Temporary and proposed regulations issued May 3, 2016, reaffirm Treasury’s position that an individual cannot be both an employee and a partner of the same tax partnership, and end the ability of tax planners to use a disregarded entity in conjunction with a tax partnership to change an individual’s self-employment tax treatment. Previously, tax planners would use the rule that disregarded entities are treated as corporations for employment tax purposes to setup a structure whereby a tax partnership owned a disregarded entity with the partners treated as employees of the disregarded entity and not the tax partnership. The primarily motivation for such structures was to permit the partners to be employees and enable Form W-2 withholding instead of having the partners pay self-employment tax and make estimated tax payments. The new regulations provide that the rule that a disregarded entity is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of individuals who are partners in a partnership that owns a disregarded entity. A link to the new regulations is here: https://www.gpo.gov/fdsys/pkg/FR-2016-05-04/pdf/2016-10383.pdf
In a recent ruling, the IRS confronted a partnership serving as a management company for investment partnerships and funds. Management fees were its sole source of income. The management company paid reasonable compensation subject to employment or self employment taxes to its owner-managers. Following a planning technique available to S corporations, the partnership treated its partner distributions as being exempt from self employment taxes. The IRS disagreed with the partnership’s position. The IRS ruled that the partner distributions were subject to self employment taxes notwithstanding the reasonableness of compensation paid as such to its owner-managers.
The ruling is significant because distributions from an S corporation structured in the same way probably would not have been subject to self employment tax. Indeed, the partnership in question used to be an S corporation, and the IRS specifically held that the S corporation rules do not apply to the new partnership.
The ruling underscores an evolving IRS position that treats service S corporations and service partnerships differently for self employment tax purposes. While technically understandable because different statutory and regulatory provisions govern the different entity types, the differing self employment tax treatment of these entities defies common sense.
Unless a sensible unified self employment tax policy emerges, when possible it remains wise to structure management or service companies either as S corporations or as partnerships with S corporation partners, to take advantage of the more flexible self employment tax planning options available for S corporations.
Here is link to the ruling: http://www.irs.gov/pub/irs-wd/201436049.pdf