Can a Partner Be an Employee of a Partnership?

The question of whether a partner can be an employee of their partnership is a common source of confusion, often stemming from the desire for a predictable salary. The answer is rooted in the specific legal and tax framework that governs partnerships in the United States. These distinctions have significant financial consequences for both the individual partners and the partnership entity.

The General Rule for Partners in a Partnership

For federal tax purposes, the Internal Revenue Service (IRS) has a clear position: a partner cannot be an employee of the partnership. This rule, established in Revenue Ruling 69-184, applies to general partners and members of a Limited Liability Company (LLC) that is taxed as a partnership. Partners are considered self-employed business owners, contributing money, property, or labor to their own venture in exchange for a share of the profits.

This classification means a partnership cannot issue a Form W-2 to a partner for services rendered. Instead of receiving a salary subject to payroll tax withholding, partners are compensated through other mechanisms. The reasoning behind this rule is to prevent partners from choosing between employee or partner status to gain tax advantages, such as avoiding self-employment taxes on their share of partnership income.

Partner Compensation and Tax Treatment

Since partners cannot receive a W-2 salary, their compensation is handled through two primary methods: guaranteed payments and distributive shares. Guaranteed payments are fixed amounts paid to a partner for services or the use of capital, made without regard to the partnership’s income for the year. These payments are often used to provide a partner with a steady, salary-like cash flow, and the partnership deducts them as a business expense.

A partner’s distributive share is their allocated portion of the partnership’s profits and losses, as dictated by the partnership agreement. This share is taxable to the partner regardless of whether the cash is actually distributed to them. Both guaranteed payments and a partner’s distributive share of the business’s ordinary income are reported on Schedule K-1 (Form 1065), which the partner uses to report the income on their personal tax return.

The tax treatment for partners is different from that of employees. Partners must pay self-employment tax under the Self-Employment Contributions Act (SECA) on both their guaranteed payments and their distributive share of partnership income. This tax covers both the employee and employer portions of Social Security and Medicare, meaning the partner bears the full cost.

Handling Partner Health and Retirement Benefits

The self-employed status of partners impacts how they receive health and retirement benefits. A partnership can pay for a partner’s health insurance premiums, but these payments are treated as guaranteed payments. This means the premium amount is deducted by the partnership and included in the partner’s gross income. The partner can then claim the self-employed health insurance deduction on their personal Form 1040.

For this deduction to be allowed, the insurance plan must be established under the business. This can be achieved if the policy is in the partnership’s name or if the partnership pays or reimburses the partner for a policy in their name, reporting the amount as a guaranteed payment. This deduction is an adjustment to income, meaning it can be taken even if the partner does not itemize deductions.

Regarding retirement, partners are not eligible for employee plans like a 401(k). Instead, they can establish and contribute to retirement plans designed for self-employed individuals, such as a Simplified Employee Pension (SEP) IRA or a Solo 401(k). Contributions to these plans are based on the partner’s net earnings from self-employment.

Alternative Business Structures for Receiving a Salary

For business owners who want to be treated as employees and receive a salary, forming a corporation is the primary alternative to a partnership. An S Corporation is a distinct legal and tax entity that allows owner-shareholders who work in the business to be classified as employees. An IRS requirement for S Corporations is that any shareholder who performs more than minor services for the company must be paid a reasonable salary. This salary is reported on a Form W-2 and is subject to FICA tax withholding.

This structure offers a tax difference compared to partnerships. While the reasonable salary is subject to FICA taxes, any remaining profits passed to the shareholder-owner as distributions are not subject to FICA or SECA taxes. This can result in tax savings on the distribution portion of the income. The IRS scrutinizes S Corporation salaries to ensure they are “reasonable” and not artificially low to avoid payroll taxes.

A Limited Liability Company (LLC) also has the flexibility to be taxed as a corporation. By filing Form 2553, an LLC can elect to be taxed as an S Corporation, or by filing Form 8832, it can elect to be taxed as a C Corporation. If an LLC makes one of these elections, its members who provide services can be paid a W-2 salary. In a standard C Corporation, owner-shareholders who work for the business are also treated as employees and must be paid a salary for their services.