Treating partners as employees: Risks to consider

Continuing to treat an employee of a partnership who has received an equity interest in the partnership as an employee can create a number of tax problems.

In today’s business environment, where many businesses find they cannot retain key employees without offering equity interests in the businesses, partnerships often grant employees interests in the company. Even a very small partnership interest, however, can cause the employee to be treated as a partner, not an employee, for federal tax purposes, while the partnership often mistakenly continues to treat the partner as an employee. This article examines problems raised by this incorrect treatment. 

This error can have many tax consequences, not the least of which is the mistaken tax treatment of the partner’s income as wages subject to Federal Insurance Contributions Act (FICA) taxes under Sec. 3101, Federal Unemployment Tax Act (FUTA) taxes under Sec. 3301, and income tax withholding under Sec. 3402 (called employment taxes in this article), instead of self-employment income subject to self-employment tax under Sec. 1401 (Self-Employment Contributions Act (SECA)), which is not subject to wage withholding.

The Code does not define the term “employee.” Generally, under Regs. Sec. 31.3401(c)-1, if a person has a right to control or direct the individual who performs the services, the individual will be deemed an employee. Beyond this, the term is defined by applying common law rules. The IRS uses a 20-factor test based on case law to determine whether an employer-employee relationship exists (Rev. Rul. 87-41). 


Cases interpreting the 1939 Code held a partner could not be an employee of his partnership under any circumstances, by adopting the aggregate theory of partnership taxation (see, e.g., Robinson, 273 F.2d 503 (3d Cir. 1959)). When Congress enacted the 1954 Code, it provided that a partnership could be an aggregate of its partners or a separate entity. Where no view of partnership taxation was adopted by a given Code provision, the view that was “more in keeping with the provision” should prevail. One Code provision that treats a partnership as a separate entity from its partners that was adopted in the 1954 Code is Sec. 707(a). It provides that, if a partner engages in a transaction with his or her partnership in other than his or her capacity as a member of the partnership, the transaction will, except as otherwise provided in Sec. 707, be treated as a transaction occurring between the partnership and one who is not a partner. Sec. 707(a) introduced the possibility that, given the right circumstances, a partner may hold the dual status of partner and employee in a single partnership. Since that time, a number of cases and rulings have addressed the issue, the most significant of which are discussed below. 

Wilson, 376 F.2d 280 (Ct. Cl. 1967). The first court to address whether a partner can be both a partner and an employee did not consider a payment to a partner for services but, instead, addressed whether a managing partner could exclude from income under Sec. 119 the value of meals and lodging the partnership provided. The court held that a partnership is not a separate legal entity from its partners, and therefore a partnership could not be regarded as the employer of a partner for Sec. 119 purposes—apparently not viewing the 1954 Code amendment as having altered the conclusion under the pre-1954 Code that a partner cannot be an employee. 

Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968). In Armstrong, as in Wilson, the Fifth Circuit considered whether a partner could exclude meals and lodging the partnership provided from income under Sec. 119. In contrast to Wilson, however, the Armstrong court held that a partner could hold the dual status of employee and partner in a single partnership because Sec. 707(a) had altered the law. The court then stated:

[I]t is now possible for a partner to stand in any one of a number of relationships with its partnership, including those of creditor-debtor, vendor-vendee, and employee-employer.

Importantly, because Armstrong did not deal with a payment to a partner for services, any part of the Armstrong court’s holding beyond Sec. 119 is dicta, which has persuasive but not precedential value.

GCM 34001 (Dec. 23, 1968) and GCM 34173 (July 25, 1969). Soon after the Armstrong decision, the IRS issued two general counsel memoranda (GCMs) examining whether a partner could be both a partner and an employee in the same partnership. Noting that Armstrong did not involve employment taxes, the IRS disagreed with the broad holding of the Armstrong court and concluded that, for employment tax purposes, a partner may not be both a partner and an employee in the same partnership.  

Rev. Rul. 69-184. Soon after issuing the GCMs, the IRS publicly ruled that a partner may be either a partner in a partnership or an employee of a partnership, but not both, for employment tax purposes.

Pratt, 550 F.2d 1023 (5th Cir. 1977). In Pratt, the Fifth Circuit considered whether management fees paid to partners for services were payments under Sec. 707(a). In concluding that the management fees were not Sec. 707(a) payments, the court held that “in order for the partnership to deal with one of its partners as an ‘outsider’ the transaction dealt with must be something outside the scope of the partnership.” Thus, the same court that rendered the Armstrong decision reached a different conclusion when confronted with an actual payment to a partner for services. The court adopted a test that limited the application of Sec. 707(a) to situations in which the transaction between the partner and the partnership is something “outside the scope of the partnership.”

The IRS agreed with the holding in Pratt by issuing Rev. Rul. 81-300. At the same time, the IRS ruled in Rev. Rul. 81-301 that payments to a partner for services rendered outside the scope of the partnership most resembled an independent contractor relationship, not an employer-employee relationship.  

Riether, 919 F. Supp. 2d 1140 (D.N.M. 2012). In Riether, a district court considered whether partners in an LLC taxed as a partnership for federal tax purposes could avoid paying self-employment tax on their entire distributive share of partnership income solely because they “received a Form W-2 from [the LLC] for the year 2006” and, thus, “were not self-employed.” After noting that the taxpayers tried to treat themselves as employees for some, but not all, of the LLC’s earnings by paying themselves $51,500 in purported wages, the court, citing Rev. Rul. 69-184, held that the taxpayers should have treated all of the LLC’s income as self-employment income, rather than characterizing some of it as wages. “Because Plaintiffs did not elect the benefits of corporate-style taxation under Treasury Regulation § 301.7701-3(a), they should not have treated themselves as employees,” the court said. The court also held that members of an LLC are not automatically treated as limited partners (citing Renkemeyer, 136 T.C. 137 (2011)).

Thus, while the enactment of Sec. 707(a) raised the possibility that a partner may be both a partner and an employee of the same partnership, the IRS has repeatedly opposed this treatment, only dicta in cases supports this treatment, and the court in Riether held that a partner may not be both a partner and an employee of the same partnership. 


Rev. Proc. 2001-43 May Not Apply
Often a partner receives a partnership interest solely in exchange for services. The IRS has concluded that the receipt of these interests will not be taxed upon receipt if certain conditions are met. In 2001, the IRS issued Rev. Proc. 2001-43, providing that, so long as certain conditions are satisfied, it will not tax a service provider’s receipt of an unvested profits interest (i.e., the interest will be treated as being received as of the date of grant when the value is $0—not at the future vesting date when the value may be significant). Rev. Proc. 2001-43 requires, among other things, that:

The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the service provider has the interest.

Because the IRS does not permit a partner to be both a partner and an employee, continuing to treat an employee who has received an unvested profits interest as an employee for employment tax purposes by issuing the partner a Form W-2, Wage and Income Statement, etc., presumably runs afoul of the above requirement. Thus, any partner who is treated as an employee at any time after receipt of an unvested profits interest may not satisfy the safe harbor set forth in Rev. Proc. 2001-43, and, thus, the IRS may argue that the issuance of the profits interest ought to be fully taxable upon vesting at the then fair market value.

Cafeteria Plans May Be Disqualified
Partners are prohibited from participating in cafeteria plans. Including them may disqualify the cafeteria plan entirely, resulting in the loss of the tax benefits the employer sought by adopting the plan.
FICA Taxes May Be Underpaid
If all of a partner’s income (whether guaranteed payment or allocable share of partnership profits) is reported to the partner on Schedule K-1 as is required, there is little risk that the partner will fail to report his or her entire share of partnership income and pay all employment taxes due on the income. If, however, a partnership decides to treat certain partners as employees for payroll tax purposes, there is a risk that not all of the partner’s allocable share of partnership income will be reported on Form W-2, because the partnership tax return will not be completed until months after the Form W-2 must be filed with the IRS and the partnership will not have final numbers to use when it prepares the Form W-2.
FICA Taxes May Be Overpaid
SECA tax is imposed on “net earnings from self-employment.” Sec. 1402 defines net earnings from self-employment to include earnings from each partnership in which the partner holds an interest plus earnings from a variety of other sources (including sole proprietorships). If a partner is treated as an employee of a partnership and FICA taxes are paid on the partner’s behalf based solely on the earnings of that partnership, then the partner may overpay employment taxes if the partner’s other self-employment activities have an overall net loss. 

Qualified Production Activities Deduction May Be Miscalculated
Sec. 199, which allows a deduction for qualified production activities, is limited to 50% of the Form W-2 wages paid to employees. Neither self-employment income nor guaranteed payments to partners are considered wages for these purposes. Partnerships taking the Sec. 199 deduction should be careful to exclude those amounts reported to partners on Form W-2 from the calculation under Sec. 199(b)(1). 

Substantial-Authority and AICPA SSTS No. 1 Requirements May Be Violated
Sec. 6664 generally prohibits taxpayers from taking tax positions and preparers from signing tax returns unless there is substantial authority or a reasonable basis for the tax treatment of an item and the taxpayer discloses the tax treatment on the taxpayer’s income tax return (using Form 8275, Disclosure Statement). The substantial-authority standard is an objective standard that is satisfied if the weight of the authorities supporting the position is substantial in relation to the weight of contrary authorities. In practice, the substantial-authority standard is generally interpreted as requiring approximately a 40% likelihood that the tax return position will be upheld on its merits if it is challenged. AICPA Statement on Standards for Tax Services (SSTS) No. 1, Tax Return Positions, generally requires that a return preparer comply with all applicable reporting and disclosure standards imposed by the governing tax authorities. These standards include Sec. 6694, which penalizes tax preparers for taking unreasonable positions on a tax return that lead to an understatement of tax liability.

Because only dicta in cases support, and the Riether case undercuts, allowing a partner to be both a partner and employee in the same partnership, taxpayers should carefully consider what level of comfort exists for the position. Moreover, because SSTS No. 1 requires adherence to rules imposed by governing tax authorities, a violation of Sec. 6694 would violate SSTS No. 1. 

State Tax Apportionment Could Be Affected
Employee wages are treated differently from partnership guaranteed payments for state law apportionment purposes. Therefore, states could disallow any apportionment based on treating partners as employees. 

Benefits Paid for the Partner Are Taxable to the Partner
Whereas employees can exclude from income certain employer-paid benefits, partners may not exclude those benefits when the partnership pays them. Health, welfare, and fringe benefits paid on behalf of a partner are generally not excluded from the partner’s income as they are for an employee. These payments are guaranteed payments under Sec. 707(c) because they are made without regard to the partnership’s income, and the value of the benefits are therefore included in the partner’s gross income. A partnership choosing to treat a partner as an employee should be sure to include the amount of employee benefits paid on the partner’s behalf in the partner’s income. 

Bonuses Paid After Year End May Be Taxable to the Partner in the Prior Year
Employees generally pay taxes on wages when the wages are paid. Guaranteed payments, however, are included in a partner’s income for the year in which the partnership is entitled to a deduction under its method of accounting. For accrual-basis, calendar-year partnerships, bonuses accrued on Dec. 31 of year 1 that are paid on March 15 of year 2 are deductible by the partnership in year 1. Thus, the guaranteed payment for bonuses accrued on Dec. 31 of year 1 will be taxable to the partner in that year even though the cash is not received until year 2.
The Partnership’s FICA Tax Deduction May Be Overstated
Any amount of FICA taxes the partnership paid on behalf of a partner who was treated as an employee constitutes an additional guaranteed payment to the partner. Partnerships treating one or more partners as employees should be careful not to deduct the half of FICA taxes paid for the partner and also claim a guaranteed payment deduction for that same amount. 

Taxpayers can work around the prohibition on a partner's being an employee of the partnership in which the partner holds an interest. Below is an overview of some of the more common techniques for accomplishing this.

Tiered Partnerships
Using a tiered-partnership structure can avoid the prohibition on a partner’s being an employee of his or her own partnership. A partner in an upper-tier partnership may properly be treated as an employee of a lower-tier partnership so long as the partner of the upper-tier partnership does not hold a partnership interest in the lower-tier partnership (or vice versa).
Disregarded Entity Beneath a Partnership
The check-the-box regulations provide that an otherwise single-member disregarded entity will be treated as an entity separate from its owner for purposes of employment taxes and collection of income (withholding) (Regs. Sec. 301.7701-2(c)(2)(iv)). However, if the owner of the disregarded entity is an individual, the individual owner will generally be subject to self-employment tax—not wage withholding.

Some taxpayers take the position that if a partnership is the sole owner of a disregarded entity, then the disregarded entity’s employees can also be issued partnership interests in the upper-tier partnership while continuing to be treated as employees of the lower-tier disregarded entity that is wholly owned by the upper-tier partnership in which the partner holds an interest. Presumably, the position is based on the fact that a partnership—not an individual—owns all the interests in the disregarded entity and, thus, the example from the regulations is inapposite.

This interpretation is likely a stretch. Simply interposing a partnership (the existence of a partnership) should not change the tax answer obtained if the partnership were not in existence.

Even if this structure does work to avoid the prohibition on a partner’s being an employee of the partnership in which the partner holds an interest, the taxpayer should have a nontax business purpose for the partnership’s existence, which would not be to avoid the prohibition on treating a partner as an employee of the partnership in which the partner holds an interest.

S Corporation Holding an Interest in a Partnership
Sometimes, a partner will choose to have an S corporation hold the partner’s interest in a partnership as a means to reduce overall self-employment taxes. Despite the similarities in the tax treatment of S corporations and partnerships, under current law, the self-employment tax regimes differ significantly for shareholders of S corporations and partners in partnerships. Generally, as long as an S corporation pays its shareholders reasonable compensation, any S corporation earnings flowing to the shareholders above and beyond that reasonable compensation are not subject to self-employment tax. Conversely, general partners in a partnership generally pay self-employment tax on 100% of their earnings flowing from the partnership. It is unclear whether interposing an S corporation would be a successful strategy, however.

For a more-detailed look at the issues discussed in this article, see “Partners as Employees? Properly Reporting Partner Compensation,” by Noel P. Brock, The Tax Adviser, Nov. 2013, page 766.


More and more businesses, including partnerships, are awarding equity interests to valued employees to keep them.

Partnerships often are unaware that even a small equity interest can stop the new partner from continuing to be treated as an employee for tax purposes.

Failure to treat these partners correctly can have numerous adverse tax effects, such as overpaying FICA tax, causing benefits paid on the partner’s behalf to be taxable to the partner, and accelerating the taxation of certain bonus payments.

Other risks include problems with state tax apportionment formulas and miscalculating the Sec. 199 domestic production activity deduction.

Although several planning techniques are available to avoid this problem, none are without shortcomings.

Noel P. Brock ( ) is an assistant professor at West Virginia University in Morgantown, W.Va.

To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at or 919-402-4828.


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Partners as Employees? Properly Reporting Partner Compensation,” Nov. 2013, page 766

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