership is the sole owner of a disregarded entity, partners in the partnership can be treated as employees of the disregarded entity because the regulations did not include a specific example applying the rule in the context of a partnership. Treating the partners as employees of the disregarded entity allows them to participate in certain tax-favored employee-benefit plans.
Temporary and Proposed Regulations
The temporary and proposed regulations clarify that a disregarded entity that is generally treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner (who is treated as a sole proprietor) or for purposes of employing an individual who is a partner in a partnership that owns the disregarded entity. The new regulations confirm that partners are treated no differently from partners of a partnership that does not own a disregarded entity. The regulations provide that the partners are subject to the same self-employment tax treatment as partners in a partnership that does not own an entity that is disregarded as separate from its owner. These new rules apply on the later of (1) Aug. 1, 2016, or (2) the first day of the latest-starting plan year following May 4, 2019, of an affected plan sponsored by an entity that is disregarded as an entity separate from its owner. Plans affected by these new rules include any qualified plan, health plan, or section 125 cafeteria plan if the plan benefits participants who are considered to be employees.
Herbein+Company, Inc. insights
These temporary regulations address a very specific situation – ownership of a disregarded entity by a partnership or LLC – and may not directly affect many of our business clients.
However, we believe it is significant that this information confirms and reiterates the IRS position that a partner in a partnership or a member of Limited Liability Company (LLC) treated as a partnership cannot be considered an employee of the partnership or LLC. In the past some clients have attempted to or have incorrectly treated partners and LLC members as employees. With the issuance of these temporary regulations the IRS has confirmed that such treatment is not permitted.
Please contact Elizabeth Hassler at firstname.lastname@example.org or Michele Burkins at email@example.com if you have questions regarding this tax alert.