Partners Cannot Be Employees

Temporary tax regulations were issued on May 4, 2016, to halt a perceived abuse where wholly owned limited liability companies (LLCs) were used to enable partners to be treated as employees for purposes of participating in tax-favored employee benefit plans.  Under Revenue Ruling 69-184, partners are not considered employees and therefore should not receive Form W-2 and should not participate as regular employees in employee benefit plans.  However, that ruling was published in 1969, and since that time LLCs have been created and the concept of disregarded entities introduced.  Some taxpayers have used the new developments to plan around the ruling.

Wholly owned or single member LLCs are generally “disregarded” as an entity separate from its owner for both income tax and self-employment tax purposes.  For employee employment tax purposes, prior regulations held that a disregarded entity is treated as a corporation, meaning that the LLC rather than the LLC owner is treated as the employer of its employees.  The prior regulations gave an example of an individual owning 100% of an LLC and stated that the individual was not an employee of the LLC.  But since the regulations did not provide an example of a partnership owning 100% of an LLC, some taxpayers interpreted the regulations as permitting the partnership’s partners to be treated as employees of the LLC and therefore eligible to participate in certain tax-favored employee benefit plans not otherwise available to self-employed individuals.

The temporary regulations require partnerships owning a business in a wholly owned LLC to treat the partners as self-employed individuals rather than as employees of the LLC beginning the later of August 1, 2016, or the first day of the next employee benefit plan year beginning after May 4, 2016.

The publication of these temporary regulations is a good reminder of the IRS’ position that partners should not be part of the payroll system.  Partner compensation is considered to be a “guaranteed payment” that is disclosed on Schedule K-1 rather than reported on Form W-2.  Guaranteed payments are self-employment income not subject to payroll tax withholding.  Therefore, partners will need to make timely estimated tax payments of their income and self-employment taxes in order to avoid a penalty for underpaying estimated tax.