Key considerations for dual-status taxpayers

Providing equity compensation or equity interests to employees and other service provides presents partnerships with unique challenges due to the restriction on “dual status” under the IRS’s long-time position.

The IRS has maintained for more than 50 years, with the support of some case law, that an individual is not permitted to have “dual status” as both a partner and an employee in the same partnership. Under this position, a partner’s salary-like payments from the partnership must be reported as guaranteed payments (as described under the partnership tax rules), which are subject to self-employment taxes rather than withholding under the Form W-2 regime for employees.

This Tax Insights provides more background on this somewhat esoteric tax technical issue and the implications for partnership businesses and their partners. It will highlight some of the strategies that partnerships have applied to manage the restriction on dual status, and discuss some of the tax issues that should be addressed by any partnership considering these strategies.

Benefits of being treated as an employee

There are several practical reasons why a partner might prefer to be treated as an employee for salary-like payments. Often, service-providing partners were first employees of a partnership and were issued partnership interests for incentive purposes. These and other partners may prefer the familiarity of the Form W-2 regime and its relative simplicity for employees. For instance, a partnership must withhold and remit FICA taxes on behalf of its employees, while partners are responsible for their own self-employment tax filings and estimated tax payments. Often, service-providing partners who are new to partner status find quarterly estimated tax payments and self-employment tax reporting an administrative burden compared to the Form W-2 regime. In addition, unlike employees, partners are unable to exclude certain partnership-paid benefits from income or participate in some employee benefit plans, such as a tax-favored cafeteria plan.

The IRS position

The IRS position on dual status is not limited to situations in which an individual partner receives salary-like payments under the Form W-2 regime from the legal entity that is the actual partnership. The dual-status position applies also to situations in which an individual receives payments under the Form W-2 regime from a disregarded entity that is owned by the partnership.

In 2019, the IRS finalized regulations that clarify the employment tax treatment of partners in a partnership that owns a disregarded entity. Generally, an entity that is disregarded from its owner for U.S. federal tax purposes is nevertheless treated as a corporation for U.S. federal employment tax purposes. However, these 2019 final regulations (as well as the temporary regulations that preceded them) provide that a disregarded entity that is owned by a partnership is not treated as a corporation for the purpose of determining the self-employment status of the partnership’s partners. In effect, the 2019 regulations shut down a workaround applied by some taxpayers in which service providing partners would receive a Form W-2 (Wage and Tax Statement) from a disregarded entity owned by a partnership, while receiving a Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc.) from the partnership itself. This recent regulatory action shows that the IRS continues to oppose partner dual-status.

Potential exposure

Despite the fact that dual-status treatment enables the IRS to collect taxes via withholding at the partnership level, which may be more reliable than payment of estimated taxes on an individual-by-individual partner basis, mischaracterizing partners as employees could entail significant risk.

For one, mischaracterizing partners as employees is inconsistent with the IRS’s position. The partner-versus-employee status may also affect an individual’s ability to participate in various partnership-sponsored employee benefit plans, such as retirement and health plans. Because partners are prohibited from participating in some tax-favored employee benefit plans, including them in the plans could jeopardize the benefit plans for all employees, not just partners. Also, certain partnership-paid benefits, such as health insurance, are included in the partner’s income, which means the partner’s gross income could be understated when a partner is incorrectly treated as an employee.

In addition, a “dual-status” partner who intends to rely on Revenue Procedure 2001-43 to obtain favorable tax treatment upon the issuance of an unvested partnership profits interest faces the risk that, if partner and employee status are mutually exclusive, the partner has not complied with the Revenue Procedure’s requirement that both the partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant (potentially resulting in a far greater inconvenience than being required to make estimated payments).

There could also be exposure related to FICA and self-employment taxes. The partnership may have over withheld and paid FICA taxes and overstated its FICA tax deduction on the Form 1065 for its share of FICA taxes. In addition, the service provider may have understated self-employment taxes. It is very difficult to recharacterize within the IRS’s systems withheld (and employer-paid) FICA taxes as self-employment taxes.

A partnership’s state tax apportionment may be incorrect because Form W-2 wages may be treated differently than guaranteed payments when determining apportionment. Also, items that are based on Form W-2 compensation paid to employees, such as the Section 199A deduction, may be incorrect when guaranteed payments are treated as Form W-2 compensation.

Potential dual-status strategies

A partnership can avoid dual-status issues by simply excluding partners from the applicable tax treatment available only to employees and reporting salary-like compensation paid to partners as guaranteed payments on a Schedule K-1, rather than wages on Form W-2.

Partnerships have also devised a variety of approaches to manage the prohibition on partner dual-status. Each of these strategies presents its own tax issues and needs to be examined on a case-by-case basis. Two examples include:

• Services entity: A “services entity” structure uses an affiliate of the partnership (i.e., not a disregarded entity owned by the partnership) to issue a Form W-2 to service providing partners. The affiliate, instead of the individual, then is reported to be providing services to the partnership. However, the determination of whether the service provider is actually a common law employee of the affiliated services entity can be a complex, fact-intensive analysis. An individual may actually be viewed as providing services to the partnership and not to the services entity.
• Holding company: This structure allows service providers to continue to be employed by the operating partnership or its disregarded entity, and instead hold a partnership interest in a management holding company that in turn owns the interest in the operating partnership. This can be achieved by having the service providers transfer interest in the operating partnership to the holding company in exchange for a partnership interest in the holding company, or by having a holding company with an operating partnership interest issue an interest in the holding company to the service providers. In connection with the issuance of the 2019 final regulations, the IRS asked for comments about the potential application of the prohibition on dual-status to tiered partnership structures like these. The viability for tax purposes of using a management holding company structure hinges upon the ability to respect the management holding company as a partnership separate from the lower-tier employer partnership under general federal tax principles. Taxpayers may face challenges in pursuing a position of a management holding company as a separate partnership in certain “back-to-back” arrangements in which the partnership interests in the management holding company are intended to be economically indistinguishable from an interest in the lower-tier partnership. If the separateness of the two partnerships cannot be sustained, then the two entities face a risk of being viewed as one entity for federal tax purposes, resulting in service provider partners having dual status.