Tax Overhaul Could Resolve Dual Partner-Employee Problem

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By Laura Davison

Nov. 28 — Internal Revenue Service rules don’t let someone be both a partner and an employee of the same partnership, to prevent people from cherry-picking the benefits of both statuses while avoiding the burdens.

But some hope that the House Republican plan to reshape the tax code might resolve a long-standing dispute between partnerships and the IRS about how to tax partners who have small stakes in partnerships. Such a change to the tax code would be welcomed by some service partnerships that are already compensating some employees with equity interests.

The House tax blueprint could make the “dual-status partner problem easier to resolve,” Kurt Lawson, a partner at Hogan Lovells US LLP who focuses on employee benefits issues, told Bloomberg BNA.

The proposal seeks to differentiate which income is a return on work versus a return on investment. House Republicans have proposed to treat the “reasonable compensation” paid to a passthrough owner-operator as income taxed at individual rates. Other business income would be subject to a 25 percent passthrough tax rate.

“If some or all of the income from an entity is treated solely as business income and not subject to Self-Employment Contributions Act taxes, some of the tax downside of an individual’s being treated as a partner-owner will go away as will some of the IRS’s incentive to treat him or her as a partner-owner for all purposes,” Lawson said Nov. 22.

Dual-Status Dance

The proposal “looks a lot like” a dual-status partner arrangement, with the only difference being whether the income is subject to SECA taxes and quarterly estimated payments or Federal Insurance Contributions Act taxes and withholding, Lawson said.

Because there isn’t a rate differential between SECA and FICA taxes, there is no concern about a loss of tax revenue to the government, Don Susswein, a principal at RSM US LLP specializing in partnerships, said.

“The reasonable compensation could be paid in salary, it could be paid as a 1099 independent contractor payment or a guaranteed payment. It shouldn’t make a difference,” Susswein said. “The whole big deal about whether partners can be employees is a controversy about nothing. It’s like Seinfeld.”

Tax groups, such as the American Bar Association Section of Taxation, have been pushing the IRS to soften its stance prohibiting individuals from receiving both wage and partnership income from an entity. As limited liability companies and other passthroughs have become the entities of choice for small businesses, owners have frequently handed out company equity to reward employees, but haven’t realized that move means that employee is no longer able to receive wages and must file taxes as a partner.

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 wages. In proposed rules (REG-114307-15) issued earlier this year, the IRS asked for comments about certain circumstances in which partners should be allowed to be treated as employees.

Reasonable Compensation Clarity

The difficult part of implementing the House Republicans’ plan would be how to determine reasonable compensation, Susswein said.

Reasonable compensation has been subject to much uncertainty in other areas of tax law, dealing with S corporations and self-employment, because it is hard to define what is or isn’t appropriate in every circumstance. The IRS implements rules to prevent individuals from taking too little compensation subject to individual tax rates and payroll taxes and shifting more income to preferential rate treatment.

Under the Republican plan, the individual wage income would be taxed at a graduated rate, topping out at 33 percent. The passthrough income would be taxed at 25 percent. President-elect Donald Trump has proposed a similar tax plan, but has a 15 percent rate for business income.

The IRS has historically struggled with writing regulations for reasonable compensation, Susswein said. This would likely be an even bigger undertaking than in the S corporation and self-employment arenas, he said.

“It’s more important because there is a larger rate difference,” Susswein said. “It’s going to be complicated.”

To contact the reporter on this story: Laura Davison in Washington at lDavison@bna.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bna.com

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