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IRS Confirms that Partners Are Not Employees

The Internal Revenue Service recently issued guidance confirming its position that an individual cannot be treated as both an employee and a partner of the same entity (sometimes referred to as the “dual status” position). This guidance clarifies that employees of partnerships and certain limited liability companies (and, in some cases, their subsidiaries) who receive equity interests in their employer cease to be treated as employees for tax and benefit plan purposes, regardless of how small of an interest they receive and whether or not they have any management responsibility. This news often comes as an unwelcome surprise to employees, as well as to employers structured as partnerships and LLCs that grant equity-based compensation awards to attract and retain key employees.

The IRS’ “all or nothing” approach has significant practical consequences to partnerships and LLCs that continue to treat partners as employees. For example, compensation paid to an employee constitutes wages reported on a Form W-2 and is subject to tax withholding, and the employee is only responsible for one-half of the FICA taxes imposed on the compensation. However, compensation paid to a partner constitutes a “guaranteed payment” reported on a Schedule K-1 and is not subject to tax withholding; rather, the partner must make estimated tax payments and pay the full amount of self-employment taxes imposed on the compensation. Continuing to treat a partner (or an LLC member) as an employee can result in an underpayment or overpayment of FICA taxes. In addition, partners are not eligible to participate in certain tax-advantaged employee benefit arrangements, such as cafeteria plans and flexible spending accounts. In fact, a partner’s participation in a cafeteria plan or flexible spending account could disqualify the entire plan and result in unanticipated taxes on the benefits received through the plan for all participants.

The IRS’ dual-status position effectively requires employers structured as partnerships or LLCs to choose between providing their employees with equity-based compensation and subjecting their employees to more complex tax rules and administrative burdens. This can create challenges for partnerships and LLCs seeking to design competitive compensation packages that attract and retain quality talent, and align the interests of their employees with the interests of their equity holders.

The IRS guidance requires employers treated as partnerships for U.S. federal income tax purposes to be in compliance with these rules as of August 1, 2016. Therefore, employers structured as partnerships or LLCs should ensure that partners are not incorrectly being treated as employees. In a future blog, we will discuss alternative structures and solutions that can be used to mitigate the effects of the IRS dual-status position and allow employees to continue to be classified as employees.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.