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Partners are not Employees of a Partnership


Rödl & Partner Tax Matters Vol 2017 – 6, published in July 2017


Several articles have come out in the past year addressing the issue of whether a partner in a partnership may be treated as an employee of the partnership. Although the issue has been debated for some time, the recent interest is driven by the temporary regulations issued by the Internal Revenue Service (“IRS”) (Reg § 301.7701-2T) in 2016. The temporary regulations preclude an upper-tier partnership from using a disregarded entity (“DRE”) to establish an employment relationship with a partner in a partnership. This is a narrow regulation with a specific intent. However, more broadly applicable, is Treasury’s reaffirmation of Revenue Ruling 69-184 in the preamble to the temporary regulations. Revenue Ruling 69-184 clearly states that a partner providing services to a partnership should be treated as a self-employed independent contractor and may not be treated as an employee for tax purposes.


Also in the preamble, the IRS acknowledges that commentators have requested clarification on the IRS position particularly after the adoption of Internal Revenue Code (“IRC”) § 707(a) which provides for treatment of a partner as “other than a partner” in certain contexts.


In response, the IRS is soliciting comments on the application of the 1969 ruling to tiered partnerships and the circumstances in which it may be appropriate and still protective against abuse, to permit partners to also be employees of the partnership. This opens the door for dialogue on the issue, as the IRS, perhaps for the first time, acknowledges that the position that no partner may ever have the dual status of an employee may not be the ideal approach.  For now, however, the IRS position in the 1969 ruling is controlling and the position is clear: partners may not be employees in a partnership.


Partners are not Employees of a Partnership

An owner of a partnership who provides services to the partnership cannot be treated as an employee of the entity. This concept is unique to owners of partnerships and LLCs and does not apply to S Corporation owners who are permitted to be “W-2 employees” of the S corporation (with some limitations if they own more than 2% of the S corporation).


This distinction has many implications for both partner and partnership as it relates to employment taxes, the taxability of employee benefits and various other issues. The issue often comes up when a partnership desires to compensate or retain a key employee by granting them an ownership interest in the partnership, but the partnership either does not wish to increase the new partner’s income tax reporting complexity by removing them from the payroll system, or the partnership may simply fail to do so by administrative oversight.


Although there is no distinction among general partner, limited partner or LLC member when it comes to the prohibition on being treated as an employee, it is worth noting that the rules for determining self-employment income may differ for each.



The IRS has long held that a member of a partnership is not an employee for employment tax purposes, but is instead considered to be a self-employed individual [1]. Although IRC § 707(a) seems to suggest that a partner could simultaneously be treated as a partner and an employee of the same partnership if the transaction in question is substantially outside the scope of the partnership’s regular activities, case law and published IRS guidance generally do not support this conclusion.


In May of 2016, the IRS issued Temporary Regulations to clarify specific rules for disregarded entities as employers. In the preamble to the Regulations, the IRS explicitly stated that a disregarded entity is treated as a corporation for employment tax purposes, but this determination does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a disregarded entity.


Employment Tax Issues

In a typical employer-employee relationship, the employer pays half of the FICA and Medicare taxes and the employee pays the other half through payroll withholding which is remitted to Treasury by the employer on the employee’s behalf. When a partner provides services to a partnership, the proper way to treat this interaction is for the partnership to report guaranteed payment income to the partner and for the partner to report the guaranteed payment as self-employment income on his or her individual tax return and pay the applicable self-employment tax (under SECA and not FICA). The partnership also deducts the guaranteed payment as compensation expense in calculating its net business profit.


Although it may seem the same employment tax is paid in either case, the distinction is significant.  In the employer-employee relationship, the employer and employee economically split the employment tax liability. In the case of a self-employed partner, the liability belongs to the partner alone.


If a partnership pays employment taxes or any other liability or expense on behalf of a partner, it is considered a guaranteed payment to the partner. Additional employment taxes would then be owed on that guaranteed payment.


There can also be situations, however, when being treated as an employee is detrimental to the partner. For example, a partner who provides services for one partnership and receives a W-2 from that partnership, but who also participates in other self-employed activities that produce a net loss. Instead of the partner reducing his or her self-employment tax by netting the loss activities against the income activity on his or her personal tax return, the partnership has withheld and paid too much FICA on the income that was reported to the partner on the W-2.


Employment Benefit Issues

Employers and employees benefit from certain tax advantages for payments by the employer of health, welfare, fringe benefit and cafeteria plans for the employee. Employees are not required to recognize taxable income upon receipt of these benefits and the employer is entitled to a deduction. Improper treatment of partners as employees may therefore result in under-reporting of income by the partner.


Additionally, since partners are not allowed to participate in cafeteria plans, a partnership treating partners as employees risks disqualifying the cafeteria plan and losing the tax benefits it was intended to provide.


It is important to note that, even though an S- corporation owner can be an employee of the S- corporation, there are very specific rules regarding tax treatment of employee benefits for shareholders owning more than 2% of the S-corporation. These rules are not covered here.


Other Issues - Substantial Authority Doctrine

Perhaps the most significant reason to address any existing situations in which a partnership is treating one or more partners as employees is the fact that tax return preparers may not be able to sign a tax return under these circumstances as they may violate the substantial authority doctrine of IRC § 6664, as well as the AICPA Statement on Standards for Tax Services No. 1, Tax Return Positions.



Although employment tax and employee benefit issues are perhaps the most common issues that arise when a partner is improperly treated as an employee, be aware that other areas may be affected as well - DPAD, state apportionment and the tax-free receipt of a profits interest, to name a few. Careful consideration to the particular facts and circumstances surrounding a specific situation should be evaluated to determine the appropriateness of treating a partner or LLC member as an employee before taking such a position on a tax return.


If you have any questions, please contact your Rödl & Partner office.



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