The Internal Revenue Service has released final and temporary regulations on the self-employment tax treatment of partners in a partnership that owns a disregarded entity and whether they can participate in employee benefit plans.
The regulations take effect Wednesday. The Tax Code states that, except as otherwise provided, a business entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner, thus making it a “disregarded entity.” However, the Tax Code also says a disregarded entity is treated as a corporation for purposes of employment taxes. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of employment taxes.
While the Tax Code treats a disregarded entity as a corporation for employment tax purposes, the rule does not apply for self-employment tax purposes. After setting forth this general rule, the regulation applies this rule in the context of a single individual owner by saying that the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on self-employment income. The regulation also includes an example that specifically illustrates the mechanics of the rule. In the example, the disregarded entity is subject to employment tax with respect to employees of the disregarded entity. The individual owner, however, is subject to self-employment tax on the net earnings from self-employment resulting from the disregarded entity’s activities.
The regulations do not include a separate example in which the disregarded entity is owned by a partnership. According to the document, it has come to the attention of the Treasury Department and the IRS that even though the regulations set forth a general rule that an entity is disregarded as a separate entity from the owner for self-employment tax purposes, some taxpayers may have read the current regulations to permit the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity because the regulations did not include a specific example applying the general rule in the partnership context.
Under this reading, which the IRS said was not intended, some taxpayers have permitted partners to participate in certain tax-favored employee benefit plans. The Treasury Department and the IRS pointed out that the regulations did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rule. Instead, the general rule applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity.
The Treasury Department and the IRS clarify in the temporary regulations 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 any individuals who are partners in a partnership that owns a disregarded entity. The rule that the entity is disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. Accordingly, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.
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