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IRS Issues New Regulations on Partnership Treatment of Partners/Employees



The IRS recently issued new temporary regulations and proposed regulations that specifically target tiered-partnership schemes that are used to treat partners as employees.


The IRS has consistently prohibited dual partner/employee status. Case law has long taken the position that partners cannot be employees of their partnerships. Revenue Ruling 69-184 states that bona fide members of a partnership are not employees of the partnership for purposes of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and income tax withholding.

Partners may prefer employee treatment because they are subject to regular income tax and payroll tax withholding. Making quarterly estimated payments of tax and paying self-employment taxes on self-employment income may cause an administrative burden. Further, employees qualify for certain tax-free employee fringe benefits that are not available to partners/members.

Some taxpayers have used a tiered partnership structure to get around the dual partner/employee status prohibition. In this structure, the partner does not provide services to the partnership itself but provides services to a disregarded entity owned by the partnership. The objective being that the individual is an employee of the disregarded subsidiary and receives a W-2 and employee benefits and at the same time the individual maintains his/her status as a partner or equity participant of the parent entity.

Regulations §301.7701-2(c)(2)(iv)(B) treat a disregarded entity as a corporation or separate entity for employment tax purposes meaning the entity  rather than its owners  is treated as the employer of the entity’s employees. This treatment does not apply for self-employment tax purposes. The regulations provide an example of an individual owner that owns a disregarded entity and that owner is subject to self-employment taxes on the disregarded entity’s activities. Neither the current regulations nor Revenue Ruling 69-184 provide an example in which the disregarded entity is owned by a partnership.  Some taxpayers interpreted this omission as allowing partners to be treated as employees of the disregarded entity.

The IRS has issued new temporary regulations intended to stop the practice of partnerships treating partners as employees of a disregarded entity owned by the partnership.  The temporary regulations clarify that self-employment tax also applies when a disregarded entity is owned by a partnership. The new regulations state:

…a partner of a partnership that owns an entity that is disregarded as an entity separate from its owner for any purpose under Reg. §301.7701-2 is subject to the same self-employment tax rules as a partner of a partnership that does not own an entity that is disregarded as an entity separate from its owner for any purpose under Reg. §301.7701-2. (Reg. §301.7701-2T(c)(2)(iv)(C)(2))

However, the IRS is considering when it would be permissible to allow tiered partnerships to treat partners as employees of the partnership. The IRS is requesting comments on the impact of Rev. Rul. 69-184 on employee benefit plans including qualified retirement plans, health and welfare plans, and fringe benefit plans if Rev. Rul. 69-184 were modified to allow partners to also be treated as employees in certain circumstances.

What Does CohnReznick Think?
Partnerships that provide ownership interests (even if “profits only” interests) to employees as compensation or for profit-sharing may inadvertently subject the employees to partner treatment.  The full impact of this should be considered, including all administrative burdens.  For example, consider the burden on the employee who becomes a partner.  Compensation is now subject to self-employment tax, and if the partnership is required to file tax returns in multiple states, the “employee/partner” may now be required to file tax returns in multiple states as well.


For more information, please contact Thomas Nice, Partner, at or at 301-961-5542 or Daniel King, Senior Manager, at or at 301-280-3069.

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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