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Working for a Disregarded Entity? Partners Must Still Pay Self-Employment Tax

The IRS has finalized a set of 2016 regulations that require partners who work for a disregarded entity owned by their partnership to pay self-employment tax on any compensation they receive.

At 15.3%, the self-employment tax is a serious tax. The IRS took the action to stop some partnerships from taking the position that their 100% owned, single-member LLCs, which are treated as separate entities, could employ partners as W-2 employees, allowing them to avoid the self-employment tax and qualifying them for tax-favored fringe benefits.

The IRS only received two comments on the proposed regulations and did not adopt the suggestions made. One comment asked that an exception be made for publicly traded partnerships (PTPs), noting that these partnerships may not know which service providers are treated as employees because individuals can purchase an interest in the PTP on the open market without the knowledge of the publicly traded partnership. The IRS declined to carve out an exception but said it will continue to consider the issue.

The final regulations make it clear: partnerships cannot use disregarded entities to put their partners on the payroll. The IRS also makes clear the early effective date of this rule. For entities with several affected employee benefit plans, the applicability date is the later of August 1, 2016, or the first day of the latest-starting plan year beginning after May 4, 2016, and on or before May 4, 2017.

The IRS is consistent in its view that partners are self-employed and must pay their payroll taxes, as these latest regulations show.

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