Menu
Tax Notes logo

Partners, Employees, and Tiered Partnerships

Posted on Jan. 13, 2020
[Editor's Note:

This article originally appeared in the January 13, 2020, issue of Tax Notes Federal.

]
Kyle Brown
Kyle Brown
Donald B. Susswein
Donald B. Susswein

Donald B. Susswein (don.susswein@ rsmus.com) is a principal and Kyle Brown is a manager in the Washington National Tax office of RSM US LLP.

In this article, Susswein and Brown address the steps that may be needed to ensure that the IRS ruling policy against treating partners as employees doesn’t apply to tiered partnership arrangements in which a partner is an employee of a related partnership.

The views expressed in this article are not necessarily those of RSM US LLP or any of its personnel, and they are not intended to serve as tax advice.

Copyright 2019 Donald B. Susswein and Kyle Brown.
All rights reserved.

Introduction

Some partnerships would like to issue partnership interests to their common law employees without losing the ability to treat them as employees — for tax purposes — solely with respect to their fixed salaries and fringe benefits. In many cases the tax benefits sought are mainly administrative. Simply put, it is easier to file tax returns as an employee than as a partner. In some cases the individuals involved are traditional employees who are offered profits interests as part of their compensation package. In other cases they are capital partners who also provide services to the partnership in what would otherwise be viewed as an employer-employee relationship. An example might be a capital partner in an engineering or architectural firm holding a 1 percent interest in profits or losses who is also retained to deal with the firm’s tax matters, under the control and supervision of the managing partner, for a fixed salary of $100,000.

Since 1969 the IRS has maintained a ruling policy that “bona fide members of a partnership are not employees” for employment tax purposes.1 As a result, some partnerships may consider modifying their organizational structure to accomplish results they could not otherwise accomplish under the ruling policy. For example, an upper-tier partnership might own 99 percent of the interests in a lower-tier operating partnership and conduct no other activities; the lower-tier partnership might employ some of the upper-tier partners in a relationship that would otherwise qualify as employment under common law principles; the remaining 1 percent of the interests in the lower-tier entity might be owned by one of the upper-tier partners who was not providing services to either entity.

This article addresses whether those structures are likely to be respected. If not, the IRS would presumably seek to recast any salaries and employee benefits deemed paid directly to partners as guaranteed payments, with various consequences. In the past 50 years the dominant trend has been to equalize the income tax, employment tax, and qualified retirement plan rules for employed and self-employed workers (including partners in a partnership), but there are still some differences — a discussion of which is outside the scope of this article.2

Different Types of Tiered Arrangements

When the IRS ruling was first issued in 1969, partnerships occupied a much smaller and less significant role in the business world. The IRS was probably not thinking about the practice of issuing profits interests to employees of the partnership, or the possibility that an employee of a publicly traded partnership might purchase an equity interest in his employer on the stock exchange. Those practices were unheard of at the time. But the IRS has not indicated that the ruling would not apply with equal force to those cases today. In pertinent part, the ruling states that:

such a partner who devotes his time and energies in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self- employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee . . . [with the result that] 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 also is not subject to federal income tax withholding.

For those seeking to accomplish similar results without violating the ruling a tiered partnership structure may be considered. The simplest structure would involve an upper-tier partnership (UTP) that owns 99 percent of the interests in a lower-tier operating partnership (LTP) with the remaining 1 percent of LTP’s interests held by one of the upper-tier partners who was not seeking to be treated as an LTP employee. If respected, this arrangement would permit (1) an employee of LTP to receive a profits interest in UTP; (2) an employee of LTP to purchase an interest in UTP as an investor; or (3) a capital partner in UTP to be hired as an employee of LTP. Of course, this assumes that the purported LTP employee would be treated as an LTP employee under the tax rules that would apply if he were otherwise unrelated to LTP and UTP.

In 2016 Treasury issued regulations clarifying, prospectively, that the IRS ruling policy could not be avoided using a structure similar to the UTP/LTP structure involving a lower-tier entity that was a disregarded entity for income tax purposes (because the upper-tier entity owned 100 percent of its interests). Although the preamble noted that commentators had asked for guidance concerning similar structures involving tiered partnerships, neither the text of the regulations nor the preamble provided any guidance on the treatment of an ostensibly similar arrangement when the lower-tier entity qualified as a partnership because the upper-tier entity owned 99 percent of its interests, not 100 percent.3

It is beyond the scope of this article to review the evolving law on when a properly formed partnership with two or more partners will be respected as a business entity and as a partnership.4 But some conclusions seem relatively clear.

Even if a tiered arrangement were used to accomplish objectives that could not be accomplished directly without violating the IRS ruling, that arrangement should be respected as long as it was also used and needed for a business purpose other than federal tax savings. For example, even if one of the purposes or effects of the UTP/LTP arrangement was to reduce what would otherwise be the total federal taxes due by the UTP partners (such as by allowing an upper-tier partner to participate in LTP’s cafeteria plan), if the UTP was also used to obtain economic benefits for the UTP partners other than federal tax savings it should not be subject to challenge under Moline Properties5 and related authorities.

If one assumes that the IRS ruling is correct, the addition of UTP is obviously necessary to permit UTP partners to provide services to LTP as employees of LTP (which they could not do if they were partners in LTP). If that treatment provided those LTP employees (and indirectly the other UTP partners) with economic benefits other than federal tax savings, such as a reduced administrative burden associated with the filing of their federal income taxes, the common law standards for respecting the separate existence of UTP should be satisfied. Taxpayers relying on the existence of such a business purpose might be well advised to conduct a study or otherwise substantiate the reasons for using a tiered structure.

We should note that Moline Properties also states that the existence of business activity in an entity may protect the entity from challenge, even without a business purpose, and there is some authority suggesting that the business activity of a lower-tier partnership may be imputed to its partners6 — such as UTP in the UTP/LTP example. However, activity conducted or deemed conducted by a separate entity may not qualify under more recent cases if there is no business need or necessity for conducting that activity in a separate business entity.7 Thus, it may be necessary to demonstrate that the separate existence of UTP and LTP was necessary to enjoy the economic benefits of the arrangement, and that those benefits were not limited to federal tax savings.

Although some have criticized the idea of a “business need” requirement, it should not be difficult to demonstrate that it is satisfied here. That is, the parties added a partnership to the structure that satisfied the normal requirements for recognition as a business entity and as a partnership, and needed that entity to qualify as a partnership in order to achieve their nontax business purpose. For example, if the upper-tier entity held 100 percent of the interests of the lower-tier entity, the desired nonfederal tax economic benefits could not be achieved under employment tax regulations. That is, any common-law employees of the lower-tier entity who were also partners in the upper-tier entity could not have their fixed salaries from the lower-tier entity treated as W-2 wages. They would be treated as guaranteed payments by the upper-tier partnership. Even if there were no difference in their federal tax liability, treatment as guaranteed payments might increase the cost of tax advice associated with filing their Form 1040s and making estimated tax payments.

In another example, if the upper-tier entity did not have multiple partners sharing in the economic benefits and burdens associated with their ownership of an interest in the lower-tier partnership, the upper-tier entity might be viewed as a grantor trust or nominee, in which case its purported partners would be partners in the lower-tier entity that was their purported employer. That would also prevent those individuals, even if they were common-law employees of the partnership, from treating their fixed salaries as W-2 wages, on account of the IRS ruling position, imposing added costs for needed tax advice and return preparation even if their tax liabilities were unaffected. And although a similar sharing of the benefits of owning a partial interest in the lower-tier entity, along with a direct partial interest in the lower-tier entity held by one of the upper-tier partners, might be accomplished directly and ostensibly more simply without the additional upper-tier entity, the nonfederal tax benefits sought by the parties related to the treatment of the employees’ fixed salaries as salaries could not be achieved without the additional upper-tier entity; as long as there is a business purpose other than federal tax savings for using a more complex structure, the taxpayers are not required to use the simplest possible structure.

Similarly, although the tax and economic benefits of issuing a profits interest to a full-time, salaried service provider could be achieved without a tiered structure — perhaps establishing that as the conceptual “baseline” of allowable tax benefits — the added ability to continue to treat the fixed salaries of those individuals as wages — to preserve or achieve demonstrable benefits other than federal tax savings — could not be achieved without a tiered structure. In that sense, the added tier was not needed to obtain the tax benefits associated with profits interests; that benefit could be achieved without a tiered structure and was not the purpose for adding another tier. The tier was added — and needed to be added — to obtain the nonfederal tax benefits of treating the workers’ fixed salaries and associated benefits as amounts paid to employees and not as guaranteed payments paid to partners. Because those amounts were literally paid by a separate business entity otherwise qualifying as a partnership, the need for and legitimacy of the tiered structure seems clear.

Other types of tiered arrangements may also be considered. In one variant the additional entity might be a partnership that exists solely to hold any partnership profits interests that are issued to employees of the operating partnership, while other partners would hold their interests in the operating partnership directly. Such an arrangement would also need to demonstrate a similar business purpose — generating benefits other than federal tax savings from treating the workers as employees. Also, this specialized holding company must involve a true sharing of economic upside and downside among its partners. It could not be a mere conduit to hold, for each partner, the particular profits interest that would otherwise have been issued directly to that partner. That might cause the purported partnership to be looked through as a grantor trust or nominee — creating a direct conflict with the ruling policy.

In another variant the additional entity might be a partnership (or other entity) owned by the operating partnership (or some or all of its partners). That entity could enter a service contract to provide managerial or operational services to the operating partnership and could employ partners of the operating partnership to assist in performing that service contract. Of course, under the terms of the arrangement the service company would need to be respected as the true employer of those individuals.8 Also, if it appeared that there was no business necessity for creating a separate entity to act as a service company — as might be argued if the service company were owned by the partnership — a business purpose like that required in the UTP/LTP structure might need to be established; that is, achieving economic benefits other than federal tax savings from allowing some service company employees to be treated as such, even though they are also partners in the partnership that is the customer of the service company.

What Economic Benefits May Be Considered?

Common examples of economic benefits — other than federal or state and local tax savings — that might meet the business purpose test would include (1) reducing the administrative burden and financial complexities for purported employees that would be associated with filing their individual federal tax returns as self-employed persons subject to required payment of estimated taxes rather than as employees subject to wage withholding; (2) easier access to mortgage credit based on Form W-2 statements instead of Schedules K-1 and other financial information about the partnership that a self-employed borrower might be required to provide; and (3) avoiding the loss of federal or state benefits under unemployment insurance programs (perhaps computed net of the employer’s costs in added taxes) or other programs (such as the Affordable Care Act or workers compensation laws) that may turn on a worker’s status for federal employment tax purposes.

A state or local income tax savings that results from the allowance of a federal income tax benefit (such as the exclusion for state income tax purposes of cafeteria plan benefits that are excluded for federal purposes) may not qualify if the expanded definition of “economic substance” in section 7701(o) is viewed as applying to the Moline Properties test. Section 7701(o)(3) treats some state income tax effects that are related to a federal income tax effect as if they were federal tax effects. However, a state income tax savings that does not result from a federal income tax benefit but results from a different treatment for federal employment tax purposes should qualify. For example, W-2 wages are generally subject to state or local income taxes only in jurisdictions where the worker lives or works, while guaranteed payments may be taxable in every state where the partnership does business. This state or local income tax effect is not “related” to a federal tax effect; wages and guaranteed payments are both fully taxable for federal income tax purposes.

Could the Partnership Antiabuse Rule Apply?

In theory, the IRS could attack some structures if more than half of the anticipated benefits are from federal tax savings. Under the partnership antiabuse rule the IRS might argue that the addition of another partnership should be disregarded if its “principal purpose” was to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner “inconsistent with the intent of subchapter K.9 For this purpose, however, federal tax savings would evidently not include related state tax savings because section 7701(o) does not apply for purposes of the antiabuse rule. That would be another reason for conducting a study to substantiate the relative value or importance of any anticipated federal tax savings and other economic benefits.

Whatever the study reveals, however, such an IRS argument could hold water only if the IRS ruling position were viewed as manifesting “the intent of subchapter K.” That is, that subchapter K was intended to preclude partners from being treated as employees, even as to services provided in a non-partner capacity. That argument was expressly rejected by the Fifth Circuit in Armstrong.10 Also, close examination of the memorandum that accompanied the 1969 ruling suggests that the ruling had little to do with subchapter K.11

According to the memorandum, the IRS was concerned with the administrative problem allegedly posed by “dual capacity” individuals — an issue that obviously existed whether the individuals were working partners in a partnership or individuals who served a corporation or government agency as employees and as independent contractors. The memorandum explained that its legal argument against dual status was based on reg. section 31.3121(d)-1(a)(3), which referred to the “relationship” between the service provider and service recipient. The memorandum took the position that there can only be a single “relationship” or “status” at any time. Again, that would be the case whether the service recipient is a partnership, a corporation, a sole-proprietor, or a government agency:

While the ‘status’ of an individual may vary with respect to different persons with whom he may have legal relationships, we think the ordinary meaning of the term ‘status’ and its most common legal usage implies a condition or relationship which continues for the duration of the existence of a particular set of facts, particularly if a defined ‘status’ is used as a part of the criteria in determining whether one legal result or another is to follow-as here where one tax or another is to be applicable depending on, in part, the ‘status’ of the individual. To introduce the possibility of dual ‘status’ into the application of the statutes in question so that the determination of ‘wages’ under section 3121(a) would virtually have to be on a transaction by transaction basis (rather than one based on a single continuing relationship) would render it almost impossible to administer the employment taxes of subtitle C. [Citation removed.]

Assuming that analysis of section 3121 is correct, the memorandum had to address the view of the Fifth Circuit in Armstrong that section 707(a) had effectively, if perhaps inadvertently, created an exception for dual capacity partners. Reviewing the legislative history the IRS concluded that in enacting subchapter K Congress showed no intention to change what the IRS asserted was the prevailing policy of section 3121 against “dual capacity” individuals, and therefore did not intend to create an exception to that presumed policy for partners in a partnership. The memorandum concluded:

In view of all the foregoing, we are satisfied that Congress had no intention of disrupting the application of the pre-existing and reenacted rules relating to the Federal employment taxes [under section 3121] when it introduced sections 707(a) and 707(c) into the tax structure in passing the Internal Revenue Code of 1954. We find no warrant for the dictum of the Armstrong case for employment tax purposes. [Emphasis added.]

Even if this were entirely correct, to say that Congress did not intend subchapter K to create an exception from the alleged policy against dual status individuals is different from saying that the policy against dual status individuals originates in subchapter K or reflects the intent of subchapter K. That is, section 707(a) may have had the effect of creating such an exception, but as a by-product of another goal or objective. Indeed, as the memorandum explains, the core federal tax policy that arguably would be avoided if Rev. Rul. 69-184 were circumvented by using a partnership would be the alleged policy of section 3121 against dual status individuals, not anything inherent in the “intent of subchapter K.” Where applying the technical provisions of subchapter K makes it possible to avoid a rule or policy that does not originate in subchapter K the anti-abuse rule does not appear to apply.12

In addition, the argument that Congress intended, at any time, to preclude dual status appears to be contradicted by the actions of the IRS even before 1969 as well as recent statements of Treasury. Published IRS rulings outstanding since the late 1950s have recognized dual status when the facts so warrant.13 Also, the preamble to the recently issued final certified professional employer organization (CPEO) regulations recognizes dual status, and affirmatively permits a CPEO to pay both wages and self-employment income to the same individual in two capacities regarding the same customer of the CPEO.14 While the preamble notes that dual status may be uncommon, it does not appear that the IRS or Treasury views dual status as “impossible to administer” or otherwise contrary to any statutes, regulations, or other evidence of congressional intent.

Conclusion

If a partnership or other entity were added to a structure exclusively to allow one or more partners to be treated as employees, solely to enjoy federal tax savings they would not enjoy as partners, the entity added to the mix might well be disregarded under Moline Properties.

An example might be when the resident manager of a hotel with a salary of $200,000 also receives $1 million of meals and lodging on the premises of the hotel that are tax free to him as an employee under section 119. The manager is then offered a profits interest in the partnership that owns the hotel. The hotel’s tax adviser might point out that this could make the manager’s $1 million of meals and lodging taxable, because section 119 applies, by its terms, only to employees, and the IRS would likely take the position that the issuance of a profits interest to the manager would preclude treating him as an employee. The hotel might then have to reimburse the manager for that tax expense, as well as the taxes on that reimbursement. To avoid taxes of $400,000 on the manager’s otherwise tax-free meals and lodging the hotel partnership drops its operations into a lower-tier operating entity and employs the manager from that entity. If that were done solely to avoid the manager’s loss of tax benefits under section 119, the arrangement might be disregarded under Moline Properties.

On the other hand, this extreme example would raise the underlying issue of whether the IRS is correct that a partner may not be an employee — even if he is providing services in a non-partner capacity for a fixed salary and doing so in a relationship that would otherwise satisfy the common law tests for an employer-employee relationship. The leading authority on that issue, at least as applied to section 119, holds that a partner providing services in a non-partner capacity — in a relationship that would otherwise be treated as employment under common law standards — may be treated as an employee as to those services or the compensation therefor.15 The McKee treatise suggests that other code provisions may be subject to a similar analysis.16

Until these issues are more clearly resolved, partnerships are well advised to use tiered structures — rather than risk directly violating the ruling policy — and to ensure that there is a demonstrable business purpose for the arrangement other than federal tax savings (and state tax savings related to federal income tax savings).

FOOTNOTES

1 Rev. Rul. 69-184, 1969-1 C.B. 256.

2 For a helpful overview, see the recent comments prepared by the American Bar Association Section of Taxation, “ABA Section of Taxation Comments on Rev. Rul. 69-184” (Dec. 9, 2019).

3 See generally T.D. 9766; reg. section 301.7701-2(c)(2)(iv)(C)(2). The regulation provides that the disregarded entity “is not the employer of any partner of the partnership that owns the entity.” Instead, it states somewhat obliquely that such a partner “is subject to the same self-employment tax rules as a partner of a partnership that does not own an entity that is disregarded as an entity separate from its owner for any purpose under this section.” Thus, if the ruling position would apply to a partnership that employs any of its partners directly, employing them indirectly through a disregarded entity would not help.

4 See generally Robert L. Whitmire, William F. Nelson, and William S. McKee, Federal Taxation of Partnerships and Partners, para. 3.03 (1977).

5 Moline Properties Inc. v. Commissioner, 319 U.S. 436 (1943).

6 See, e.g., George A. Butler v. Commissioner, 36 T.C. 1097 (1961).

7 See ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000); Saba Partnership v. Commissioner, 273 F.3d 1135 (D.C. Cir. 2001); and Boca Investerings Partnership v. United States, 314 F.3d 625 (D.C. Cir. 2003).

8 See, e.g., Rev. Rul. 69-183, 1969-1 C.B. 255.

9 See reg. section 1.701-2(b).

10 Armstrong v. Phinney, 394 F.2d 661 (1968).

11 See GCM 34001 (Dec. 23, 1968).

12 See reg. section 1.701-2(d), examples 1 through 6, notably Example 2.

13 See Rev. Rul. 58-360, 1958-2 C.B. 423; Rev. Rul. 58-505, 1958-2 C.B. 728.

14 Preamble to T.D. 9860.

15 See Armstrong, 394 F.2d 661.

16 Whitmire, Nelson, and McKee, supra note 4, at para. 14.02.

END FOOTNOTES

Copy RID