In every stage of a business’ lifecycle, in the budget of all departments, and ingrained in every new initiative, is the challenge of compensation. There are a variety of ways to compensate employees and many of them contain tax benefits for both the business and the individual. Partners in a partnership, however, are often unable to take advantage of those benefits because they are not allowed to be considered employees. This is because the current legal theory surrounding partnerships holds that a partnership is not an entity but rather an aggregation of the individual business dealings of the partners. Under this theory (called the “aggregate theory”), a partner cannot be an employee of the partnership because he or she would just be an employee of his or herself, which is impossible based on the definition of “employee”.
For years, tax practitioners have taken the position that partners can be employees of an entity wholly-owned by the partnership. These entities are typically disregarded entities, so there is no additional tax reporting required and all the income and deductions for the entity is reported with the owner’s return. They are, however, treated as separate entities for employment tax purposes. Accordingly, practitioners have argued that partners can be considered employees if they use a disregarded entity and they can share in employee-benefit plans just like other employees.
Unfortunately, the IRS has issued regulations clarifying that a partnership may not use a disregarded entity to turn partners into employees. This rule is in the temporary stage but was binding as of August 1, 2016 for most employee-benefit plans. It is expected to be finalized soon. If you have any questions or would like additional information, please contact your trusted advisors at Lurie, LLP.