The Treasury Department recently issued final regulations that treat an eligible disregarded entity the same as an entity regarded as separate from its owner for employment tax and related reporting requirements.1 The new regulations require each entity otherwise disregarded for federal tax purposes to calculate, withhold, pay, and report withholding and employment taxes for wages paid on or after January 1, 2009, in the same manner as a regarded entity.

In general, an employer must withhold employment and income taxes from its employees' wages and make deposits of those taxes and must pay the employer portions of Social Security and Medicare ("FICA") taxes and unemployment compensation ("FUTA") taxes. An employer also must comply with other administrative obligations such as issuing IRS Forms W-2 to its employees and filing IRS Forms 940 (annual return for FUTA taxes) and IRS Forms 941 (quarterly return for FICA and income taxes).

Generally, for federal tax purposes, a business entity that is not a corporation and has a single owner is disregarded. This means that for federal income tax purposes, its income, gain, loss, deductions, credits, assets, and liabilities are treated as those of its owner. Also, certain corporations owned by (i) REITs ("Qualified REIT Subsidiaries") or (ii) S corporations may be disregarded.

Before the new regulations, IRS Notice 99-6 permitted a disregarded entity, other than a Qualified REIT Subsidiary, to satisfy its employment tax obligations in one of two ways. The owner of a disregarded entity either could (i) calculate, withhold, pay, and report taxes associated with an employee under the owner's name and EIN or (ii) it could have the disregarded entity calculate separately and withhold, pay, and report under its own name and EIN. Consequently, the owner of a disregarded entity was able to determine the most efficient method of calculating, withholding, paying, and reporting wages paid to that entity's employees. If an owner chose the first method, IRS Notice 99-6 required the owner to seek IRS approval to change subsequently to the second method.

Effective for wages paid on or after January 1, 2009, the new regulations treat all disregarded entities, other than Qualified REIT Subsidiaries, the same as regarded entities for withholding and employment tax purposes.2 As a result, each entity that otherwise is disregarded will be treated as an employer separate from its owner and will be required to issue IRS Form W-2 under its own name and EIN, withhold, deposit, and report income, FICA and FUTA taxes from wages paid to its employees and to pay the employer portion of FICA and FUTA taxes. If an owner currently withholds, pays and reports taxes associated with its disregarded entity’s employees, it is not required to seek IRS consent after August 16, 2007 and before January 1, 2009, to change methods.3

Problem: Treating a disregarded entity and its owner as separate entities may have an adverse impact on the owner's overall FICA and FUTA tax liability where an employee works for more than one entity. This potential exposure arises from the fact that the employer's share of both its FUTA liability and the Social Security tax component of its FICA liability are subject to wage caps. For 2007, the Social Security Tax wage base is limited to $97,500 and the FUTA wage base is limited to $7,000. Thus, for example, if for 2007 Employee A is paid $80,000 by each of an owner and a subsidiary treated as a disregarded entity, the owner's aggregate employer Social Security tax liability would be $6,045 (6.2% times $97,500) and its aggregate FUTA liability would be $434 (6.2% times $7,000). By contrast, if the subsidiary is treated as a regarded entity, the owner's aggregate Social Security tax liability would be increased to $9,920 (6.2% times $80,000 for each entity) and its aggregate FUTA liability would be increased to $868 (6.2% times $7,000 for each entity).

Potential Solution: A disregarded entity that is treated as a regarded entity under the new regulations will be treated as a corporation for employment tax and related reporting purposes. Consequently, an owner and a disregarded entity, or a group of related disregarded entities, that concurrently employ the same person may be able to avoid this potential duplicate tax burden by using a common paymaster. Generally, any member of a group of related corporations may act as a common paymaster by disbursing wages to employees of two or more of those related entities and keeping books and payroll records for those employees. If one corporation (a common paymaster) pays wages to an employee for work for multiple related corporations, all taxable compensation paid by the related corporations in cash is combined for purposes of applying the Social Security and FUTA wage base limits. Thus, use of a common payment arrangement would eliminate or at least ameliorate the exposure to additional Social Security and FUTA tax burdens created by treating each disregarded entity as a separate employer under the new regulations.

Summary:

For wages paid on or after January 1, 2009, newly finalized regulations treat an entity that otherwise is disregarded as a separate entity for federal withholding and employment taxes purposes. Such entities will be subject to income and employment tax, withholding, reporting, and depositing requirements and, in some cases, to increased employer Social Security and FUTA taxes. Utilizing a common paymaster may minimize or eliminate additional Social Security and FUTA tax burdens and reporting requirements.


  1. The final regulations also treat a disregarded entity as a regarded entity for certain excise tax purposes, such as environmental taxes on certain chemicals, certain transportation taxes, certain fuel and alternative fuel taxes, as well as miscellaneous taxes on gas guzzlers, tires, vaccines, sporting goods, wagering, and insurance policies issued by foreign insurers, effective for taxable periods beginning after December 31, 2007.
  2. The final regulations do not alter the rule that an individual owner of a disregarded entity is subject to self-employment tax on the net earnings from self-employment derived through the disregarded entity. That is, the owner will not be regarded as an employee of the entity.
  3. A disregarded entity owned by an organization exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code is subject to the new regulations, but wages paid by such an entity remain exempt from FUTA taxes.


Copyright © 2007 by Ballard Spahr Andrews & Ingersoll, LLP.
www.ballardspahr.com

This newsletter is a periodic publication of Ballard Spahr Andrews & Ingersoll, LLP and is intended to alert the recipients to new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and specific legal questions you have.