A common question among partnerships with service partners (i.e., partners working for the partnership in an employee-type capacity) is whether those service partners may be treated as employees of the partnership, receiving wages reported on Form W-2 and participating in tax-favored benefits along with other non-partner employees of the partnership. While it appears the Internal Revenue Service (IRS) has taken a fairly clear stand on this issue, confusion – or even blatant disregard – remains about the rules governing whether a partnership may treat a service partner as an employee. To bring clarity to this matter, it helps to understand the position of the IRS, the perceived benefits, and the potential pitfalls of a partnership treating a service partner as an employee.
What the IRS thinks
The IRS has long held that a partner who provides services to the partnership is not an employee of the partnership. This position is made clear in Rev. Rul. 69-184, which states that “bona fide members of a partnership are not employees of the partnership” with respect to employment taxes, and that “a partner who devotes his time and energies in the conduct of the trade or business of the partnership … is … a self-employed individual.” In addition to the general prohibition on treating partners as employees stated in Rev. Rul. 69-184, there are several other more specific restrictions on partners being treated as employees.
In the context of group health benefits paid to an employee, Rev. Rul. 91-26 states that a partner is not treated as an employee, and the payment on the partner’s behalf for his or her health insurance premiums would not be excluded from the partner’s income as it would for an employee who was not a partner. Similarly, Prop. Reg. §1.125-1(g)(2)(i) states that “a partner in a partnership…is not an employee for purposes of section 125, and thus is not permitted to participate in a cafeteria plan.” More recently, the new regulations stemming from the Affordable Care Act state that for purposes of the Act, “a partner in a partnership … is not an employee.” See Reg. §54.4980H-1(a)(15).
AGH issued an alert on this topic in June, 2016.
While the IRS’s position is clear that partners in a partnership may not be treated as employees, many partnerships continue to treat partners serving in an employee-type capacity as employees. This begs the question, “What are the benefits – or perceived benefits – of treating a service partner as an employee?” These benefits fit into two categories: payroll tax withholding and participation in tax-favored benefit plans, and they are especially applicable to former non-owner employees of a partnership who have been compensated with an ownership interest in the partnership. Such new owners are accustomed to receiving a wage with income tax and FICA withholdings and participating in tax-favored employee benefit plans, such as Section 125 cafeteria plans, group health plans, and employee retirement plans.
What's the risk?
Although it may seem simpler to continue treating these partners as employees and avoid the hassle to the company and individual of making the necessary changes, there are potentially substantial disadvantages and risks that the partnership and the partner should consider before ignoring IRS guidance and continuing to treat partners as employees of the partnership:
- As mentioned above, the regulations for Section 125 state that “a partner in a partnership…is not an employee for purposes of section 125, and thus is not permitted to participate in a cafeteria plan.” Thus, if a partner continues to participate in the plan, the partner not only risks having his or her contributions to the plan becoming taxable, but the firm risks having the entire plan be deemed unqualified due to the partner’s participation and having all employee contributions treated as taxable.
- If a partner personally incurs any business expenses of the partnership, if that partner is treated as an employee, those expenses will be considered unreimbursed employee expenses subject to the 2% of AGI limitation and possibly subject to the overall phase-out of itemized deductions as well. Conversely, the IRS has stated in TAM 9330001 that the 2% limitation of Section 67 “does not apply to the deduction of business expenses by partners, as they are not considered employees of the partnership.” Treating a partner as an employee limits or possibly eliminates the deduction attributable to partnership expenses paid by the partner.
- If a partner is treated as an employee and receives wages from the partnership with FICA taxes withheld, it is possible that the partner will overpay employment taxes to the government. Consider this example: A partner treated as an employee receives wages of $100,000 with the appropriate FICA taxes withheld. However, this partner has other activities that are subject to self-employment taxes, but these activities have a loss for the year of $50,000. If the partnership had reported the wages instead as guaranteed payments, the partner would have only had $50,000 of self-employment income to pay employment taxes on, rather than the $100,000, and the partner has overpaid employment taxes.
These are just a few of the possible risks and disadvantages of treating a partner as an employee of the partnership. In yet another reaffirmation of its stance, the IRS has recently issued temporary regulation §301.7701-2T stating that not only should partners not be treated as employees of the partnership, but partners also cannot be treated as employees of a disregarded entity that is owned by the partnership, similar to how the owner of a sole proprietorship should not be treated as an employee of the sole proprietorship. However, the IRS has also asked for comments on when it may be appropriate for partners to be treated as employees.
With this most recent clarification, the IRS has provided partnerships that treat service partners like employees with yet another statement about the risks of such an arrangement – not only to the partner, but to the entire firm and other employees’ assets. Those who continue to disregard the IRS’ directive for the “convenience” of treating partners like employees are ignoring a clear warning signal to stop the practice.
For more information about this topic, contact Shawn Sullivan uisng the information below.
NOTE: Any advice contained in this material is not intended or written to be tax advice, and cannot be relied upon as such, nor can it be used for the purpose of avoiding tax penalties that may be imposed by the IRS or states, or promoting, marketing or recommending to another party any transaction or matter addressed herein.
Senior Vice President
Shawn serves as one of two primary leaders in the firm’s large tax group. He has extensive public and private experience in the fields of tax and accounting and works frequently with clients in the manufacturing, wholesale/retail distribution, real estate development and management, construction, and contractor industries. In addition to enhancing business performance to minimize tax consequences, he has experience in mergers and acquisitions and international tax and business structuring.
A certified public accountant, Shawn is a member of the American Institute of Certified Public Accountants, the Kansas Society of Certified Public Accountants (KSCPA) and chairs the KSCPA Committee on Taxation.