The Internal Revenue Service recently adopted temporary regulations to clarify that a disregarded entity that is owned by a partnership is not treated as a corporation for purposes of employing the individual partners in the partnership, even if the disregarded entity is otherwise treated as a corporation for employment tax purposes. Rather, the disregarded entity is disregarded as an entity separate from the partnership for purposes of employing the individual partners in the partnership. This means that a partner in a partnership that owns a disregarded entity (such as a limited liability company) that employs the partner, is deemed to be self-employed and is subject to self-employment taxes on the net earnings from the disregarded entity’s activities. Consequently, the partner will not be entitled to participate in certain tax-advantaged employee benefit plans that would otherwise be available to the disregarded entity’s other employees.

The existing regulations already provided that an individual owner of a disregarded entity is deemed to be a sole proprietor and is subject to self-employment taxes. The purpose of the clarifying temporary regulations was to foreclose an interpretation of the existing regulations as permitting a partner in a partnership that owned a disregarded entity to be treated as an employee of the disregarded entity and to participate in tax-favored employee benefit plans, which the Internal Revenue Service did not intend.

The Internal Revenue Service acknowledged requests from those commenting on the temporary regulations for rules that would allow treatment of partners as employees in some situations, such as tiered partnership situations and situations where employees receive small amounts of equity pursuant to employee equity compensation programs. The Internal Revenue Service requested proposals for how these situations should be treated and what exceptions from the rules would be appropriate. However, until such time as the Internal Revenue Service creates exceptions for these situations, an individual who is either (a) a direct owner of a disregarded entity or (b) a partner in a partnership or a member in a limited liability company that owns a disregarded entity, will be deemed to be self-employed with respect to the disregarded entity’s activities and will not be entitled to participate in certain tax-advantaged employee benefit plans and programs that would otherwise be available to the disregarded entity’s other employees or other tax-advantaged benefits.