Limited liability companies (LLCs) have become the fastest-growing entity choice for businesses in recent years. LLCs provide flexibility in operations and distributions. However, to the surprise of many businesspeople, if an entity, including an LLC, is treated as a partnership for federal income tax purposes, the IRS believes that anyone who owns an interest in that entity cannot be an employee of that entity. This rule also applies to the holder of a profits interest in a partnership1.

As a result, many LLCs and partnerships misclassify their service provider partners as employees. This article uses the term "partnership" to mean an entity (including an LLC or partnership) that is treated as a partnership for federal income tax purposes and the term "partner" to mean an owner of such an entity.

Employee Vs. Partner Withholding and Benefits Treatment

When a service provider partner is an employee, the employer is required to withhold FICA taxes (Social Security tax and Medicare tax), Federal Unemployment Tax Act (FUTA) tax, as well as federal, state, and local income taxes. In addition, the employer must pay the employer portion of the FICA taxes. In contrast, a service provider partner is allocated a share of the partnership's income. Distributions to a service provider partner are not subject to FICA, FUTA, or federal, state, or local income tax withholding. Instead a service provider partner must pay, typically though estimated taxes, its own federal, state, and local income taxes and self-employment taxes. Self-employment taxes essentially are the sum of the employee and employer portion of the FICA taxes. Then, for federal income tax purposes, a partner can deduct 50% of the self-employment taxes paid.

The differences in the tax treatment of a service provider partner as compared to an employee are not limited to withholding. These differences also include:

  • Medical insurance premiums are included in a service provider partner's income (and insurance premiums are then deductible), but most employer-funded medical insurance premiums are not included in an employee's income.

  • All disability and life insurance premiums paid by the partnership are taxable to service provider partners, whereas certain disability and life insurance benefits can be provided tax-free to employees.

  • Service provider partners cannot participate in cafeteria plans (through which certain welfare benefits can be purchased on a pretax basis), whereas employees can participate in cafeteria plans.

Current State of the Law—Disregarded Entity

In 2007, regulations were finalized that treat a disregarded entity (DRE)2 as a corporation for withholding tax purposes. Many practitioners and businesses believed that these regulations allowed a service provider partner to be an employee of his partnership's DRE. But in May 2016, the IRS issued temporary regulations providing that a DRE is disregarded for purposes of determining if a service provider partner is its owner. Thus, a service provider partner of a partnership cannot be treated as an employee of that partnership's DRE. The regulations are effective starting the later of August 1, 2016, or if the partnership has a qualified retirement plan, cafeteria plan, or health plan that was in existence on May 1, 2016, the first day of the latest annual starting date of those plans that occurs after May 1, 2016.

Risks of Treating a Partner as an Employee

While the law that a service provider partner cannot be the partnership's employee has been settled since the late 1960s, many partnerships have been unaware of this law and misclassified service provider partners as employees and have done so without recourse by the IRS. Notwithstanding that, for the most part, the correct amount of tax is being paid, although not by the correct taxpayers (see above regarding self-employment tax), there are risks in continuing to misclassify service provider partners as employees.

Profits Interest Safe Harbor May Not Apply

As discussed above, profits interests provide a unique situation for a service provider partner whereby an ownership interest in the partnership can be received without paying tax on receipt of that interest. To receive this tax-free treatment, "[t]he partnership and the service provider [must] treat the service provider as the owner of the partnership interest from the date of its grant . . . and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider's income tax liability for the entire period during which the service provider has the interest."3

Because the partnership and the service provider are required to treat the service provider as a partner, if the partnership treats the service provider as an employee for withholding tax purposes, the safe harbor for tax-fee receipt of the profits interests might not be satisfied. Thus, the IRS could argue that the recipient would be fully taxable when the profits interest vests on the then-fair market value of the profits interest.

Cafeteria Plans May Be Disqualified

Partners are prohibited from participating in cafeteria plans. As a result, if the service provider partner participates in the partnership's cafeteria plan, the entire cafeteria plan may be disqualified.

What To Do

First and foremost, do not treat service provider partners as employees of the partnership for federal, state, and local income tax purposes or FICA and FUTA purposes. Second, review benefit plans to make sure that partners are covered for the intended benefits, even though they are not employees. Third, if a partnership has service provider partners it has been treating as employees, change that treatment. As discussed above, an employer is required to withhold an employee's share of the FICA taxes and the employer pays the employer portion of such taxes. A partner pays both the employer and employee portion of those taxes and is entitled to deduct 50% of those taxes. Partnerships could consider increasing the service provider's draw/pay by the employer portion of the FICA taxes that the partnership otherwise would pay if the partner were an employee.

Attorneys in Ballard Spahr's Tax Group advise clients on compliance with federal and state tax filing requirements.

1. A profits interest is an ownership interest in a partnership that provides the holder with a right to current distributions and to future appreciation. If structured correctly, the recipient of a profits interest will not be taxed on the receipt of the profits interest.

2. A DRE is a partnership or LLC that is wholly owned directly or indirectly through another pass-through entity by a taxpayer.

3. Rev. Proc. 2001-43, 2001-2 C.B. 191.

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