In today’s business environment, where many businesses find they cannot retain key employees without offering equity interests in the businesses, partnerships often grant employees interests in the company. Even a very small partnership interest, however, can cause the employee to be treated as a partner, not an employee, for federal tax purposes, while the partnership often mistakenly continues the partner to be treated as an employee. If your business is organized as a partnership, however, there are some tax traps you should avoid.
Employees pay half of the Social Security and Medicare taxes on their wages, through withholdings from their paychecks. The employer pays the other half. Partners are treated as being self-employed, paying the full amount of self-employment taxes through quarterly estimates. Often, when employees receive partnership interests, the partnership continues and the partner to be treated as an employee for tax purposes, withholding employment taxes from their wages and paying the employer’s share. The problem with this practice is that, because a partner is responsible for the full amount of employment taxes, the partnership’s payment of a portion of those taxes will likely be treated as a guaranteed payment to the partner. That payment would then be included in income and trigger additional employment taxes. Any employment taxes not paid by the partnership on a partner’s behalf are the partner’s responsibility.
The partner to be treated as an employee can also result in overpayment of employment taxes. If the partner’s self-employment activities generate losses, the losses will offset the partner’s earnings from your partnership, reducing or even eliminating self-employment taxes.
Partnerships sometimes grant unvested profits interests to employees or other service providers. Generally, these interests are not taxable until they vest. But if certain conditions are met, a safe harbor allows recipients to elect to pay the tax when the interest is granted rather than when it vests. Because profits interests often have low or zero value when granted, the election produces significant tax savings.
Partners and employees are treated differently for purposes of many benefit plans. For example, employees are entitled to exclude the value of certain employer-provided health, welfare and fringe benefits from income, while partners must include the value in their income and are prohibited from participating in a cafeteria plan. Moreover, continuing the partner to be treated as an employee for benefits purposes may trigger unwanted tax consequences or even disqualify a cafeteria plan.
If your business is contemplating offering partnership interests to your employees, consider the tax implications and potential impact on your benefit plans. Also, consider techniques that allow you to continue treating partners as employees for employment tax purposes. For example, you might create a tiered partnership structure and offer employees of lower-tier partnership interests in an upper-tier partnership. Because employees are not partners in the partnership that employs them, many of the problems discussed above will be avoided.
