The IRS recently released temporary regulations clarifying that an employee of a disregarded entity is liable for self-employment tax if the employee is a partner in the partnership that owns the disregarded entity. See Treasury Decision 9766 (May 4, 2016).

The IRS imposes self-employment tax on all of a partner’s income from a partnership.  Currently, the self-employment tax rate is 15.3% (12.4% for social security and 2.9% for Medicare). The social security tax rate applies only to the first $118,500 of a person’s income. An additional 0.9% Medicare tax may apply depending on whether the person’s income exceeds a threshold amount. The employer-equivalent portion of the self-employment tax is deductible from a partner’s gross income; however, self-employment tax is calculated on the partner’s gross income without taking into account the deduction. Because the partnership is not withholding income tax on behalf of the partner, the partner is required to make quarterly payments of estimated tax. With respect to health insurance, the partner is entitled to a deduction from gross income; again, self-employment tax is calculated on the gross amount. Further, the deduction may be subject to income limitations.  

By contrast, when a person is an “employee” of an entity, both the employee and the entity are subject to employment tax.  Employers must pay: (1) federal unemployment tax (6% on the first $7,000 of wages); (2) social security tax (6.2% on the first $118,500 of wages); and (3) Medicare tax (1.45% with no wage base limit).  Employees must pay: (1) social security tax (6.2% on the first $118,500 of wages); and (2) Medicare tax (1.45% with no wage base limit).  An additional 0.9% Medicare tax may apply depending on whether the person’s income exceeds a threshold amount. In addition to employment tax, the entity is required to withhold and pay over income tax on behalf of the employee, alleviating the obligation to make quarterly payments of estimated tax. Lastly, employees (unlike self-employed individuals) are permitted to participate in certain tax-favored employee benefits plans.     

In recently issued temporary regulations, the IRS provided that if a partnership owns a disregarded entity, the partners of the partnership cannot be treated as employees of the disregarded entity. Instead, such partners would be treated as providing services to the partnership and consequently subject to self-employment tax. The temporary regulations are applicable on the later of: (1) August 1, 2016; or (2) the first day of the latest-starting plan year following May 4, 2019 of an affected plan that is sponsored by a disregarded entity. In issuing the temporary regulations, the IRS acknowledged that while “some taxpayers may have read the current regulations to permit the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity,” such a reading was not intended.  

Many real estate entities operate through a partnership holding company that in turn owns single member limited liability companies that own individual properties. Under the clarified rules, the IRS has provided that a partner of such holding company is liable for self-employment tax even if the partner is employed by one of the single member limited liability companies rather than the holding company itself. All persons utilizing such a structure should be aware of the IRS temporary regulations and should consult with a tax advisor to ensure that all parties are in compliance with the temporary regulations before the applicable date of the regulations.  

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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