A person who is both an employee and a partner in a partnership is not treated as an employee for tax purposes. Rev. Rul. 69-184 states “bona fide members of a partnership are not employees of the partnership [for employment tax purposes because a partner is] a self-employed individual.” An employee will generally be treated as a partner if he or she (a) receives a profits interest, (b) receives a vested capital interest, or (c) makes a Section 83(b) election.

A primary difference between the tax treatment of self-employed persons and employees is employment taxes. An employee receives a Form W-2 each year reporting the FICA taxes withheld from the employee’s wages. The employee bears the burden of half of the FICA taxes, while the employer pays the other half. In contrast, partners are considered self-employed and therefore subject to self-employment taxes. Partners pay 100% of FICA taxes rather than the 50/50 split in the employee-employer context. When a partner receives a salary, it is treated as guaranteed payments under Section 707(c) and thereby subject to self-employment taxes.

Another issue associated with a partner’s being self-employed rather than an employee is partners, unlike employees, are prohibited from participating in cafeteria plans under Section 125. Such plans allow employees to use pre-tax compensation to pay health insurance premiums, which are not treated as wages for income tax purposes. However, an employee who receives an interest in the employer/partnership can no longer participate in a cafeteria plan.

Finally, an employee’s becoming a partner impacts the calculation of the Section 199A qualified business income deduction. That deduction, as discussed in my prior blog post Section 199A Pass-Through Deduction and the Magic Number, is often based in part on 50% of the business W-2 wages for the year. As discussed above, when employees become partners, they are no longer treated as W-2 wage earners even if they continue to receive regular payments from the partnership that are not linked to profits. Therefore, their wages are not included in the 50% of W-2 wages component of the Section 199A deduction.

Some strategies may allow employees to invest in the employer/partnership without losing employment status. For example, employees may hold interests in an upper-tier partnership that in turn holds an interest in the partnership/employer. Although the IRS has asked for comments about such tiered partnership arrangements, it is common to treat the employees holding interests in the upper-tier partnership as employees of the lower-tier partnership.

John G. Hodnette is an attorney with Johnson, Allison & Hord in Charlotte.

September 14, 2022/by TAX