Tax News
Temporary Regs Shut Down Partner-Employee Planning
May 04, 2016
Administrative Actions
In the investment fund and private M&A world it is very common to issue profits interest to key-men. In the investment fund context these could be top traders for example who share in the GP’s carry. In the private M&A context these would be non-founding member executive talent. Often these individuals would be perceived by the founders and other parties as employees but would be remunerated like partners. In fact, many times, individuals who were previously purely treated as employees are converted to profit interest members.

That usually presents a predicament from a tax perspective. An ancient IRS ruling (Rev. Rul. 69-184) states that a bona-fide partner cannot be an employee of the partnership. The end-result of this ruling is that a profit interest member cannot get a W-2 and is generally treated as self-employed for FICA/FUTA purpose.  Well, this peculiarity is difficult to explain to non-tax people. Moreover, the end-result is often undesirable from a business perspective, i.e. the executives want to continue to receive W-2s and have the fund withhold just as before the issuance of the profits interest. Also, they may want to continue to participate in employee plans which are otherwise not available to partners. Two main workarounds to this issue have usually been implemented in the past. One, a disregarded SMLLC is dropped down below the profit interest partnership. The SMLLC employs the partners. The position is that for employment tax purposes the LLC is treated as a corporation. The other approach has been to create an incentive holdco above the operating partnership that would house the profits interest for executives who work at the opco.

The IRS now has come on the record that the former option (the SMLLC drop-down) does not work.  The preamble to Temp. Reg. 301.7701-2T explains that the rule that a disregarded entity is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a disregarded entity. Accordingly, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

This rule is one of those where it is difficult to find rhyme or reason but alas, it continues to persist. There were some comments in the past indicating that the IRS is reconsidering the rule altogether. The rule seems to add unnecessary administrative complexity and cost, not to mention, that in the profits interest context it translates to the business person with apparent difficulty.  In all likelihood, what will end up happening as a result of these temporary regulations is that drop-down LLCs will be converted to above the opco incentive holdco-s, adding yet another layer of administrative cost.   

The temporary regulations can be found here
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Tags: RIN 1545-BM87, 301.7701–2T, profits interest, employment tax