Tax Implications and Structuring Alternatives To Avoid Dual Partner-Employee Status
August 8, 2023
Does the grant of an unvested profits interest to an employee create “partner” status? If so, what are the tax implications of treating a partner in a partnership as an employee? What are some structuring alternatives to avoid dual partner-employee status?
In this post, we evaluate a hypothetical scenario to illustrate how different structuring options affect a company’s tax obligations and its ability to reward an employee with profits interests.
Situation
OpCo, LLC (OpCo) is organized as a limited liability company that is taxed as a partnership for federal income tax purposes. OpCo grants profits interest to key employees to motivate performance and retain talent.
Law and Analysis
An individual who receives a “profits interest” in a partnership, whether vested or unvested, is deemed to be a partner of the partnership upon receipt of the interest, regardless of whether they have a “capital interest” in the partnership (Rev. Proc. 93-27, 1993-2 CB 343 and Rev. Proc. 2001-43, 2001-34, IRB 191).
Rev. Ruling 69-184 considers a partner who provides services to a partnership to be a self-employed individual. Therefore, “bona fide members of a partnership are not employees of the partnership within the meaning of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages,” and payments received for services are not “wages” with respect to “employment” or subject to such taxes (Rev. Ruling 69-184).
IRC Sec. 3121(d)(2) defines an employee under common law rules, which classify an employee-employer relationship where the employer has control over the nature of services to be performed by the employee.
IRC Section 125(d)(1)(A) provides that all participants in a cafeteria plan must be employees for the cafeteria plan to enable plan participants not to be taxed on cash made available to them and used to purchase nontaxable benefits. Prop. Reg. 125-1(g)(2)(i) excludes self-employed individuals and partners of a partnership from the definition of employee with respect to cafeteria plans.
Reg. Sec. 301.7701-2(c)(2)(iv)(C)(2) clarifies that an LLC solely owned by a partnership is “disregarded as an entity separate from its owner” and “is not treated as a corporation for purposes of employing a partner of the partnership.”
Conclusion
Both the IRS and Treasury have taken the position that an individual cannot be an employee of a partnership in which they are a partner. Payments to a partner for services, whether such services are provided to the partnership, or to a disregarded entity owned by the partnership, are not subject to Social Security or Medicare taxes and are instead subject to self-employment taxes. It is important to note the distinction between employees that pay Social Security and Medicare taxes under the rules of IRC Sec. 3121 and partners that pay self-employment tax under IRC Sec. 1401. While a self-employment tax of 15.3% is equivalent to Social Security tax of 12.4% and the Medicare tax of 2.9%, these are different taxes levied on different entities, to the extent of the employer share of Social Security and Medicare taxes.
Partners are not eligible to participate in several types of fringe benefit plans, most notably cafeteria plans under IRC Sec. 125. Per IRC Section 125(d)(1)(A), all participants in a cafeteria plan must be employees for the cafeteria plan to enable plan participants not to be taxed on cash made available to them and used to purchase nontaxable benefits. Prop. Reg. 125-1(g)(2)(i) excludes self-employed individuals and partners of a partnership from the definition of employee. If any individual other than an employee participates in the plan, the plan is disqualified. As a disqualified IRC Sec. 125 plan, all employees participating in the plan will be taxed on what would otherwise be a nontaxable benefit, not just the partner with dual partner-employee status who participated in the plan.
Alternative Solutions
There are multiple restructuring alternatives that could accomplish the goal of rewarding an employee with profits interest, while allowing them to maintain their status as an employee or otherwise lessen the administrative burden of being both an employee and a partner. A few options are set forth below.
Option 1
Instruct the profits interest partners to contribute their interests to a newly formed LLC taxed as partnership such that the profits interest partners are owners of an upper-tier partnership that owns the profits interest. Under this arrangement, an upper-tier partnership owns the profits interest units and the individuals continue to be employees of the lower-tier partnership, whose wages are subject to Social Security and Medicare taxes instead of self-employment taxes.
Option 2
Instruct the partners to contribute their profits interest to an S corporation such that the partners are employed by the partnership and are the owners of an S corporation that owns the profits interest. Each profits interest holder could individually form their own S corporation to hold their profits interest, or the profits interest holders could contribute their interests to a commonly owned entity. Under this arrangement, an S corporation owns an interest in the partnership and the individual continues to be an employee of the partnership whose wages are subject to Social Security and Medicare taxes instead of self-employment taxes.
Option 3
Upper-tier OpCo LLC forms a lower-tier LLC that is taxed as a partnership. Upper-tier OpCo LLC then contributes its human capital to the lower-tier LLC. The upper-tier partnership would own the majority of the lower-tier partnership (e.g., 99% or 99.5%) and an existing upper-tier partner(s) would own a minority share. Upper-tier partnership would contract with the lower-tier partnership to lease the employees. The lower-tier partnership could be treated as an employer of the upper-tier entity’s partner, while the upper-tier entity maintains control of the lower-tier entity. Under this arrangement, the individual continues to be an employee of the lower-tier partnership whose wages are subject to Social Security and Medicare taxes instead of self-employment taxes. The lower-tier partnership could be used for additional business purposes as well.
Option 4
A fourth option is to have the partnership treat the profits interest holders as partners, in a sense that the partnership would pay guaranteed payments to its profits interest holders (subject to self-employment tax) as compensation for their services instead of Form W-2 wages. While these individuals typically would be responsible for making estimated tax payments with respect to the guaranteed payments, the partnership could choose to assume such responsibility, drafting the partners’ capital accounts for the estimated taxes and filing a Form 1040-ES on each partner’s behalf to transmit those amounts to the IRS.
Final Thoughts
Many factors could affect the suitability of these options for a particular partnership. The partnership should consider the flexibility of the ownership structure, its business model and desired compensation arrangements to choose whether to compensate its partners with guaranteed payments for which the partners would have to pay estimated taxes; treat its partners as a partner and have the partnership pay the estimated taxes on each partner’s behalf; or restructure operations so that the individual is an employee of one entity and a partner of a partnership for which services are not performed. As it is possible that any restructuring of operations would need business purpose, we suggest you discuss these alternatives with your legal counsel.