Partners who are working for their partnership are generally considered to be self-employed and are not employees for federal tax purposes. This means that a partner is subject to self-employment tax and isn’t eligible for certain tax favored employee benefits sponsored by their partnerships. These rules would also apply to an LLC taxed as a partnership. Some taxpayers have been attempting to get around this by having their partnership or LLC, own 100% of another LLC, that is treated as a Disregarded Entity (DRE) for tax purposes. The theory in that plan, is that the DRE is defaulted to a corporation for employment tax purposes and the partners are no longer considered self-employed. Final Treasury Regulations §301.7701-2 provide that this strategy doesn’t work.
Prior to 2016 there was some ambiguity on this issue. The regulations treated a DRE as a corporation for employment tax purposes. The regulations included an example of a single individual owner of a DRE who is subject to SE tax on the net earnings from SE activities within the DRE, while the DRE is subject to employment tax for its employees. The regulation did not include an example of partners in a partnership that wholly owns a DRE. This was where some taxpayers came up with the tax planning strategy outlined above.
On May 4, 2016, the Treasury issued temporary regulations that clarified the rule. IRS commented that it did not intend the existing regulations to create a difference between a DRE owned by an individual vs owned by a partnership. The IRS recognized that the absence of a specific example made some taxpayers interpreting the existing regulation as permitting partners to be treated as employees of a DRE entity owned by the partnership. So they created a specific example of a DRE owned by a partnership was added to the regulations in subsection (c)(2)(iv)(c). On July 2, 2019 those regulations became final. The bottom line is that an individual cannot be both a partner in the partnership and an employee of a DRE wholly owned by the partnership. Therefore, partnerships which treated partners as employees (through their DRE), are required to adjust both their payroll and benefit plans.