The IRS has issued final, temporary and proposed regulations extending the religious and family member Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) exceptions to disregarded entities (T.D. 9554; NRPM REG-136565-09). The temporary regulations also clarify the existing rule that the owners of disregarded entities, except for qualified subchapter S subsidiaries, are responsible for backup withholding and related information reporting requirements.
Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to Social Security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. However, the wages for the services of a child are subject to Social Security, Medicare, and FUTA taxes if the child works for a corporation, even if controlled by the child's parent.
Generally, the wages for the services of an individual who works for his or her spouse in a trade or business are subject to Social Security and Medicare taxes, but not to FUTA tax. Similar rules apply to wages for services of a parent employed by his or her child.
Additionally, wages are not subject to Social Security tax when paid to an employee who is a member of a recognized religious group by an employer who is also a member of a recognized religious group. The employer and the employee must have filed and had approved an application certifying that they are members of a qualifying religious sect.
Prior to 2009, family members of the owner of a disregarded entity were considered employed by the owner of the disregarded entity and wages paid to them were exempt from FICA and FUTA under Code Secs. 3121(b)(3) , 3127, and 3306(c)(5). The FICA exemption also applied where an employee and the owner of a disregarded entity for which the employee worked were both members of a religious faith opposed to the Social Security Act.
In 2007, the IRS issued final regulations providing that, with respect to wages paid after December 31, 2008, a disregarded entity is treated as a separate entity for purposes of employment taxes and related reporting requirements. The separate entity is treated as a corporation for purposes of employment taxes. Under this treatment, the entity, rather than the owner, is the employer of any individual performing services for the entity.
Because of the 2007 regulations, family members of disregarded entities no longer qualify for the FICA and FUTA exceptions for family employment. Services performed in the employ of a corporation are not within the FICA and FUTA exceptions for family members and members of qualified religious sects.
The new regulations treat disregarded entities as corporations for employment tax purposes. Such entities cannot qualify for the FICA and FUTA exceptions contained in Code Secs. 3121(b)(3), 3127, and 3306(c)(5), because the individual owner is no longer considered the employer. The IRS did not intend to render these exceptions inapplicable to disregarded entities that were eligible for the exceptions prior to the effective date of the new regulations in Reg. §301.7701-2(c). The inability of these entities to benefit from the exceptions for family employees and members of religious faiths has an adverse impact on small businesses. Accordingly, a change is necessary to correct this problem.
The temporary regulations allow certain disregarded entities to qualify for the FICA and FUTA exceptions. A disregarded entity will continue to be treated as a corporation for all employment tax purposes, except that the entity will be disregarded for the limited purposes of applying the FICA and FUTA exceptions found in Code Secs. 3121(b)(3), 3127, and 3306(c)(5). For purposes of applying these exceptions only, the owner of the disregarded entity will be treated as the employer and the employee will be considered to be an employee of the owner.
Additionally, the regulations clarify the existing rule that disregarded entities under Reg. §301.7701-2 are not responsible for backup withholding and information reporting of reportable payments under Code Sec. 3406. Rather, the owner of a disregarded entity is responsible for backup withholding and information reporting of reportable payments.
This does not change the existing rule. However, the existing final regulations do not explicitly state that disregarded entities are not responsible for information reporting and backup withholding, which has caused some confusion as to the responsible party for filing information returns for reportable payments and related backup withholding requirements. Therefore, the regulations have been amended to clarify the existing rules with respect to backup withholding and related information reporting responsibilities.
The text of the temporary regulations also serves as the text of the proposed regulations. The regulations, as proposed, apply to wages paid on or after October 31, 2011. However, the rules in the proposed regulations may be relied on by taxpayers for wages paid after December 31, 2008.