Can a Partner/LLC Member be Treated as an Employee?

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IRSWe are often asked whether an LLC, which is treated as a partnership for income tax purposes, can pay a member as an employee on a W-2 rather than simply making gross distributions from which the member pays self-employment taxes and makes quarterly estimated payments for income taxes.  The short answer is no, but read on and learn why and what may be in the offing.

Interestingly, the main reason people prefer to be paid as an employee is not tax motivated.  While there may be some minor benefits in the form of ability to participate in certain plans available to “employees,” the primary reason is because the LLC members prefer to have employment taxes and income tax withholding done with their regular compensation payments.  They do not want to have to make estimated payments, are confused as to how to compute those amounts, and we have seen many cases where the member, on April 15, is obligated to make a large payment of income taxes but the money has been spent.  The justification for paying a member as employee is the practical notion that the government should be happy to get its money sooner rather than later and they are more assured of receiving payment when it is made on a regular basis as the member receives his compensation.  Nevertheless, the position of the IRS is, and has been for almost 50 years, that a partner cannot be an employee.

The issue was brought to light last year when temporary Regulations were issued with respect to a particular method that taxpayers were using to get around the general rule.  (Regulation §301.7701-2T) The IRS became aware of an attempt to get around the IRS’s long standing rule promulgated in Rev. Rul. 69-184 which flatly provides that bona fide members of a partnership are not employees for FICA, FUTA, or income tax withholding purposes, regardless of how they might be characterized for state law purposes.  While over the years there have been a few cases that may have suggested otherwise, many cases, and the most recent case, follow the position stated in Rev. Rul. 69-184.  What last year’s temporary regulations dealt with was a particular (and in the view of the IRS, an inappropriate) attempt to get around that rule using disregarded entities.

The §301-7701-2 regulations hold, among other things, that an LLC owned by a single member is disregarded as a separate taxable entity from its owner for income tax purposes.  However, those same regulations do treat disregarded entities as an employer for employment tax purposes giving the example of an LLC that is owned by a single individual taxpayer.  In that case, the LLC is treated as the employer for employment tax purposes and withholds and pays over employment and income tax withholding payments.  In reliance on this example in the Regulations, an LLC would create a wholly owned subsidiary LLC which is disregarded for income tax purposes as separate from the parent LLC.  Business was conducted through the subsidiary LLC and some members of the parent LLC were then paid by and treated as employees of the subsidiary LLC.  In reliance on the regulations recognizing the disregarded entity as an employer for employment tax purposes, the companies felt that treating the members of the parent LLC as employees of the subsidiary entity was proper and they were paid on a W-2.

The newly issued temporary regulations come out flatly against that position.  The regulations themselves are fairly short and simply note that the example given with the sole proprietor type LLC was not intended to apply to a disregarded entity owned by a partnership or to change the long standing rule stated in Rev. Rul. 69-184.  An additional example is provided of an LLC wholly owned by another LLC that is taxed as a partnership and provides that members of the upper tier LLC cannot be treated as employees of the subsidiary LLC.

What is more informative is the preamble to those regulations which indicates some willingness of the Service to reconsider Rev. Rul. 69-184 in certain circumstances and to request comments.  Commentators have noted that there are situations where perhaps the blanket rule itself is inappropriate.  Those are typically situations where an individual who may have historically been an employee of a company is given a very small, compensatory profits interest in the company usually as an incentive to continue.  Commentators have questioned whether it would be more appropriate to continue to treat the individual as an employee with regard to his compensation, noting that the Service has held, in other areas (such as with TEFRA rules and in determining if there have been terminations of partnerships under Section 708) that even a de minimus interest in the partnership is sufficient to treat a person as a partner.

Comments are also requested on some aspects of the new regulations that are left unanswered.  The temporary regulations deal only with an LLC-partnership that is the sole owner of another LLC which is therefore a disregarded entity.  Unanswered is the proper treatment of a tiered partnership where the lower tier LLC is not a disregarded entity but is itself a partnership.  Can a partner in the upper tier partner be treated as an employee of the lower tier partnership?  At this point the Service has only said that they will review these matters on a case by case basis looking at such things as the level of ownership of the lower tier “employee” in the upper tier partnership and the historic services that he may provide for the company.  At this point, if even a de minimus interest in the lower tier entity could result in its being treated as a partnership, the new regulations by their terms do not apply to whether the upper tier member could be treated as an employee of the lower tier “partnership.”  This is among the issues now being considered and hopefully there will be guidance in the future.

In the meantime, it appears that taxpayers are stuck with the IRS position in Rev. Rul. 69-184 meaning simply that if a person is a partner in an LLC taxed as a partnership (or other partnership) for tax purposes, he cannot be paid on a W-2 and treated as an employee.  In fact, given the recent developments in this area, it would be difficult to defend that position on a return.  There is typically not a lot of activity in this area since for the most part treating the partner as an employee resulted in all of the taxes due being paid in any event but this is apparently something that the Service is beginning to look at more seriously and our recommendation would be not to treat persons that are partners in a partnership for tax purposes as an employee for employment tax and withholding purposes.


Arthur DiPadovaArthur A. DiPadova is a shareholder in the firm. He earned his J.D. at the Rutgers University School of Law, where he graduated with honors. He earned his LL.M. in Taxation at New York University. Mr. DiPadova’s particular areas of expertise include estate, partnership and real estate taxation, corporate taxation and business planning.