On May 4th, the Internal Revenue Service (IRS) released final and temporary regulations which address the self-employment tax treatment of partners in a partnership, which has been an area of confusion for some time now. These regulations affect partners that own a disregarded entity (DRE) and will determine whether or not they can participate in employee benefit plans.

The Problem

Currently, some are treating partners in a partnership that owns a DRE as employees of that entity (leads to unfair, tax-favored employee benefit plans for these partners).

More about the regulations

The regulations went into effect Wednesday, May 4th 2016. (Full text can be accessed here: T.D. 9766, RIN:1545-BM87 )

As for the contents of these regulations, they state that:

• Partners should NOT be counted as employees.
• A business entity that has a single owner and is not a corporation is treated as a ‘disregarded entity’ or DRE (an entity separate from its owner)
• For purposes of employment taxes, though, a DRE is treated as a corporation, and therefore is considered to be the employer of the entity’s employees (instead of the owner).
• The owner of an entity who is treated in the same manner as a sole proprietorship is subject to self-employment income taxes.

Where does the confusion lie?

The IRS states that this interpretation was “unintended” though many taxpayers will argue that the rules were not clear. The confusion lies in a “loophole,” so to speak, in the regulations. While the regulations DO contain an example illustrating how the rule works when a DRE is subject to employment tax, they do NOT contain an example of a situation in which the disregarded entity is owned by a partnership.

Partnerships, remember, are considered “pass-through” entities meaning all profits and losses of the partnership ‘pass through’ the business to the partners, who, in turn, pay taxes on their share of the profits. Since partnerships are not separate legal entities from their partners, they cannot be treated as employers of their partners.

In the problem situation discussed in this blog, partners are instead treated as employees, leading to the possibility of underpaid FICA (Federal Insurance Contributions Act) taxes and unfairly acquired employee benefit plans.

How much time do partnerships have to implement changes?

Though the new rules were effective May 4th, the IRS is giving partnerships time to make payroll and employee benefit plan adjustments in accordance with the clarified rules. The temporary rules, therefore, will apply on the first day of the latest-starting, new employee benefit plan year (after May 4th 2016), or by August 1st 2016.

This could drastically change the way certain partnerships conduct business—contact your tax advisor to begin the compliance process.

Our tax advisors are here to help—contact us today.