IRS Shuts Down Work Around for Treating a Partner as an Employee

The IRS has long taken the position that a partner cannot also be an employee of the partnership. The prohibition also applies to persons that hold equity in a limited liability company (“LLC”) that is taxed as a partnership – an LLC member cannot also be an LLC employee.

Not permitting dual partner or member/employee status in today’s business environment can be problematic. The use of LLCs has grown exponentially and so has the use of equity incentive compensation for the millennial generation and start-ups. Issuing incentive equity to an employee turns him or her into a partner for tax purposes. This often results in unwanted consequences for the former employee, such as not having income taxes withheld on compensation, being required to pay self-employment taxes and to file quarterly estimates on self-employment income, and perhaps no longer being eligible for certain employee benefits.

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