On May 3, 2016, the Treasury Department issued temporary and proposed regulations (the “New Regulations”) to clarify that a partner of a partnership that owns an entity that is disregarded for federal income tax purposes will be treated as self-employed when the partner provides services to the disregarded entity, as opposed to being treated as an employee of the disregarded entity. Because employee status is precluded, such a partner is not eligible to participate in certain tax-favored employee benefit plans sponsored by the disregarded entity.
Existing regulations provide that a business entity, which is not a corporation, with a single owner is disregarded as an entity separate from its owner for federal income tax purposes. Such an entity, however, is treated as a corporation for federal employment tax purposes, meaning that the disregarded entity, as opposed to the sole owner of the entity, is treated as the employer for employment tax purposes. Although the disregarded entity is treated as a corporation for employment tax purposes, such treatment does not apply for self-employment tax purposes.
Assume, for example, that an individual taxpayer is the sole owner of a limited liability company (the “LLC”) that has not elected to be taxed as a corporation and the LLC has two employees. While the LLC is disregarded as an entity separate from its individual owner for income tax purposes (meaning that all income and loss of the LLC will be reported on Schedule C of the individual’s Form 1040), the LLC is treated as the employer of the two employees and, therefore, is subject to employment tax responsibilities with respect to the two employees. The individual owner, however, is not an employee of the LLC and, therefore, is subject to self-employment tax with respect to the LLC.
While the existing regulations contain an example specifically illustrating the scenario described above, the existing regulations do not include an example where the disregarded entity is owned by an entity taxed as a partnership. Apparently due to the lack of such an example, the Internal Revenue Service has determined that some taxpayers are taking the position that the partners of a partnership that own a disregarded entity (where such partners provide services to the disregarded entity) are employees of the disregarded entity, thereby allowing such partners to participate in various employee benefit plans offered by the disregarded entity. The Internal Revenue Service believes that such a position is not intended under the existing regulations.
To clarify that the existing regulations did not intend to make a distinction between a disregarded entity owned by an individual, on the one hand, and a disregarded entity owned by a partnership, on the other hand, the Treasury Department has issued the New Regulations. The New Regulations make clear that if a partnership is the owner of a disregarded entity, the entity is not (i) treated as a corporation for purposes of employing a partner of the partnership that owns the entity, and (ii) the employer of any partner of the partnership that owns the entity. Further, the New Regulations clarify that a partner of a partnership that owns a disregarded entity is subject to the same self-employment tax rules as a partner of a partnership that does not own a disregarded entity.
To allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the New Regulations will apply on the later of (i) August 1, 2016, or (ii) the first day of the latest-starting plan year following May 4, 2019 of an affected plan (meaning any qualified plan, health plan, or Internal Revenue Code Section 125 cafeteria plan if the plan benefits participants whose employment status is affected by the New Regulations) sponsored by a disregarded entity.