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Who's the Employer?

Question 155: What effect does IRS Notice 99-6 have on your response in Q&A 154? It says that a disregarded entity can pay employment taxes as though it weren't disregarded. That seems to contradict your conclusions about partners not being employees of single member LLCs that are wholly owned by the partnership. Answer: Properly understood, I don't think it does, and one of the authors of that Notice agrees. Relax, grab a glass of your favorite beverage, and let me tell you a story about the interaction that sometimes happens with this column, and then I'll explain how I came to that conclusion. The Story Within hours after I posted Q&A 154, I received an email from the astute reader who had sent me the question. He had done some additional research and had found IRS Notice 99-6, which he thought contradicted my conclusions. I'll discuss that in just a moment. While Notice 99-6 definitely does bear on the issue and I am grateful the reader pointed it out to me, I read the Notice differently so I decided to call the people who wrote it. One of them is no longer at the IRS, but the other, John Richards, works in the IRS Chief Counsel's office. But although it was early afternoon for me here on the Left Coast, for the minions of our nation's government on the Right Coast it was supper time, so I had to content myself with leaving a voice mail. I then quickly added a paragraph to the Q&A, indicating that this issue exists and saying I had called the IRS. The following morning, Mr. Richards was kind enough to call me. He said, in effect "I was reading your column this morning and thought to myself 'That's odd. He hasn't called me.' Then I listened to my voice mail and found that you had." It turns out that Mr. Richards maintains a strong interest in this area. He just finished a thorough and scholarly article entitled "Welfare Benefits Provided By PEOs," for Tax Lawyer, a publication of the American Bar Association. (I was fascinated and honored to note that the third heading in his outline is entitled "Who Is the Employer?") Anyway, he said that he agreed with me, that Notice 99-6 does not affect the conclusions I reached. In saying that, I note that an informal conversation with me is naturally not the same as a formal position of the IRS, and that he had not separately researched the issue. I would comment that he seemed like a charming gentleman, but I'm concerned about what my endorsement might do to his career. In a recent ASPA presentation I made with Jim Holland of the IRS, I commented quite favorably about a Technical Advice Memorandum that Richard Wickersham had written about excluding independent contractors. Jim confirmed that I liked the TAM and quipped "Note to self: Repeal TAM." Regardless, thank you, Mr. Richards; and I am pleased to have you among my readers. The Issues With those preliminaries out of the way, let's look more closely at Notice 99-6, which I have posted in the Who's the Employer Reading Room. As I noted in Q&A 154, an LLC that has a single member is disregarded for tax purposes unless it is taxed as a corporation. Apparently, some taxpayers felt that this "disregarding" was limited to income tax returns. Notice 99-6 labels that view as "incorrect," and points out that the LLC is disregarded for all tax purposes, including employment tax issues. It also said commentators had pointed out that this posed practical difficulties, and they would rather file and pay employment taxes at the level of the disregarded LLC. Given this situation, the IRS has requested comments and has said that the following rules apply while they sort things out: Until additional guidance is issued, the Service generally will accept reporting and payment of employment taxes with respect to the employees of a QSub or an entity disregarded as an entity separate from its owner under section 301.7701-2(c)(2) if made in one of two ways: Calculation, reporting, and payment of all employment tax obligations with respect to employees of a disregarded entity by its owner (as though the employees of the disregarded entity are employed directly by the owner) and under the owner's name and taxpayer identification number; or Separate calculation, reporting, and payment of all employment tax obligations by each state law entity with respect to its employees under its own name and taxpayer identification number. If the second method is chosen, the owner retains ultimate responsibility for the employment tax obligations incurred with respect to employees of the disregarded entity. This method merely permits the employment tax obligations of the owner incurred with respect to the disregarded entity to be fulfilled through the separate calculation, reporting, and payment of employment taxes by the disregarded entity. In effect, the IRS has said "It doesn't really matter to us whether the correct method is followed, and the LLC's owner files and pays the employment taxes, or whether you choose instead to let an entity we are generally ignoring file the returns and pay the taxes. We just want to make sure that a return is filed and the tax is paid." This is a sensible position, to allow the taxpayer to decide what is easiest for them. The dollars end up being the same either way. Except, as regards the issue in Q&A 154. Someone might be treated as an employee of the disregarded LLC, but not be an employee of the partnership. Let me illustrate the quandry with an couple of examples: Example 1. Jack is a partner in the AB partnership. AB owns 50% of the XYZ LLC. The other 50% is owned by an unrelated entity. XYZ is taxed as a partnership. Jack performs services as one of many common law employees of XYZ. Because XYZ has two owners, it is treated as a separate entity for tax purposes, and must file its own employment tax return. Jack is not a partner in XYZ. Accordingly, XYZ treats Jack as an employee, gives him a W-2, and withholds taxes accordingly. Example 2. Same facts as example 1, except that the AB partnership has bought out the other member of XYZ, and is now the only member of that LLC. XYZ flashes out of existence for purposes of tax law. It is now simply a department or division of AB. Under the analysis of Q&A 154, Jack cannot be an employee of AB and now he cannot be an employee of XYZ. The question concerns what we do with Jack if AB chooses to have XYZ file and pay employment taxes on its employees. Does it include Jack as one of those employees or not? I answer "no," because the whole thrust of Notice 99-6 is "it doesn't matter whether AB pays the tax out of its general pocket, or out of its XYZ pocket, so long as the tax is paid." That's the effect of the IRS statement that "This method merely permits the employment tax obligations of the owner incurred with respect to the disregarded entity to be fulfilled through the separate calculation, reporting, and payment of employment taxes by the disregarded entity." (See also Rev. Rul 2001-51.) Notice 99-6 does not change the fundamentals of the tax amount or determination. It just changes how many returns are filed and payments are transferred. To treat Jack as an employee in this situation, when he clearly would not be an employee if AB paid the payroll taxes directly, would be to change fundamentally not only who pays the taxes, but also how much is to be paid. It would also add great confusion to the retirement plan arena. Why? Because Notice 99-6, by its terms is limited to "reporting and payment of employment taxes." It does not purport to affect, in any way, the determination of employee status for retirement plan purposes. This means that, regardless of how AB chooses to file its payroll taxes, Jack is a self-employed individual with respect to AB, and not a common law employee. That's the conclusion of Q&A 154 and Notice 99-6 does nothing to change that conclusion. Thus, even if AB or XYZ mistakenly gives Jack a W-2, he is still a self-employed individual and his compensation for plan purposes is computed accordingly. I know of no guidance in this area, but I suggest that Jack's compensation is based on what his net earnings from self-employment would have been had AB filed its return properly and reflected payments to Jack as guaranteed payments on his K-1. That would be his gross pay, increased by the employer's share of payroll taxes paid with respect to Jack. From this, we would deduct 1/2 of what Jack should be paying as self-employment tax, plus retirement contributions made on his behalf, to arrive at his earned income. That is the amount treated as his compensation. Other issues involving self-employed individuals are discussed in Chapter 1 of my book, Who's the Employer. If Mr. Richards or my other readers have comments, I'd be delighted to hear them. You can reach me through the Ask a Question link, below.

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Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.