Can partners be employees? And should they? The answer, as in many other areas of the tax law: it depends.
IRS Revenue Ruling (RR) 69-184 states, “Remuneration received by a partner from the partnership is not ‘wages’ with respect to ‘employment’ and therefore is not subject to the taxes imposed by the Federal Insurance Contributions Act and the Federal Unemployment Tax Act. Such remuneration is not subject to Federal income tax withholding.”
That seems straightforward, but some do not to take it at face value.
For instance, the California Employment Development Department has said for LLCs treated as a partnership: if a member was not a manager under the articles of organization and was subject to the direction and control by one or more managers, then the member would normally be a common law employee. This is no longer the law effective Jan. 1, 2015.
Is the Business a Partnership?
RR 69-184 applies to partnerships, so the first determination that has to be made as if the business is a partnership. A partnership has to have two or more partners. A partner can be an equity partner, a profits partner or both.
An equity partner must have sufficient size (not defined in the tax code, but many assume to be at least 1 percent) to be a partnership interest and is a partner immediately. A profits partner is a partner upon receiving the profits interest.
For instance, if a couple wholly own an unincorporated business as community property, they may elect to report the business as a partnership or as a sole proprietorship of the one running the business. The spouse not reporting the business could be an employee of the reporting spouse.
In the case of LLCs with two or more owners, the default entity of the LLC is a partnership, but the LLC members may elect to be treated as a C or S corp.
Under the C or S corp election, the LLC members may be required to be reported as employees. If they had elected to be reported as a partnership, they would not have qualified to be reported as an employee.
Change in Benefits
One issue that occurs is when a valid employee of a business becomes a partner of the business.
That new partner is no longer an employee; no longer has income tax withholding; is required to make estimated tax payments; becomes liable for the full Social Security tax instead of only paying half of the tax with the business paying the other half; and has lost some “employee” benefits, such as worker compensation, disability and unemployment benefits along with some company provided benefits. All this may come as a surprise to the new partner.
The loss of these benefits could just be the beginning for the new partner depending on what benefit plans the business may have for employees and partners.
The tax code may limit partners as to their participation in some benefit plans. Some plans require the partners to include the plan benefits in their income from the partnership while partners may not be allowed to participate in other plans.
Individual Partner’s Tax Return Limitations
If a partner is reported as an employee, the amount of income reported on their individual tax return could be a different total (W-2 gross wages plus K-1 distributive income) than just the K-1 partnership distributive income. The partnership may take a deduction for employment taxes paid plus benefits paid for “an employee” instead of limiting these items to what they should be for a partner. Thus, the partner’s individual tax return limitations may be correct and affect the tax paid by the partner on their individual tax return.
If reported as an employee, the partner may have only worked in one state while the partnership may have income in other states. With most or all of the partner’s income reported on a W-2, the remaining partner’s distributed income may be below the limits for filing in other states. If all of the partner’s income has been reported on the K-1, the partner may have to file other state returns.
Over Reporting of Self-Employment Tax
A potential problem for partners that are reported as employees is that they may end up over-reporting Social Security/self-employment taxes. This occurs if the partner has another partnership or business that creates a net self-employment loss.
For instance, spouse A is a partner of a partnership and is reported as an employee, and spouse B operates a business in a community property state. The couple elects to treat the spouse B business as a partnership. If it has a loss and spouse A has all their income from the partnership on a W-2, then the spouse B business loss portion reported for spouse A cannot reduce spouse A’s self-employment tax.
Tax Deductions and Credits
Depending on if the person is a partner or an employee not only can affect what is deductible, but also where it is deducted or if they are entitled to a credit on their tax returns. For instance, under the Affordable Care Act, what is paid by the partnership for a partner or employee can affect the amount of penalty the partner may have to pay, the amount of premium credit the person may be entitled to claim, etc.