Evolution in pay practices over the past two decades has piqued interest in a common question arising in the partnership area: How do partnerships treat (former) employees once they receive an equity interest in a partnership? May a partner in a partnership also be an employee of the partnership in which the partner holds the partnership interest? (That is, may a partner in a partnership also be an employee of the same partnership for purposes of the Federal Insurance Contributions Act (FICA) and the collection of tax at source on wages. (1))
This renewed interest is driven by compensation practices that have shifted dramatically over the past two decades. Even with two economic downturns driving down profits and drying up job prospects, employers often found (and continue to find) it difficult to retain key talent without offering them some kind of equity interest. In the case of a partnership, providing an equity interest can have significant consequences. For example, whereas employees can exclude from income certain employer-paid benefits, partners may not exclude those benefits when paid by the partnership. Moreover, partners are strictly prohibited from participating in some employee benefit plans.
Often, the partnership interests granted to employees are very small. Because many employees who receive these small interests do not understand or want to comply with the more complex tax rules associated with being a partner in a partnership (including a more complicated individual income tax return), partnerships often want to continue to treat the partner/former employee as an employee for purposes of withholding and remitting FICA taxes. Other times, through oversight, a partnership simply fails to change the employee's treatment in its accounting system. For these and other reasons, tax advisers often are asked whether it is possible to treat a partner/former employee as an employee for nurboses of withholding and remitting FICA taxes.
This article examines the general test for employee status and some of the ways federal tax law treats employees differently from partners and the consequences and risks of treating a partner as an employee. Next, the article looks at common planning techniques to avoid the IRS's prohibition (2) on a partner also being an employee of the partnership in which the partner holds a partnership interest for employment tax purposes. Finally, the article recommends action Congress could take to solve this problem.
Employee vs. Partner Status Test for Determining Employee Status
The Code does not define the term "employee," (3) but current Treasury regulations provide useful guidance regarding when an individual is an employee for federal tax purposes. Generally, an employer-employee relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services both with respect to (1) the result but also as to the details and (2) the means by which the result is accomplished. (4) Moreover, people who follow an independent trade, business, or profession in which they offer services to the public are generally not employees. (5) Importantly, whether an employer-employee relationship exists will be determined based on all the facts and circumstances, (6) and any designation placed on the relationship by the parties "is immaterial" to the determination. (7)
The IRS has set forth 20 factors it uses to determine whether an employer-employee relationship exists. (8) The importance of each factor varies based on the particular circumstances of each case. Moreover, no one factor is deemed controlling.
Differences in the Tax Treatment of Employee vs. Partner
U.S. federal tax laws make numerous distinctions between a partner and an employee.
FICA and wage withholding vs. self-employment taxes: One area of distinction is how partners and employees pay their Social Security (old-age, survivors, disability insurance) (9) and Medicare (hospital insurance) taxes, which are commonly referred to as employment taxes. (10) Employees, through FICA, pay only half of the employment taxes on their wages and make that payment via withholdings from their payroll checks, which their employers then remit to the U.S. government. (11) Individual partners, however, through the Self-Employment Contributions Act (SECA), pay the full amount of their employment taxes and pay the taxes via quarterly estimates. (12)
Importantly, because an individual partner owes the entire amount of his or her employment taxes on the partner's self-employment earnings, if a partnership pays part of the partner's tax, then the partnership should report the amount paid on the partner's behalf as a guaranteed payment to the partner (13) (i.e., any time a partnership pays a liability of a partner, the payment should be treated as a distribution to the partner followed by the partner's payment of the partner's employment tax liability (14)). Additional employment taxes will be due on those guaranteed payments. Moreover, any amount of employment tax not paid by the partnership on the individual partner's behalf must be paid directly by the partner.
Finally, if the partnership pays part of an individual partner's employment taxes, but the partner is involved in other self-employment activities (other partnerships or sole proprietorships) and those other activities lose money, then the partnership may overpay the partner's employment tax liability. (The Code imposes employment taxes on the "net earnings from self-employment" of individual partners, (15) which includes income or loss from every partnership in which the individual partner holds an interest and net income from any other trade or business activity carried on by the taxpayer. (16))
Certain benefit plan participation: Another area of distinction between a partner and an employee relates to the right to participate in certain benefit plans.
Health, welfare, and fringe benefit plans: The income tax rules for health, welfare, and fringe benefit plans prohibit partners from excluding the value of benefits from income in the same way that employees can (17) Health, welfare, and fringe benefits paid on behalf of a partner are generally not excluded from the partner's income (18) and are treated as guaranteed payments because they are made without regard to the partnership's income. The value of those benefits is therefore included in the partner's gross income. (19) The partner may be entitled to a deduction on his or her individual return to the extent provided in Sec. 162(1).
Cafeteria plans: The rules related to cafeteria plans are even more onerous than the ones for other employee benefits. Partners are strictly prohibited from participating in cafeteria plans. (20) Thus, including partners in cafeteria plans may disqualify the plan entirely and result in a loss of the tax benefits sought when adopting the plan.
Tax-Free Receipt of Unvested Profits Interests
Before 2001, taxpayers and their advisers were unsure whether the recipient service provider of an unvested profits interest in a partnership could make an election under Sec. 83(b) to accelerate the timing of the taxable event to the time of grant (when the fair market value (FMV) of the interest was $0 under existing IRS guidance) versus the later time of vesting (when FMV may be significant). (21) Some questioned whether Sec. 83 applied solely to corporations and not to partnerships. Most advisers believed, however, that Sec. 83 also applied to a transfer of partnership interests for services. Thus, a Sec. 83(b) election could be made upon receipt of an unvested profits interest, and taxpayers were advised to make a Sec. 83(b) election upon receiving the interest.
In 2001, the IRS issued Rev. Proc. 2001-43 (22) providing that, so long as certain conditions are satisfied, the IRS will not tax the receipt of an unvested profits interest by a service provider (i.e., the interest will be treated as being received as of the date of grant when the value is $0--not at the future vesting date when the value may be significant). Assuming the recipient service provider complies with the revenue procedure, he or she does not even have to make a Sec. 83(b) election (i.e., Rev. Proc. 2001-43 applies without any action on the part of either the partnership or the partner so long as its requirements are satisfied).
In addition to complying with all the rules of Rev. Proc. 93-27, (23) Rev. Proc. 2001-43 adds, among others, the following requirement:
The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes 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. (24) Continuing to treat a partner who has received an unvested profits interest as an employee for purposes of withholding and remitting employment taxes, issuing the partner a Form W-2, Wage and Tax Statement, etc., likely runs afoul of the additional requirement set forth above. Thus, any partner who is treated as an employee at any time after receipt of an unvested profits interest likely cannot satisfy Rev. Proc. 2001-43, and, thus, the IRS will likely argue that the issuance of the profits interest ought to be fully taxable upon vesting at the then FMV.
It is important to note, though, that Rev. Proc. 2001-43 is a safe harbor; taxpayers may always argue for a given result even if they do not satisfy the safe-harbor requirements. Thus, if a partnership continues to treat a partner as an employee after the partner receives an unvested partnership profits interest in exchange for services, the partnership and the employee may argue that existing case law supports their position that the tax implications...