Final Regs Address Employment Taxes for Disregarded Entities Owned by a Partnership

(Parker Tax Publishing July 2019)

The IRS issued a final regulation clarifying that, if a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. Thus, taxpayers that are partners in a partnership that owns a disregarded entity cannot participate in certain tax-favored employee benefit plans of the disregarded entity. T.D. 9869.

Background

Generally, under Reg. Sec. 301.7701-2(c)(2)(i), a business entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner (i.e., a disregarded entity). However, Reg. Sec. 301.7701-2(c)(2)(iv)(B) provides that an entity that is a disregarded entity is treated as a corporation for purposes of employment taxes. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity's employees for employment tax purposes and is required to file the appropriate employment tax returns. While Reg. Sec. 301.7701-2(c)(2)(iv)(B) treats a disregarded entity as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes.

In 2016, the IRS issued a temporary regulation (T.D. 9766) clarifying the employment tax treatment of partners in a partnership that owns a disregarded entity. Before that, the regulations did not explicitly address situations in which the owner of a disregarded entity is a partnership, and the IRS noted that some taxpayers were reading the regulations to permit the treatment of the individual partners in a partnership that owned a disregarded entity (either directly or through tiered partnerships) as employees of the disregarded entity. Taxpayers found their way to this interpretation, the IRS said, because the regulations did not include a specific example applying the general rule in the partnership context. Under this reading of the rules, which the IRS stressed was not intended, partners were participating in certain tax-favored employee benefit plans to which they were otherwise not entitled to participate.

Final Regulations

Reg. Sec. 301.7701-2(c)(2)(iv)(C)(2) clarifies that a disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, who is treated as a sole proprietor, or employing an individual who is a partner in a partnership that owns the disregarded entity. Rather, the entity is disregarded as an entity separate from its owner for this purpose. The IRS notes that existing regulations already provide that the entity is disregarded for self-employment tax purposes and specifically notes that the owner of an entity treated in the same manner as a sole proprietorship under Reg. Sec. 301.7701-2(a) is subject to tax on self-employment income. Accordingly, if a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

Observation: In the preamble to the temporary regulation, the IRS requested comments on the appropriate application of the principles of Rev. Rul. 69-184 to tiered partnership situations, the circumstances in which it may be appropriate to permit partners to also be employees of the partnership, and the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if Rev. Rul. 69-184 were to be modified to permit partners to also be employees in certain circumstances. The holding in Rev. Rul. 69-184, which the IRS notes still applies, provides that: (1) bona fide members of a partnership are not employees of the partnership within the meaning of the employment tax provisions in the Code, and (2) a partner who devotes time and energy in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. One practitioner asked the IRS to consider an exception to the principles of Rev. Rul. 69-184 for publicly traded partnerships, but the IRS declined to make an exception at this time. In the final regulation, the IRS did not address the application of Rev. Rul. 69-184 in tiered partnership situations but said it is continuing to look at the application of Rev. Rul. 69-184.

For a discussion of the employment tax treatment of partners in a partnership that owns a disregarded entity, see Parker Tax ¶20,590.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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