IRS Issues Proposed and Temporary Regulations Clarifying the Self-Employment Tax Treatment of Partners in a Partnership That Owns a Disregarded Entity | Practical Law

IRS Issues Proposed and Temporary Regulations Clarifying the Self-Employment Tax Treatment of Partners in a Partnership That Owns a Disregarded Entity | Practical Law

The Internal Revenue Service (IRS) issued temporary and proposed regulations clarifying that a partner in a partnership may not be treated as an employee of a disregarded entity owned by the partnership for self-employment tax purposes.

IRS Issues Proposed and Temporary Regulations Clarifying the Self-Employment Tax Treatment of Partners in a Partnership That Owns a Disregarded Entity

by Practical Law Employee Benefits & Executive Compensation
Published on 09 May 2016 • USA (National/Federal)
The Internal Revenue Service (IRS) issued temporary and proposed regulations clarifying that a partner in a partnership may not be treated as an employee of a disregarded entity owned by the partnership for self-employment tax purposes.
On May 4, 2016, the Internal Revenue Service (IRS) issued temporary (81 Fed. Reg. 26693) and proposed regulations (81 Fed. Reg. 26763) clarifying that a partner in a partnership may not be treated as an employee of a disregarded entity owned by the partnership for self-employment tax purposes.

Background

Under current regulations, an entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner (a "disregarded entity") (26 C.F.R. § 301.7701-2(c)(2)(i)). However, disregarded entities are generally treated as corporations for employment tax purposes, and therefore the disregarded entity, rather than the owner, is considered the employer of the entity's employees for purposes of withholding and remitting employment taxes.
Disregarded entities are not, however, treated as corporations for self-employment tax purposes. Rather, the general rule applies. Applying the general rule in the context of a sole proprietorship, the regulations include an example in which:
  • The disregarded entity is subject to employment tax with respect to the employees of the disregarded entity.
  • The individual owner is subject to self-employment tax.
(26 C.F.R. § 301.7701-2(c)(2)(iv)).
The regulations do not include a separate example in which the disregarded entity is owned by a partnership. According to the IRS, while it did not intend to create this distinction, some taxpayers may have:
  • Read the regulations to permit partners in a partnership that owns a disregarded entity to be treated as employees of the disregarded entity.
  • Permitted these partners to participate in certain tax-favored employee benefit plans.
The IRS issued these temporary regulations to clarify this issue.

Proposed and Temporary Regulations

The proposed and temporary regulations clarify 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 individuals who are partners in a partnership that owns a disregarded entity. Rather, the rule that the entity is disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner.
The disregarded entity is not treated as the employer of any partner of the partnership that owns the entity. Instead, the partner is treated as self-employed and payments to the partner from the disregarded entity are taxed as if they were payments directly from the partnership. As a result, partners that provide services to the disregarded entity:
  • Are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.
  • Are not eligible to participate in certain tax-favored employee benefit plans sponsored by the disregarded entity.

Effective Date

The temporary regulations will apply on the later of:
  • August 1, 2016.
  • The first day of the latest-starting plan year following May 4, 2016 of an affected plan sponsored by a disregarded entity.
Affected plans include qualified plans, health plans, or Code Section 125 cafeteria plans that benefit participants whose employment status is affected by these regulations.

Comment Request

The IRS is requesting comments on the application of Revenue Ruling 69-184 (providing that an individual cannot be both a partner and an employee for purposes of wage withholding, payroll taxes, or FUTA) in the context of tiered partnership situations. Specifically, the IRS is interested in:
  • The appropriate application of Revenue Ruling 69-184 to tiered partnership situations.
  • The circumstances in which it may be appropriate to permit partners to also be treated as employees of the partnership.
  • The impact on employee benefit plans and employment taxes if Revenue Ruling 69-184 were modified to permit partners to be treated as employees of the partnership in certain situations.
Comments must be received by August 2, 2016. For more information on various structures that have been developed to address the consequences of treating an individual as both a partner and employee of the same entity, including tiered partnerships, see Practice Note, Dual Status: Treating Partners as Employees.

Practical Implications

The proposed and temporary regulations make it clear that partners in a partnership that owns a disregarded entity are generally not able to participate in tax-favored employee benefit plans sponsored by the disregarded entity. Partnerships that own disregarded entities and that allow partners to participate in these types of plans should familiarize themselves with the regulations and make necessary plan adjustments by the applicable deadline. Additionally, interested parties should submit timely comments to http://www.regulations.gov.