BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

New Regulations Clarify The Intersection of Partnerships, Disregarded Entities, And Self-Employment Taxes

Following
This article is more than 7 years old.

In temporary and proposed regulations issued earlier this month, the Treasury Department clarified the self-employment tax treatment for partners of a partnership that own a disregarded entity.

Let me provide some background.

The treasury regulations provide generally that a business that has a single owner and is not a corporation is treated as “disregarded as an entity separate from its owner.” See Treas. Reg. § 301.7701–2(c)(2)(i). The quintessential disregarded entity is the single-member LLC (SMLLC). That is, for federal tax purposes, the default treatment of the SMLLC is a disregarded entity; so, for example, if an individual owns an SMLLC, the individual owner reports all the income and loss from the entity on his individual tax return.

But, the regulations also provide that, for employment taxes (under subtitle C—for example, FICA taxes), the disregarded entity is treated as a corporation. Therefore, the entity—and not the individual owner—is considered to be the employer for purposes of employment taxes.

Now, another twist, is that this rule—i.e., treating the entity as a corporation for employment taxes—does not apply for self-employment taxes.

The regulations provide the following example in Treas. Reg. § 301.7701-2(c)(2)(iv)(D):

(i) LLCA is an eligible entity owned by individual A and is generally disregarded as an entity separate from its owner for Federal tax purposes. However, LLCA is treated as an entity separate from its owner for purposes of subtitle C of the Internal Revenue Code. LLCA has employees and pays wages . . . .

(ii)  LLCA is subject to the provisions of subtitle C of the Internal Revenue Code and related provisions under 26 CFR subchapter C, Employment Taxes and Collection of Income Tax at Source, parts 31 through 39. Accordingly, LLCA is required to perform such acts as are required of an employer under those provisions of the Internal Revenue Code and regulations thereunder that apply. All provisions of law (including penalties) and the regulations prescribed in pursuance of law applicable to employers in respect of such acts are applicable to LLCA. . . . .

(iii) A is self-employed for purposes of subtitle A, chapter 2, Tax on Self–Employment Income, of the Internal Revenue Code. Thus, A is subject to tax under section 1401 on A's net earnings from self-employment with respect to LLCA's activities. A is not an employee of LLCA for purposes of subtitle C of the Internal Revenue Code. . . .

The Treasury Department and IRS, however, discovered that

some taxpayers may have read the current regulations to permit the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity because the regulations did not include a specific example applying the general rule in the partnership context.

Consequently, the Treasury explained, “some taxpayers have permitted partners to participate in certain tax-favored employee benefit plans.”

Therefore, the new regulations make clear that “the rule that a disregarded entity is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a disregarded entity.”

In other words, “[t]he rule that the entity is disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner.” Consequently, the Treasury notes, “the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.”

You can find the new temporary regulation, Treas. Reg. § 301.7701-2T(c)(2)(iv)(C)(2), here (TD 9766 May 4, 2016).

Follow me on Twitter or LinkedIn