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May 3 — Partners in a partnership that owns a disregarded entity—a single-owner business that isn't a corporation—are subject to self-employment taxes the same way a sole proprietor is, the IRS said in rules intended to clear up what it said is a misconception among some partners.
But the agency might be willing to change its stance if tax practitioners can lay out the case for why it is necessary and wouldn't open new doors for abuse.
Partners aren't allowed to participate in tax-favored employee benefit plans, the Internal Revenue Service confirmed May 3 in final, temporary rules (T.D. 9766, RIN:1545-BM87) and proposed rules (REG-114307-15). The rules said some were treating partners of a partnership that owns a disregarded entity as employees of that entity because the regulations didn't include a specific example applying the rule in a partnership context.
“It’s a good thing for the IRS to be clear if they have a view on this,” Don Susswein, a principal at RSM US LLP, told Bloomberg BNA May 3. “They are saying, ‘yes we still believe this, and we believe it enough to eliminate disregarded entity loophole, if you want to call it that. We're not totally convinced this is the right answer. So help us figure it out.”
The agency asked for comments on whether to allow partnerships to treat partners as employees in certain circumstances—“for example, employees in a partnership who obtain a small ownership interest in the partnership as an employee compensatory award or incentive”—and the effect on employee benefit plans and employment taxes.
It also asked for comments on two-tiered structures and whether an investor partner in an upper-tier entity can be an employee of a lower-tier entity.
It doesn't come out and say that the disregarded entity “technique is wrong under current law,” Kurt Lawson, a partner at Hogan Lovells US LLP, told Bloomberg BNA. “It simply says this reading of the existing regulation ‘was not intended' and points taxpayers to Rev. Rul. 69-184 for the traditional IRS view that an individual cannot be a partner and an employee of the same partnership.”
Groups including the American Bar Association Section of Taxation have been pushing the IRS to soften its stance in light of the widespread practice of “rank-and-file” partners in small service partnerships. The ABA tax section's goal is to allow partnerships and limited liability companies to elect to treat partners, who own small interests, as employees for benefit purposes and to treat their guaranteed payments as W-2 wages (26 DTR G-3, 2/9/16).
“That leaves question of is Rev. Rul. 69-184 correct? And if so, does it apply in all cases?” Susswein said.
The IRS is saying if the private sector cares about this, the private sector can do the work of educating government and explaining why nothing bad will happen if they clarify the law, Susswein said.
“This is one of the most explicit public statements yet that the IRS might be willing to step back from its broad position,” Lawson said.
The IRS needs to address the fact that some accounting firms and tax preparers are ignoring the regulations and issuing Schedules K-1 and Forms W-2 to someone who is a partner-employee, said J. Leigh Griffith, a partner at Waller Lansden Dortch & Davis LLP.
“The IRS either needs to enforce the law or find a way to make it work in appropriate circumstances,” he said.
To give partnerships time to make payroll and benefit plan adjustments, the IRS said, the temporary rules will apply on the later of Aug. 1 or the first day of the latest-starting plan year after May 4, 2016, of an affected benefit plan sponsored by the business.
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Texts of T.D. 9766 and REG-114307-15 are in TaxCore.
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