If a partnership owns an LLC it treats as a disregarded entity under the check the box rules, may partners of the partnership be treated as employees of the disregarded entity, receiving a W-2 and obtaining certain tax beneficial fringe benefits open to employee but not partners? The IRS says the answer has always been no, but since some read the existing regulations otherwise the agency has issued Temporary Regulation §301.7701-2T(e)(8)(i) (TD 9766) and an identical proposed regulation (REG-114307-15).
The “check the box” provisions found in Reg. §301.7701-2 were created to deal with state law entities that had no direct equivalent under federal law (with the prime example being limited liability companies (LLCs)). Under those rules, the taxpayer elects to treat the entity “as if” it was an entity the IRC has a treatment for, picking from a list that depends on the number of owners.
But this “pretend” treatment of an entity as something it really isn’t sometimes creates issues, which the IRS quickly discovered when dealing with payroll taxes and such entities—leading the IRS to create a modified set of rules for payroll tax issues and entities that elected “disregarded” treatment. The problem was that, under state law, any liabilities of those entities did not “leak out” to owner.
The treatment of “disregarded entities” under the check the box regulations is different for income and payroll taxes as explained in the preamble to the temporary regulations
Section 301.7701-2(c)(2)(i) states that, except as otherwise provided, a business entity that has a single owner and is not a corporation under §301.7701-2(b) is disregarded as an entity separate from its owner (a disregarded entity). However, §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 imposed under subtitle C of the Internal Revenue Code (Code). Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of employment taxes imposed by subtitle C.
But the “lack of liability leakage” problem isn’t really a problem for self-employment taxes, since there the liability would not exist for the LLC but rather the entity owning the interest. So the IRS sought to add more “clarification” that held that for self-employment tax purposes the income tax treatment would apply (that is, total disregard of the entity).
But it turns out in the example found in the regulations explaining the application of the self-employment tax rule the IRS had only discussed the case of a sole proprietor—leading some partnerships to take the position that while an LLC held 100% by an individual could not treat that individual as an employee under Reg. §301.7701-2(c)(2)(iv)(C)(2).
As the IRS notes in the preamble:
Under this reading, which was not intended, some taxpayers have permitted partners to participate in certain tax-favored employee benefit plans. The Treasury Department and the IRS note that the regulations did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rule. Rather, §301.7701-2(c)(2)(iv)(C)(2) provides that the general rule of §301.7701-2(c)(2)(i) applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity. In addition, the Treasury Department and the IRS do not believe that the regulations alter the holding of Rev. Rul. 69-184, 1969-1 CB 256, which provides that: (1) bona fide members of a partnership are not employees of the partnership within the meaning of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24, respectively, subtitle C, Internal Revenue Code of 1954), 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.
Specifically, the IRS adds the following language to the end of Reg. §301.7701-2T(c)(2)(iv)(C)(2):
Also, if a partnership is the owner of an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2, the entity is not treated as a corporation for purposes of employing a partner of the partnership that owns the entity; instead, the entity is disregarded as an entity separate from the partnership for this purpose and is not the employer of any partner of the partnership that owns the entity. A partner of a partnership that owns an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2 is subject to the same self-employment tax rules as a partner of a partnership that does not own an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2.
Interestingly, while the IRS insists this is how the regulation always should have been applied, the agency is providing an “effective date” for this provision, indicating it is meant to “give time” to partnerships to make adjustments to payroll and benefits plans. Explaining Temporary Reg. §301.7701-2(e)(8)’s transition rule, the preamble provides:
In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, these temporary regulations will apply on the later of: (1) August 1, 2016, or (2) the first day of the latest-starting plan year following May 4, 2019, of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2019) sponsored by an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2. For these purposes, an affected plan includes any qualified plan, health plan, or section 125 cafeteria plan if the plan benefits participants whose employment status is affected by these regulations. For rules that apply before the applicability date of these regulations, see 26 CFR part 301 revised as of April 1, 2016.
The last line may raise some concern since the IRS did not explicitly “bless” the treatment prior to that date and the inclusion of non-employees in many of those plans could result in a qualification issue. Presumably, though, based on language before that sentence, the IRS plans to not “push” the issue unless the agency finds a set of “bad facts.”