In new regulations issued on May 4, 2016, the IRS clarified that partners in a partnership (including members of a limited liability company that is taxed as a partnership) that owns a subsidiary that is a disregarded entity may not be treated as “employees” of the disregarded entity, and must instead be treated as self-employed individuals for self-employment tax and employee benefit plan purposes. Therefore, such partners must pay self-employment tax and are ineligible for certain benefits available only to employees under certain tax-qualified employee benefit plans sponsored by the disregarded entity, including qualified retirement plans, health and welfare plans, and fringe benefit and transportation plans.

Background and Summary of IRS Guidance

Existing Rule Unclear

As a general rule, for federal tax purposes, a business entity with a single owner and that is neither required nor elects to be classified as a corporation is disregarded as an entity separate from its owner (i.e., it is a “disregarded entity”). This general rule does not apply for federal employment tax purposes, under which the disregarded entity is treated as a corporation and as the employer of the entity’s employees. However, the general rule treating the entity as a disregarded entity does apply for self-employment tax purposes.

Prior to the new guidance, the existing regulations included only a single example in which a sole proprietor owned a disregarded entity and was required to pay self-employment tax, rather than having social security taxes withheld from wages, on income attributable to the owner’s services for the disregarded entity. The existing regulations did not include any example in which a disregarded entity was owned by a partnership. Certain taxpayers interpreted the IRS’ omission in the partnership context (versus its express guidance for sole proprietorships) as permitting the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity and, under that interpretation, such individuals would not subject be to self-employment tax on compensation received from the disregarded entity and would be entitled to participate in tax-qualified benefit plans of the disregarded entity.

IRS Provides Clarifications

In the new regulations, the IRS clarified that it did not intend to establish an exception to the general self-employment tax rules for partnerships that own disregarded entities. Instead, the rule that a disregarded entity is disregarded for self-employment tax purposes applies to partnerships in the same way that it applies to sole proprietorships. Accordingly, partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

As a result of these clarifications, partnerships and LLCs that have been characterizing certain partners as “employees” of a disregarded entity will have to re-characterize them as partners for self-employment tax purposes (thus reporting their income on a Form K-1, rather than Form W-2). This may have wide-ranging impacts on compensation reporting, employment taxes, and participation in certain employee benefit arrangements of the disregarded entity. In particular, partners currently participating in certain tax-qualified benefit plans of a disregarded entity as “employees” of that entity may no longer be permitted to participate in such plans. Partners in a partnership are not permitted to participate in cafeteria plans (including medical and dependent care flexible spending accounts) under Code Section 125 and in qualified transportation expense plans under Code Section 132.

Note that, in the preamble to the new regulations, the IRS confirmed that the continued applicability of Revenue Ruling 69-184 (which generally provides that a bona fide partner of a partnership is not an employee of the partnership for employment (FICA) tax purposes) will not be altered by this new guidance. In other words, this new guidance does not change the long-held IRS position that a partner in a partnership (or member of an LLC that is taxed as a partnership) may not be treated as an employee of the partnership/LLC and may not be paid W-2 compensation from the partnership/LLC. The IRS further clarified that the new guidance only applies to partnerships owning a disregarded entity, and does not address tiered partnership structures. The IRS has requested comments on the new rules (including regarding their impact on employee benefit plans and employment taxes), leaving open the possibility that Rev. Rul. 69-184 could be modified to permit partners to also be considered employees under certain circumstances, but that is not the case currently.

Delayed Effective Date

In order to allow adequate time for partnerships to make the necessary payroll and benefit plan adjustments, the IRS has delayed the application of the new rules until the later of (i) August 1, 2016 or (ii) the first day of the latest-starting plan year following May 4, 2016 of an “affected plan” (based on the plans adopted before, and the plan years in effect as of, May 4, 2016) sponsored by a disregarded entity. Thus, for calendar year plans in existence on May 4, 2016, the effective date will be January 1, 2017. An “affected plan” includes any qualified retirement plan, health plan, or Section 125 cafeteria plan, if the plan benefits participants whose employment status is affected by the new regulations. Note that if a partnership or LLC does not currently maintain a benefit plan at the disregarded entity, the new regulations will take effect on August 1, 2016.

Next Steps

The IRS has indicated that, given its historical silence in this area, it is aware that some taxpayers have permitted partners to participate in certain tax-favored employee benefit plans as “employees” of a disregarded entity – an outcome that the IRS has specifically stated was unintended. In light of the increased scrutiny invited by the new regulations on this previously grey area, taxpayers should consider the following steps to ensure that they are compliant once the regulations are effective:

• Determine whether your partnership or LLC owns a disregarded entity and therefore falls under the new rules. These types of arrangements are not uncommon, especially in the areas of private equity, certain REIT structures, other operating partnerships and LLCs.
• Review any employment, benefit, and payroll arrangements or contracts between partners, the partnership or LLC, and/or any disregarded entities owned by that partnership or LLC to identify if the disregarded entity treats any partners as employees with respect to employment, compensation and/or tax qualified benefit purposes.
• Determine whether any changes are required to correctly report compensation attributable to the disregarded entity for affected partners on Form K-1 instead of W-2. Affected partners would be subject to self-employment taxes rather than ordinary employment taxes (i.e. FICA) withheld from W-2 wages, a change which would generally increase the employment tax burden on these individuals (albeit partially alleviated by a corresponding income tax deduction).
• Review tax-qualified employee benefit plans (such as qualified retirement plans, health and welfare plans, and fringe benefit and transportation plans) to determine whether there will have to be any participation or design changes with respect to affected partners. Note that any participation changes to a plan may in turn affect reporting requirements for the plan (for example, Form 1094/1095 reporting for a group health plan).
• Review nonqualified deferred compensation, incentive, equity, or profits sharing arrangements to determine whether affected partners may still be incentivized under such arrangements, and if so, whether such grantees are properly reported as K-1 partners.

The new regulations may have a significant effect on LLCs and partnerships that have existing “employees” in wholly owned disregarded subsidiary entities. Given the complexity of such pass-through structures, potentially affected taxpayers should consult with their legal and tax advisors to assess the impact of the new regulations on their existing and prospective benefit, compensation and tax reporting arrangements.

If you have any questions about these new regulations, or any other matter involving your employee benefit or health and welfare plans, please contact a member of the Sherman & Howard Employee Benefits Group.

Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.

©2016 Sherman & Howard L.L.C.                                                                                   June 1, 2016