New Employment Tax Rules for Disregarded Entities Go Into Effect January 1, 2009

On January 1, 2009, new IRS rules will go into effect that may substantially change the way that disregarded entities, such as single member limited liability companies, report and pay employment taxes. Under these new rules, disregarded entities will be required to withhold, report and pay employment taxes (i.e., FICA, FUTA, income tax withholding) under their own names and employer identification numbers (EINs). This is a substantial change from prior law that may require action by such entities.

For the last decade, the IRS has given disregarded entities—other than qualified REIT subsidiaries—some flexibility with respect to their employment-tax obligations. These taxes could be withheld, paid and reported under the name and EIN of either (1) the disregarded entity itself or (2) the owner of the disregarded entity. After 2008, disregarded entities will no longer have this flexibility under the new IRS rules. Such entities will be responsible for withholding, reporting and paying these taxes themselves. Affected entities that have not already done so will need to acquire EINs to comply with the new requirements.

These new IRS rules have the potential to catch disregarded entities and their owners unaware. This is especially true for U.S. taxpayers with wholly owned foreign subsidiaries that have "checked the box" to be treated as disregarded entities for U.S. tax purposes. In cases where such a foreign entity pays U.S. source wage income to an employee, for example, the foreign entity itself will be subject to the new reporting and withholding rules. The foreign disregarded entity will therefore be required to obtain an EIN and to file U.S. information and tax withholding returns (such as IRS Forms W-2, 940 and 941) even if it has no other U.S. connection. (Foreign employers should note that even if an employee is exempt from U.S. income tax under the Internal Revenue Code or an applicable tax treaty, the employee may not be exempt from U.S. employment taxes.) Taxpayers with foreign check-the-box (disregarded) entities will need to ensure that those entities are in compliance with these new rules.

To mitigate the burdens of these new rules, affected entities may be able to take advantage of the IRS's common paymaster rules or appoint agents to handle certain of their information-reporting duties. (Generally, however, an employer may not appoint an agent to report, deposit or pay its FUTA taxes.) Affected taxpayers should assess the applicability of these rules and consider the administrative tasks that need to be completed to ensure compliance prior to the January 1, 2009, effective date.