Partnerships Can No Longer Treat Partners as Employees for Tax Purposes

August 18, 2016
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New regulations change how partnerships treat partners as employees

The IRS and the U.S. Department of Treasury recently issued regulations to address the way the former taxes partners in a partnership that has a sole owner of a non-corporate entity. Specifically, the regulations apply to partners employed by the partnership. According to a National Law Review report, in the regulation, partners in these situations are not treated as employees for employment tax and benefit plan purposes. The partners are treated as self-employed individuals.

As a result of the regulation, partnerships will need to examine their structures and the manner in which they classify their partners and employees within their company structures.

Changes in the new rules

These non-corporate entities will continue to not be subject to federal income taxes, but they will be treated as corporations for employment tax purposes. Furthermore, these entities are not treated as corporations for self-employment tax reasons either. As a result, each partner in the entity partnership will be subject to self-employment taxes on net earnings.

With partners considered as self-employed in the partnership, they will also be unable to participate in Section 125, which offers a favorable tax benefit plan. This is significant because these partners will not be able to deduct employer-provided accident and health plans from gross income.

Impact on non-corporate entities owned by partnerships

Aside for the self-employment taxes, partners that were previously regarded as employees need to be aware of compensation reporting, health and compensation benefits plans and state tax implications, according to Law 360.

The self-employment taxes calls for a partner to deduct the employer-equivalent portion of the self-employment tax when calculating his adjusted gross income.

Compensation reporting will also change because partners will not longer be able to file W-2 employment tax forms. They will not need to file this information on Schedule K-1 tax forms submitted by the non-corporate partnership entity.

Benefit & retirement plans

Health benefits plans are now treated as income tax earned by the partners, as self-employed individuals in a partnership can deduce the cost of health insurance from their net earnings.

Retirement plans are also treated differently for tax purposes. While partners can still participate in 401(k) retirement plans – and these savings vehicles’ favorable tax statuses – they will not be eligible to participate in compensation benefit plans with favorable tax structures.

The implementation date is set for Aug. 1, but any health or benefit plan or non-corporate partnership entity started before May 4 of this year will be subject to the new regulation.