Temp Regs Clarify Self-Employment Tax Obligations Where a Partnership Owns a Disregarded Entity.

(Parker Tax Publishing MAY 2016)

The IRS has issued temporary regulations 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. The regulations are aimed at correcting a misinterpretation by some taxpayers that partners in a partnership that owns a disregarded entity can participate in certain tax-favored employee benefit plans. T.D. 9766.

Background

Reg. Sec. 301.7701-2(c)(2)(i) generally provides that 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 taxes purposes. 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.

Specifically, Reg. Sec. 301.7701-2(c)(2)(iv)(C)(2) provides that the general rule of Reg. Sec. 301.7701-2(c)(2)(i) applies for self-employment tax purposes. Under that general rule, except as otherwise provided, a business entity that has a single owner and is not a corporation under Reg. Sec. 301.7701-2(b) is disregarded as an entity separate from its owner. In applying this rule in the context of a single individual owner, the regulations state that the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on self-employment income.

The regulation includes an example illustrating the mechanics of the rule. In the example, under Reg. Sec. 301.7701-2(c)(2)(iv)(D), a disregarded entity is subject to employment tax with respect to employees of the disregarded entity. The individual owner, however, is subject to self-employment tax on the net earnings from self-employment resulting from the disregarded entity's activities. The regulations do not include a separate example in which the disregarded entity is owned by a partnership.

Issue

Even though the regulations provide that an entity is disregarded as an entity separate from the owner for self-employment tax purposes, some taxpayers were reading the rules to permit the treatment of individual partners in a partnership that owns a disregarded entity 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. There is no distinction, the IRS stated, between a disregarded entity owned by an individual (i.e., a sole proprietorship) and a disregarded entity owned by a partnership in applying the self-employment tax rule. Rather, Reg. Sec. 301.7701-2(c)(2)(iv)(C)(2) provides that the general rule of Reg. Sec. 301.7701-2(c)(2)(i) applies for self-employment tax purposes for any owner of a disregarded entity. There is no exception for a partnership that owns such a disregarded entity.

The IRS also pointed out that the holding in Rev. Rul. 69-184 is still valid. The holding in that ruling 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) such 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.

To address the unintended reading of the regulations under Reg. Sec. 301.7701-2(c)(2), the IRS issued temporary regulations, as well as proposed regulations (REG-114307-15) that adopt the temporary regulations language.

Temporary Regulations Close Perceived Loophole

In Reg. Sec. 301.7701-2T(c)(2)(iv)(C)(2), the IRS 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 that 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. The IRS applies this existing general rule to illustrate 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.

OBSERVATION: While the temporary regulations provide that a disregarded entity owned by a partnership is not treated as a corporation for purposes of employing any partner of the partnership, they do not address the application of Rev. Rul. 69-184 in tiered partnership situations. The IRS noted that practitioners had requested that the IRS provide additional guidance on the application of Rev. Rul. 69-184 to tiered partnership situations, and have also suggested modifying the holding of Rev. Rul. 69-184 to allow partnerships to treat partners as employees in certain circumstances, such as, for example, employees in a partnership who obtain a small ownership interest in the partnership as an employee compensatory award or incentive. However, because these practitioners did not provide detailed analyses and suggestions to the IRS as to how the employee benefit and employment tax rules would apply in such situations, the IRS did not provide additional guidance in these areas. Instead, the IRS requested comments from practitioners 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 the IRS was to modify Rev. Rul. 69-184 to permit partners to also be employees in certain circumstances.

Effective Date

In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the temporary regulations apply on the later of: (1) August 1, 2016, or (2) 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 an entity that is disregarded as an entity separate from its owner for any purpose under Reg. Sec. 301.7701-2. For these purposes, an affected plan includes any qualified plan, health plan, or Code Sec. 125 cafeteria plan if the plan benefits participants whose employment status is affected by these regulations.

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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