The Employee Benefits Group of Jackson Kelly PLLC provides third party administrative services to numerous qualified plans. A large percentage of the plan sponsors are either partnerships or limited liability companies(LLC) electing to be taxed as partnerships. Oftentimes when we receive payroll data, we will see partners/members who are receiving both K-1’s as partners and W-2’s as employees. While partners/members are eligible to participate in qualified plans, this dual status (as an employee and member) makes it challenging to determine what “compensation” to use for qualified plan purposes.
There are numerous fringe benefit programs in which only common law employees may participate on a pre-tax basis. For example, employer paid health premiums are only excludable on employees. Health premiums paid by a partnership for a partner would be includable in his taxable share of partnership income (treated as a guaranteed payment). Likewise, a partner may not be a participant in a Section 125 cafeteria plan or health reimbursement account. The Internal Revenue Service has long taken the position that a partner/member may not properly be an employee of the partnership/LLC. In Revenue Ruling 69-184, the Service ruled that bona fide members of a partnership are not employees of the partnership for FICA and withholding tax purposes. In Revenue Ruling 91-26, the Service extended this view to the area of fringe benefits. Even in light of what we view as a clear rule prohibiting partners/members from being treated as employees of the partnership for any purpose, apparently some advisors relied upon regulations under Section 7701 of the Code to reach a different conclusion in limited circumstances. To the extent a loophole exists, the Service intends to eliminate it under final and temporary regulations issued under Section 7701 of the Code (T.D. 9766).
The sole issue addressed by the new regulations involves an LLC electing to be taxed as a partnership in which the sole owner is another partnership. The current regulations make it clear that where an individual owns an LLC which has elected to be taxed as a partnership, the LLC is disregarded for income tax purposes but is not disregarded for employment tax purposes. For employment tax purposes, the disregarded LLC is treated as a corporation. As such, the LLC is required to withhold on the wages paid to its common law employees and, in addition, pay FICA and FUTA taxes on these employees. The current regulations have an example which points out that the owner of the LLC (which is disregarded) is treated as a sole proprietorship and subject to self-employment income on income which he receives from the disregarded LLC.
The regulations do not include a separate example in which the disregarded entity is owned by a partnership, and apparently relying upon this, partners in the partnership which own the disregarded LLC have treated themselves as employees of the LLC with the LLC paying them wages. Apparently, as employees, these partners have been participating in tax preferred fringe benefit programs sponsored by the disregarded LLC. The Service believes that the law is clear that these individuals may not be deemed to be employees of the disregarded entity, but in order to eliminate this confusion, are issuing the revised regulations to specifically provide “A partner of a partnership that owns an entity that is disregarded as an entity separate from its owner for any purpose under Section 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 owners for any purpose under Section 301.7701-2.”
There are two interesting aspects to the Service’s announcement. First, the Service invites comments with regard to the continued application of Revenue Ruling 69-184 to tiered partnership situations. The Service implies that it might be open to allowing minority partnership owners in a tiered partnership arrangement to be treated as employees for retirement plan, health and welfare and fringe benefit plan purposes. Thus, an otherwise employee who was granted a one or two percent ownership interest in the parent tiered partnership could continue to be treated as an employee of the subsidiary partnership.
The second interesting aspect of the Internal Revenue Service’s announcement is the effective date. The amendment clarifying that partners of a partnership which own a disregarded entity are not to be treated as employees of the disregarded entity is effective on the latter of August 1, 2016 or “the first day of the latest starting plan year following May 4, 2019 or 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 owners for any purpose under Section 301.7701-2.”
The clear inference is that to the extent partners in the parent partnership of a disregarded entity are participating in the health and other benefit plans of the disregarded entity, they may continue to do so until the end of 2019. An even more aggressive view would be that these owners are not currently being treated as employees and thus participating in the fringe benefit programs of the disregarded entity. In this instance, the plan could be amended or new plans could be adopted prior to May 4, 2019.
This article was written by Michael D. Foster, an attorney practicing in the Jackson Kelly PLLC Tax Practice Group. He also serves as Assistant General Counsel to the Firm.