The IRS has issued final regulations that bar partnerships from treating partners working for a disregarded entity owned by the partnership as employees.[1]  The final regulations replace identical temporary regulations that were issued in May of 2016.[2]

Some partnerships had argued that since single member LLCs are treated as separate entities, and therefore “like” C corporations, for payroll tax purposes, partners of a partnership holding 100% of the interests in the LLC could be employees of the disregarded entity.  By doing so, the partners could qualify for various tax benefits, such as tax favored benefits available to employees but not self-employed persons.

In Rev. Rul. 69-184 the IRS held that a partner of a partnership cannot be an employee of that partnership.  This can create issues, since some partners may prefer to have taxes withheld from a regular paycheck, while others might want to avail him/herself of employee benefits such as participation in a cafeteria plan sponsored by the partnership.

The final regulations make clear that using a disregarded entity will not allow partners to end up on a payroll.  Reg. §301.7701-2(c)(2)(iv)(C)(2) provides:

(2) Paragraph (c)(2)(i) of this section applies to taxes imposed under subtitle A of the Code, including Chapter 2 — Tax on Self-Employment Income. Thus, an entity that is treated in the same manner as a sole proprietorship under paragraph (a) of this section is not treated as a corporation for purposes of employing its owner; instead, the entity is disregarded as an entity separate from its owner for this purpose and is not the employer of its owner. The owner will be subject to self-employment tax on self-employment income with respect to the entity’s activities. Also, if a partnership is the owner of an entity that is disregarded as an entity separate from its owner for any purpose under this section, 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 this section 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 this section.[3]

The IRS also notes in the preamble to the regulations that the agency discovered some taxpayers had interpreted a later effective date than the IRS feels is the proper interpretation of the effective date of the regulations.  The preamble notes:

The temporary regulations provided that their applicability date would be the later of August 1, 2016, or the first day of the latest-starting plan year following May 4, 2016 of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2016) sponsored by an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2. It has come to the attention of the Treasury Department and the IRS that some taxpayers may have read the applicability date to begin on the first day of the last plan year prior to the termination of an affected plan (as defined in §301.7701-2(e)(8)), which may have been a date after May 4, 2017. This is not a proper reading of the applicability date.

In the case of an entity with several affected plans that may have different plan years, the applicability date was the first day of the plan year of the affected plan that had the latest plan year beginning after May 4, 2016, and on or before May 4, 2017 (assuming that date is after August 1, 2016). For example, an entity may have had two affected plans, with one plan year that began on September 1, 2016, and another plan year that began on January 1, 2017. In this case, the applicability date for this entity would have been January 1, 2017. The applicability date for any entity affected by these regulations should not have been delayed beyond May 4, 2017 in any case. For this reason, the final regulations clarify in §301.7701-2(e)(8) that the applicability date of §301.7701-2(c)(2)(iv)(C)(2) is the later of August 1, 2016, or the first day of the latest-starting plan year beginning after May 4, 2016, and on or before May 4, 2017, of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2016) sponsored by an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2.[4]

[1] TD 9869, 6/28/19, https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-14121.pdf retrieved June 29, 2019

[2] TD 9766, 5/4/16

[3] TD 9869, p. 7

[4] TD 9869, p. 5-6