The IRS has issued temporary regulations under Code Sec. 7701 to clarify that a disregarded entity that is treated as a corporation for employment tax purposes is not treated as a corporation for purposes of employing an individual who is a partner in a partnership that owns the disregarded entity.

Under the current regulations, a disregarded entity is treated as a corporation for employment tax purposes. The entity, rather than its owners, is treated as the employer of the entity’s employees and bears employment tax responsibilities with respect to the employees. For self-employment tax purposes, however, the entity is treated as a sole proprietorship, and the owner of the entity is therefore subject to self-employment tax on the net earnings resulting from the disregarded entity’s activities. Some taxpayers have read the current rules to permit the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity, because the existing regulations did not include an example specifically applying the general rule in the partnership context. This unintended reading of the rule has resulted in some taxpayers permitting partners to participate in tax-favored employee benefit plans.

The regulations do not create a distinction between a disregarded entity owned by an individual (where the individual owner is clearly subject to self-employment tax) and one owned by a partnership. In addition, these regulations do not alter the holding of Rev. Rul. 69-184, which generally holds that bona fide members of a partnership are not employees of the partnership for employment tax purposes, but rather, to the extent they devote time and energy in the conduct of the trade or business of the partnership or provide services to the partnership as an independent contractor are in either event self-employed individuals rather than employees.

To address this issue, the temporary regulations provide that the treatment of a disregarded entity as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a disregarded entity. If a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

These regulations do not address the application of Rev. Rul. 69-184 in tiered partnership situations. Comments are requested on the appropriate application of the principles of Rev. Rul. 69-184 to tiered partnership situations, the circumstances in which it may be appropriate to permit partners to also be employees of the partnership (for example, where employees in a partnership obtain a small ownership interest as a compensatory award or incentive), and the impact on employee benefit plans and on employment taxes if Rev. Rul. 69-184 were to be modified to permit partners to also be employees in certain circumstances.

In order to allow time for partnerships to make the necessary payroll and benefit plan adjustments, the temporary regulations apply on the later of (1) August 1, 2016, or (2) the first day of the latest-starting plan year following May 4, 2016 of an affected plan (based on the plans adopted before, and the plan years in effect as of that date) sponsored by a disregarded entity under Reg. §301.7701-2. For these purposes, an affected plan includes any qualified plan, health plan, or cafeteria plan if the plan benefits participants whose employment status is affected by these regulations.

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