Can a Partner Be an Employee?

Can a Partner Be an Employee?

There is a real difference for employment and self-employment tax purposes between being a partner and being the employee of a partnership (references to a partnership include a limited liability company or a limited partnership).  Partners are liable for making their own payments of self-employment tax and estimated income tax. Employees of a partnership do not make estimated tax payments.  Instead, the partnership withholds payroll taxes for its employees.  This is particularly important because a lot of limited liability companies (which are usually taxed as partnerships) treat partners that they have granted equity to as employees in contravention of the tax law.

A common form of providing incentive compensation for employees of a partnership is the issuance of a profits interest.  A profits interest is an interest that would give the holder no share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.  A profits interest gives the service provider a share of the appreciation and future cash flow of the partnership’s business but is not taxable on issuance.

The ability to issue profits interest to service providers is a real advantage that partnerships enjoy over corporations.  Partnerships are available to issue non-qualified options, phantom interests and virtually every form of equity-derivative incentive compensation that a corporation may issue other than incentive stock options.  Incentive stock options may give rise to alternative minimum taxable income for an option holder.  A profits interest does not give rise to income on receipt or when the profits interest becomes eligible to receive partnership distributions (of course, income allocated from partnership operations is taxable to the profits interest holder).

Revenue Procedure 2001-43 calls for the partnership and the service provider to treat the service provider as the owner of the partnership interest from the date of its grant and for the service provider to take into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the service provider has the interest.  If an employee of a partnership receives a profits interest in that partnership, is that employee instantly converted to a partner?

Treasury Decision 9766 is the preamble to recently issued temporary regulations affecting disregarded entities.  In that Treasury Decision, Treasury stated that the purpose of the temporary regulation is to clarify that a disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, who is treated as a sole proprietor, or employing an individual that is a partner in a partnership that owns the disregarded entity. Rather, the entity is disregarded as an entity separate from its owner for this purpose. The regulations provide that the entity is disregarded for self-employment tax purposes and specifically note that the owner of an entity treated in the same manner as a sole proprietorship under § 301.7701- 2(a) is subject to tax on self-employment income.

That temporary regulation expressly deals with disregarded entities, including single member partnerships.  Note that Revenue Procedure 2001-43 calls for the holder of a profits interest to be treated as a partner for all purposes from the date of grant.  However, in 2005 the Internal Revenue Service (IRS) released for discussion a proposed revenue procedure that would treat profits interests as subject to Section 83, with payments on unvested profits interests treated as compensation and not partnership distributions.  That position points up the bipolar treatment that the IRS has taken toward profits interest holders.  Is the employee of a partnership who holds a small profits interest suddenly subject to self-employment tax and quarterly estimated tax payments?  That employee may never have paid quarterly estimated taxes in his or her life, especially if the employee would otherwise properly be classified as an employee in the absence of a strained position that all profits interest holders should be treated as partners for employment tax purposes.  Does the IRS really want to abandon the withholding at source treatment in place for three quarters of a century for owner-employees of a partnership?  Certainly, in the area of S corporation taxation, the IRS has been active in treating income distributed to shareholder-employees as compensation and not distributions.

Nevertheless, in Treasury Decision 9766, the IRS expressed some uncertainty in the treatment of profits and distributions to a service provider holding a profits interest.  That uncertainty may be attributable to the IRS’s policy originally set forth in Revenue Ruling 69-184 and carried through in Revenue Procedure 2001-43, that a partner is a partner for all purposes—unlike an S corporation shareholder-employee.

In Treasury Decision 9766, Treasury noted:

“Several commenters have requested that the IRS provide additional guidance on the application of Rev. Rul. 69-184 to tiered partnership situations, and have also suggested modifying the holding of Rev. Rul. 69-184 to allow partnerships to treat partners as employees in certain circumstances, such as, for example, employees in a partnership who obtain a small ownership interest in the partnership as an employee compensatory award or incentive. However, these commenters have not provided detailed analyses and suggestions as to how the employee benefit and employment tax rules would apply in such situations. The Treasury Department and the IRS request comments 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, and the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe 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.” (emphasis supplied.)

So, for the time being, at least, the Treasury and the IRS have thrown their hands in the air and walked away from providing express guidance on the treatment of remuneration to a partner, especially a service provider who is primarily an employee under the IRS’s own guidance.  Employers that are partnerships are left in no man’s land on this issue until proper guidance is available from the IRS.

An LLC employing a number of people who would otherwise be classified as employees but are treated as partners because they each hold small profits interests must weigh the risks in treating the service providers as partners.  If any of them is hurt, will he or she be eligible for workers compensation?  If any of them is terminated, will he or she be eligible for unemployment compensation?  Those determinations are made by state agencies not bound by 47-year-old IRS revenue rulings.  When the partner/employees fail to pay self-employment tax and quarterly tax payments—as many of them almost certainly will—will the IRS look to the LLC for failure to have withheld from service providers who in the context of a corporation almost certainly would be classified under the 20 common law factors as employees?  Finally, and one of concern to any CEO, CFO or manager of such an LLC, if the LLC’s business fails, will the IRS come looking to them personally for the taxes that should have been withheld on the theory that they failed to have withheld and paid over employment taxes?

Some practitioners have advised issuing profits interests from the operating LLC to a newly formed LLC all of whose members would be the service providers who would be receiving profits interests for the services performed for the operating LLC.  That expedient avoids the issue of having the service providers being classified as members of the operating LLC.  Consideration should be given to employing such a device until definitive guidance is issued on the treatment of profit interest holders who otherwise would be classified as the operating LLC’s employees.

Given the potential risks to an LLC and its management in not treating the profits interests holders as employees and the very little upside in treating them as partners, it may still be prudent for LLC management to continue to treat as employees any service providers holding profits interests but who would otherwise be classified as employees.