Treating Partners as Employees: Risks to Consider Continuing to Treat an Employee of a Partnership Who Has Received an Equity Interest in the Partnership as an Employee Can Create a Number of Tax Problems

More and more businesses, including partnerships, are awarding equity interests to valued employees to keep them.  Partnerships often are unaware that even a small equity interest can stop the new partner from continuing to be treated as an employee for tax purposes.  Failure to treat these partners correctly can have numerous adverse tax effects, such as overpaying FICA tax, causing benefits paid on the partner's behalf to be taxable to the partner, and accelerating the taxation of certain bonus payments.  Other risks include problems with state tax apportionment formulas and miscalculating the Sec. 199 domestic production activity deduction.  Although several planning techniques are available to avoid this problem, none are without shortcomings.  In today's business environment, where many businesses find they cannot retain key employees without offering equity interests in the businesses, partnerships often grant employees interests in the company. Even a very small partnership interest, however, can cause the employee to be treated as a partner, not an employee, for federal tax purposes, while the partnership often mistakenly continues to treat the partner as an employee. This article examines problems raised by this incorrect treatment. This error can have many tax consequences, not the least of which is the mistaken tax treatment of the partner's income as wages subject to Federal Insurance Contributions Act (FICA) taxes under Sec. 3101, Federal Unemployment Tax Act (FUTA) taxes under Sec. 3301, and income tax withholding under Sec. 3402 (called employment taxes in this article), instead of self-employment income subject to self-employment tax under Sec. 1401 (Self-Employment Contributions Act (SECA)), which is not subject to wage withholding.  Generally, under Regs. Sec. 31.3401 (c)-1, if a person has a right to control or direct the individual who performs the services, the individual will be deemed an employee. Beyond this, the term is defined by applying common law rules. The IRS uses a 20-factor test based on case law to determine whether an employer-employee relationship exists (Rev. Rul. 87-41). CURRENT STATE OF THE LAW: TREATING A PARTNER AS AN EMPLOYEE Cases interpreting the 1939 Code held a partner could not be an employee of his partnership under any circumstances, by adopting the aggregate theory of partnership taxation (see, e.g., Robinson, 273 E2d 503 (3d Cir. 1959)). When Congress enacted the 1954 Code, it provided that a partnership could be an aggregate of its partners or a separate entity. Where no view of partnership taxation was adopted by a given Code provision, the view that was "more in keeping with the provision" should prevail. One Code provision that treats a partnership as a separate entity from its partners that was adopted in the 1954 Code is Sec. 707(a). It provides that, if a partner engages in a transaction with his or her partnership in other than his or her capacity as a member of the partnership, the transaction will, except as otherwise provided in Sec. 707, be treated as a transaction occurring between the partnership and one who is not a partner. Sec. 707(a) introduced the possibility that, given the right circumstances, a partner may hold the dual status of partner and employee in a single partnership. Since that time, a number of cases and rulings have addressed the issue, the most significant of which are discussed below. Wilson, 376 F.2d 280 (). The first court to address whether a partner can be both a partner and an employee did not consider a payment to a partner for services but, instead, addressed whether a managing partner could exclude from income under Sec. 119 the value of meals and lodging the partnership provided.

Field of study: Business