IRS clarifies: Partners cannot be employees

Regulations quash taxpayers' position that partners can be employees of a disregarded entity owned by the partnership.
By Sally P. Schreiber, J.D.

The IRS issued temporary regulations intended to halt the practice some partnerships have adopted of treating partners as employees of a disregarded entity owned by the partnership so they can be included in employee benefit plans and receive other benefits. However, the IRS is also asking for comments on when it might be appropriate to allow partners to also be employees of a partnership.

To give taxpayers time to implement the new rules, the IRS is allowing any plan sponsored by an entity that is disregarded as an entity separate from its owner to apply them on Aug. 1, 2016, or the first day of the latest-starting plan year following May 4, 2016, whichever is later.

Under Regs. Sec. 301.7701-2(c)(2)(iv)(B), a disregarded entity is treated as a corporation for employment tax purposes, meaning that the entity, rather than its owner, is treated as the employer of the entity's employees. However, this rule does not apply for self-employment tax purposes, so the owner of an entity that is treated as a sole proprietorship is subject to self-employment tax.

The regulations include an example in which the owner of the disregarded entity is an individual who is subject to self-employment tax on the net earnings from the disregarded entity's activities. The regulations do not provide an example in which the disregarded entity is owned by a partnership.

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 general rule in the context of a partnership.

In the preamble to the temporary regulations, the IRS explains that the holding of Rev. Rul. 69-184 is still in effect. That ruling stated that (1) bona fide members of a partnership are not employees of the partnership for purposes of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and income tax withholding, and (2) a partner who devotes time and energy in conducting the partnership's trade or business, or who provides services to the partnership as an independent contractor, is considered self-employed and is not an employee.

The preamble notes that the IRS did not intend to "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 rule." Rather, the general rule making the owner of an entity that is treated as a sole proprietorship subject to self-employment tax applies for any owner of a disregarded entity—there is no exception for partnerships.

Therefore, the IRS explicitly clarifies in the preamble that "the rule that a disregarded entity 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 disregarded entity."

The IRS is considering issuing rules that would permit tiered partnerships in some circumstances to treat partners as employees of the partnership and is asking for comments on the impact on employee benefit plans (including qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if the IRS were to modify Rev. Rul. 69-184 to permit partners to also be employees in certain circumstances and also what those circumstances might be.

  • T.D. 9766

—By Sally P. Schreiber, J.D., a JofA senior editor.

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