For many years, some partnerships that owned disregarded entities (single-member LLCs) claimed that their partners were employees of the single-member LLC to minimize self-employment taxes and participate in tax-favored benefit plans. However, recent temporary regulations issued by the Treasury have brought this topic into focus. These regulations may have a significant impact on partnership structures because of the self-employment tax consequences that could result.
The regulations treat a disregarded entity as a corporation for employment tax purposes, but not for self-employment tax purposes. Therefore, the individual partners in the partnership owning the disregarded entity are subject to self-employment tax on the net earnings resulting from the disregarded entity’s activities. Because partners of the partnership own the single-member LLC, the regulations look-through the partnership and treat partners as self-employed individuals subject to self-employment tax.
Once the partners lose their treatment as employees of the single-member LLC, there can be various disadvantages. First, self-employment tax will be levied at 15.3% on the disregarded entity’s net earnings, due to the individual being liable for paying both the employee and employer portion of Social Security and Medicare taxes, which may necessitate a change in payroll reporting obligations for the employee partners. Second, if the partners are classified as self-employed, restrictions on participation tax-favored employee benefit plans such as cafeteria and retirement plans may apply. For these purposes, an affected plan includes any qualified plan, health plan, or Section 125 cafeteria plan if the plan benefits participants whose employment status is affected by the regulations.
The Treasury has set an effective date that will allow sufficient time for partnerships to effectively address changes to payroll and employee benefit plans. The temporary regulations will be applied August 1, 2016 or the first day of the latest starting plan year following May 4, 2016 of an affected plan sponsored by an entity that is disregarded as an entity separate from its owner.