The Internal Revenue Service (the “IRS”) issued temporary and final regulations, effective May 4, 2016, clarifying the employment tax treatment of partners in a partnership that owns a disregarded entity (the “Final Regulations”).

Specifically, the Final Regulations provide that an individual who is both an employee of a disregarded entity and a partner in the partnership that owns such disregarded entity (including an individual who owns a profits-interest in such partnership) shall be treated, for employment tax purposes, only as a partner of the partnership and not as an employee of the disregarded entity.

While it has been the long-standing position of the IRS that individuals granted profits interests are treated as K-1 partners and not as W-2 employees, many companies have implemented different structures, including a pass-through entity structure, in an attempt to treat such individuals as W-2 employees, since K-1 partners are responsible for self-employment taxes, are ineligible for certain benefit plans, and are required to make estimated tax payments to the IRS.

By issuing the Final Regulations, the IRS has not only clarified that a company cannot use a disregarded entity scheme to treat individuals granted profits interests as W-2 employees and not as K-1 partners, but the IRS has also made it clear that individuals granted profits interests are treated as K-1 partners, and any structure trying to avoid such result will be heavily scrutinized.

The Final Regulations will be effective as of the later of (1) August 1, 2016; or (2) the first day of the plan year that begins after May 4, 2016.

If you have questions or comments about the temporary and final regulations, or any of the rules surrounding profits interests, please contact one of the authors or the Reed Smith attorney who sent you this alert.

Client Alert 2016-208