To retain talent and incentivize performance, businesses often grant equity compensation to their employees. Granting an equity interest to an employee in a partnership has significant tax implications that should be understood by both the company and the employee before equity is granted. A partnership can be a general partnership, limited partnership, limited liability partnership, or a limited liability corporation classified as a partnership.
In this article, we will look at dual status concerns and alternative approaches to handle these concerns. The grant of equity to an individual is an incentive award that can be highly tax efficient. Generally, the grant of equity is an appreciation award (meaning the company’s value must increase for the award to become valuable). These awards are commonly classified as profits interests. If properly structured, the individual granted these profit interests will have no income on the grant date and the appreciation has the potential to be taxed at capital gains rates. Please note, there are different types of partnership interests. We will discuss the types of partnership interests and equity compensation in a future article.
Unlike with an S corporation or C corporation, a partner of a partnership cannot also be an employee for employment tax purposes. When an employee is granted an equity interest in a partnership, the individual is no longer considered an employee for employment tax purposes and the individual receives a Schedule K-1 for future pay (rather than a W-2). Recently finalized regulations also present a new dilemma when a partner of a partnership is an employee of a disregarded entity wholly owned by that same partnership. In this situation, although the partner is an employee of the disregarded entity and not of the partnership, the regulations clarify that the disregarded entity is also disregarded for employment tax purposes. As a result, the partner can no longer be an employee of the disregarded entity and would be subject to the self-employment tax rules as if the disregarded entity did not exist. Therefore, all payments from the disregarded entity to the partner or on behalf of the partner would be recharacterized as guaranteed payments to the partner.
Mischaracterizing partners as employees could entail significant risk in a variety of areas. Below are a few areas of risk:
- Payroll Taxes – The partnership may have over-withheld and overstated its payroll tax deduction. All payroll taxes paid on behalf of partners should be treated as guaranteed payments.
- Retirement and Health Plans – A partner would not be entitled to take part in certain tax advantaged retirement or health plans that are typically available for employees.
- Qualified Business Deduction (IRC (Internal Revenue Code) Sec. 199A) – Wages paid to these partners are not eligible as W-2 wages for purposes of calculating the qualified business deduction. i
- State Apportionment – Wages paid to partners would be characterized as guaranteed payments and are not included in payroll apportionment factors.
- Profits interests relying upon Rev. Proc. 2001-43 – If partner and employee status are mutually exclusive, the partner has not followed the Rev. Proc.’s requirements, and the partner would not be treated as a partner on the grant date of the equity interest. This could result in income and tax on the unvested profits interests.
Partnerships have developed a variety of approaches to manage dual status concerns. A few commonly utilized structures include:
- Management Holding Company (“Tiered partnership structure”).
- In this scenario, employee-partners would own their profits interests in another partnership sometimes referred to as a “management aggregator” (the upper tier partnership (UTP)) and the UTP would own these same profits interests in the operating partnership or holding partnership (the lower tier partnership (LTP)) owning the operating disregarded entity. As a result, the employee-partners would be partners of the UTP and can be treated as employees of the disregarded entity wholly owned by the LTP. Please note, the IRS asked for comments on these types of tiered structures. For this tiered structure to be acceptable, it is dependent on respecting the management holding company as a partnership separate from the LTP.
- Services or payroll entity.
- A separate affiliate company of the partnership issues a wage to the employee-partners. The separate affiliate company would receive a management fee from the partnership to supplement the wages paid to these employee-partners. A facts and circumstances analysis should be considered to mitigate the concerns of the employee-partners being viewed as providing services directly to the operating partnership or operating disregarded entity.
- Single Shareholder S Corporation.
- In this structure, the employee-partner owns his or her profit interest through an S Corporation. Under this scenario, the employee partner would continue to receive wages from the operating partnership or operating disregarded entity, their new S Corporation would hold their interest in the partnership, and the S Corporation would allocate the employee partner’s earnings to them via an S Corporation K-1. Careful attention to the reasonable compensation rules for S Corporations should be kept here.
We Can Help
The dual status dilemma can be difficult to navigate. The implications of granting equity interests to employees are complex and the effectiveness of these structures depends upon the facts of your situation. If you are considering granting equity compensation to employees or have other questions, please reach out to us for assistance.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.