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For some time the IRS and Department of the Treasury have been aware that certain taxpayers have misread IRS to permit certain prohibited actions regarding partners participating in tax-favored employee benefits plans. In some cases, entities have permitted partners who own a disregarded entity to be treated as an employee of the same disregarded entity rather than as the employer. This confusion has come into play because of confusion regarding the IRS’s position that for, employment tax purposes, the disregarded entity is the employer – not the partner. This has resulted in confused readings and misinterpretations that has resulted in improper actions by partnerships and others.
The IRS is now clarifying its position on the issue although the agency does remain open to changing its position on this issue. However, for now the IRS has issued final, temporary rules (T.D. 9766, RIN:1545-BM87) and proposed rules (REG-114307-15) regarding the treatment of partners in disregarded entities.
The IRS’s rule regarding the treatment of partners in a disregarded entity applies per Section 301.7701-2(c)(2)(i) of the Internal Revenue Code. Under the statute and absent an exception, business entities with a single owner that are not corporations underSection 301.7701-2(b)are considered a disregarded entity. Disregarded entities receive special employment tax treatment under Section 301.7701-2(c)(2)(iv)(B). Under this section, a disregarded entityis treated as if it was a corporation for employment tax purposes. This means that the disregarded entity is the employer for purposes of subtitle C employment taxes.
However, this treatment does not apply for self-employment tax purposes. While Section 301.7701-2(c)(2)(I applies as a general rule for self-employment tax concerns, the rule is clarified in the case of a single individual owner by holding that the owner should be considered and treated as a sole proprietor for self-employment tax purposes. Thus, while the disregarded entity is responsible for the employee employment tax obligation, the individual owner is accountable for self-employment taxes imposed on the profit resulting from the entity’s business activities.
The problem in regard to partnerships is that the regulations did not create a distinction between a disregarded entity owned by a single individual and a disregarded entity that is jointly owned by a collection of partners. Thus, the IRS believes this results in a proper reading of the rule where members of a partnership are not eligible to be treated as employees and are therefore ineligible to participate in tax-favored employee benefit plans.
Tax preparers, accountants, and responsible parties who continue to issue Schedules K-1 and Forms W-2 to partners as an employee are in violation of this rule and the IRS’s interpretation thereof. However, the agency has requested public comment on the issue. This issue disproportionally affects professionals and partners in small service partnerships and LLCs. While the IRS has signaled a willingness to relent on this positon should the private sector present a convincing argument, it is essential to note that this has yet to occur.Now that the IRS has made public comment on the issue it could even take the opposite approach and engage in increased enforcement activities and scrutiny of partnerships that improperly allow partners to participate in these tax-favored plans.
The IRS recognizes that it may take partnerships and other disregarded entities time to adjust their payroll and benefits plan concerns to comply with the rules as stated above. As such, the IRS has stated that the temporary rule will not apply until the later-occurring date: August 1, 2016 or the first day of the latest-starting plan year of an affected benefit plan after May 4, 2016. Businesses and organizations are encouraged to engage in a compliance review as soon as possible.
While there are still several months to achieve compliance with the IRS’s stated interpretation of the rule, this window is quickly closing. Organizations and individuals that fail to review and adjust their practices after an explicit IRS statement may open the door to serious tax charges related to their claims for tax-benefits when they are ineligible to receive tax-favored status.