The Internal Revenue Service and the Department of the Treasury recently released final regulations regarding the application of the self-employment tax laws in a structure where a partnership owns a disregarded entity (such as a wholly-owned limited liability company). Specifically, the final regulations provide that a partner in the partnership who also provides services for the disregarded entity will not be considered an employee of the disregarded entity, but rather will be subject to self-employment tax on the services income in his or her capacity as a partner in the partnership. The regulations are not surprising given that they replace temporary regulations from just over three years ago and do so essentially verbatim, other than clarifying the effective date of the guidance.
The final regulations mean a partnership that owns a disregarded entity, and has partners who perform services for the disregarded entity, must continue to include the services income on an IRS Form K-1 (not an IRS Form W-2). They also mean the partner providing services to the disregarded entity must continue to pay self-employment tax (not employment tax) on the services income and may also be excluded from certain employee benefit plans, or be included only as an owner, not as an employee.
As we noted in a First Alert at the time the temporary regulations were issued in 2016, that guidance mentioned two meaningful areas unaddressed by that guidance but for which Treasury was seeking comments. The first is the application of the self-employment tax regime to tiered partnerships, specifically where a partner in the upper-tier partnership is a service provider to the lower-tier partnership, but is not a partner in the lower-tier partnership. The second is where an individual is an employee of a partnership in the first instance, but as a form of employee compensation the employee is granted (often as a “profits interest”) a small amount of ownership in the partnership. Unfortunately, however, in the preamble to the final regulations IRS and Treasury explicitly leave both these as open questions. In fact, they note one additional level of uncertainty: the
application of the regulations in the case of publicly traded partnerships. Hopefully, future guidance can offer some clarity on these matters and Calfee will continue to monitor any developments.