EBIA Weekly Newsletter

IRS Regulations Clarify That Partners Are Not Employees of “Disregarded Entities” for Self-Employment Tax Purposes

   June 30, 2016

Self-Employment Tax Treatment of Partners in a Partnership that Owns a Disregarded Entity, 2016-21 I.R.B. 855 (May 23, 2016); Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulations; Self-Employment Tax Treatment of Partners in a Partnership That Owns a Disregarded Entity, 2016-21 I.R.B. 1006 (May 23, 2016)

Available at https://www.irs.gov/pub/irs-irbs/irb16-21.pdf

The IRS has issued temporary and proposed regulations clarifying the self-employment tax treatment of partners in a partnership that is the sole owner of a disregarded entity. For this purpose, a “disregarded entity” is a business entity that is not a corporation and has a single owner. Generally, the Code ignores such entities, i.e., it does not treat them as separate from their owner, but one of the regulations refining that general rule states that disregarded entities will be treated as corporations for employment tax purposes. (Employment taxes include FICA, FUTA, and income tax withholding.) That apparent recognition of separate status is further modified, however, by a special rule for self-employment taxes. The special rule appears to restore the general rule (disregarded entities are not treated as separate from their owner) for self-employment tax purposes. However, some taxpayers—influenced by an example in the regulations that refers only to sole proprietors and the absence of any example addressing partners—have apparently interpreted the special rule narrowly and have allowed partners in a disregarded entity to be treated as employees of that entity.

The new regulations amend the current regulations to explicitly provide that a non-corporate entity that is wholly owned by a partnership will not be treated as a corporation for self-employment tax purposes. Instead, the entity will be disregarded and partners of the partnership owning the entity will be subject to the same self-employment tax rules as partners in partnerships that do not own disregarded entities. The regulations become effective on the later of August 1, 2016, or the first day of the “latest-starting plan year following May 4, 2016, of an affected plan” sponsored by the disregarded entity. The term “affected plan” includes tax-qualified plans (including 401(k) plans), health plans, and Code § 125 cafeteria plans if the plans benefit participants whose employment status is affected by the amended regulation.

EBIA Comment: Some plans, including 401(k) plans, can allow partners to participate. But others, including cafeteria plans and HRAs, cannot be offered to partners (or cannot be offered on a tax-favored basis). These regulations are intended to reinforce those restrictions and discourage partnerships from trying to circumvent those rules. The preamble suggests that the IRS might be willing to draw finer distinctions in the case of “tiered” partnerships, which may have some individuals who are called partners but lack the usual attributes of partners and whose relationship to the partnership is more like that of an employee. The IRS has requested comments on tiered partnership situations, the circumstances in which it might be appropriate to permit partners to also be employees, and the impact on employee benefit plans and employment taxes. For more information, see EBIA’s Cafeteria Plans manual at Section IX.B (“Which Individuals Are Ineligible to Participate in a Cafeteria Plan?”). See also EBIA’s Consumer-Driven Health Care manual at Section XXII.B.5 (“HRAs: Self-Employed Individuals and Individuals Who Are Not Spouses, Children Under Age 27, or Tax Dependents”), EBIA’s Self-Insured Health Plans manual at Section XIV.C (“Which Employees and Other Workers Will Be Allowed to Participate”), and EBIA’s 401(k) Plans manual at Section VII.B (“Eligibility Condition #1: Participation Limited to Common-Law Employees, Partners and Sole Proprietors, Some Leased and Statutory Employees”).

Contributing Editors: EBIA Staff.