Tax Treatment of Compensation to Service Provider Partners: Navigating New IRS Prohibitions on Employee Treatment

Description

The IRS recently issued final and temporary regulations clarifying Self-Employment Tax Treatment of Partners in a Partnership that Owns a Disregarded Entity. Under the new regulations, the Service’s position is that partnerships that own single-member LLCs electing under Section 7701 to be treated as a corporation for employment tax purposes may not treat the service provider partners as employees eligible to participate in employee benefit plans.

The new regulations clarify IRS rules that require partners to be treated as self-employed for purposes of withholding tax. Many partnerships had used downstream DREs to include service provider partners in benefit plans set up for non-partner employees. The new rules require partnerships to amend any benefit plan documents that included partners covered under these arrangements.

The regulations requested comments on whether and under which circumstances tiered partnerships could treat lower-tier partners as employees. The rules likely will have broader implications on partnership operations, including compelling changes in how partnerships compensate service provider partners and forcing partnerships to alter how they grant partnership interests to existing employees. Partnership tax advisers should have a thorough grasp of the service provider partner compensation rules to avoid costly tax consequences.

Listen as our experienced panel provides a thorough and practical guide to the rules governing service provider partner compensation, including a detailed discussion on the impact of the new disregarded entity and employee benefit plan rules.