Articles & Alerts
Update: Private Investment Fund Asset Management Firms – Self-Employment Tax Limited Partner Exception Developments
There continue to be significant developments as a result of the Internal Revenue Service’s (IRS’) Self-Employment Contributions Act (SECA) audit campaign regarding the potential tax liability of investment professionals through their limited partnership interests in fund management vehicles. Additionally, there are several ongoing IRS tax audits and pending U.S. Tax Court cases that may provide long-awaited clarity to partnerships and their limited partners related to the application of the SECA tax to limited partners’ distributive shares from a partnership.
Internal Revenue Code (IRC) Section 1402(a) establishes a rule that the distributive share income of a partner in a partnership is subject to self-employment (SE) taxes, with IRC Code Section 1402(a)(13) creating an exception for limited partners, stating that “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in IRC Section 707(c) to that partner for services rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.” The income from a limited partner was to be considered an investment in nature and thus be excluded from SE taxes just like interest, dividends, and capital gains.
In a law that was originally enacted in 1977, Congress intended to prevent passive investors, known as “limited partners”, from contributing minimal capital to ventures with low income, resulting in minimal SE tax payments, yet qualifying for social security benefits. Today the SE tax is 15.3% of earnings up to $160,200 in 2023 (rising to $168,600 in 2024) and 2.9% thereafter. In 1977, the SE tax rate was 7.9% and applied to a maximum of $16,500 of earnings. By paying the tax, a person could generate covered quarters for future Social Security benefits — benefits that would be expected to exceed the cost of the SE tax paid. Individuals who were either exempt from Social Security or those with only passive investment earnings found it attractive to create a SE tax liability to bring themselves into the Social Security system. Promoters of investment vehicles in a partnership form solicited investments with the promise of a Schedule K-1 listing SE earnings for the business income of the partnership. By investing in such a partnership, an individual could intentionally create SE earnings that would bring the partner within the Social Security system.
However, the term “limited partner” lacked a defined scope, leading to unforeseen challenges. The rise of state-formed partnerships introduced partners with limited liability who can participate actively, thereby excluding their income from SE taxes by adopting this exclusion. After sitting on this issue for almost 20 years, the IRS issued its first set of proposed regulations about Section 1402(a)(13) in 1994 (the “First Proposed Regulations”). Under the First Proposed Regulations, the amount subject to SECA taxes generally included an individual’s distributive share from any trade or business carried on by an LLC of which the individual was a member. They went on to explain that a member of an LLC would be treated as a “limited partner” for purposes of Section 1402(a)(13) if the member met the following two criteria:
- The member could not be a “manager” of the LLC; and
- The pertinent entity could have been formed as a limited partnership instead of an LLC, and the member could have qualified as a limited partner instead of as a member.
With the First Proposed Regulations, the IRS aimed to ensure that a member of an LLC, and a limited partner in a limited partnership, who got involved in the management or control of an entity to the same degree would be treated similarly for purposes of SECA taxes.
In 1997, after reviewing written comments from the public about the First Proposed Regulations, the IRS decided to withdraw the First Proposed Regulations and released a new set of regulations (the “Second Proposed Regulations”). With the issuance of the Second Proposed Regulations, the IRS was attempting to provide guidance covering all entities classified as partnerships for federal tax purposes, not just LLCs. The Second Proposed Regulations aimed at clarifying the original intent of the term “limited partner” by stating that an individual was presumed to be a limited partner unless the individual:
- Was personally liable for the debts or other claims against the partnership based on their status as a partner; or
- Had authority under state law to contract on behalf of the partnership; or
- Participated in the partnership’s trade or business for more than 500 hours during a taxable year.
The IRS aimed to make it clear that a limited partner’s status should not be determined by state classifications but by the specific activities the partners contribute to the partnership. The IRS further explained that it decided to use “functional tests” to ensure that different individuals, owning interests in similar entities formed under different state laws, would be treated the same. Congress imposed a moratorium in 1997 on these regulations and has not issued any guidance or legislation to resolve the limited partner issue since then.
Without any substantive regulatory guidance, taxpayers were left to interpret court decisions that apply the Section 1402(a)(13) limited partner exception to members of an LLC, concluding that LLC members operating in a professional services organization are subject to SE tax on all distributive share income. The case most often cited for this conclusion is Renkemeyer, Campbell & Weaver LLP v. Commissioner 136 T.C. 137 (2011) (Renkemeyer). In the Renkemeyer case, the court ruled against a law firm whose active partners were deemed ineligible for the SECA exclusion. The court emphasized that the exclusion was designed for individuals who invested in partnerships without active involvement. This precedent was subsequently referenced in other IRS cases and memorandums dealing with the limited partner exception.
In 2018, the IRS launched its SECA tax “compliance campaign,” and began opening issue-based examinations focusing its audit attention on limited partnerships operating predominantly in the asset management, financial services, private equity, and hedge fund industries. The IRS asserts that the limited partners in these partnerships provide services to the partnership and thus should be subject to SECA taxes on their annual allocations of partnership earnings at the current SE tax rate. Note that the IRS’ position is in direct opposition to a reporting position that limited partnerships and their partners have taken for decades; that limited partner interests are explicitly exempted from SECA taxes under the IRC Section 1402(a)(13) Limited Partner Exemption (LP Exception). The LP Exception provides that a limited partner’s distributive share of partnership income or loss generally isn’t subject to SECA taxes. This exclusion does not apply to guaranteed payments that a limited partner receives for services rendered to the partnership. While the LP Exception was enacted more than 40 years ago, there is no specific authority that provides that a partner who is a limited partner for state law purposes somehow would not qualify for the LP Exception. However, several significant cases that are currently docketed may force the US Tax Court to finally address this issue. Notably, Soroban Capital Partners LP, a New York hedge fund, underwent an IRS audit claiming that they underreported net earnings from self-employment. On February 7, 2023, Soroban filed a motion for summary judgment, urging the court to rule on the limited partner exemption for a state law limited partnership. In opposition, the IRS called for the application of a “functional test,” which would determine whether limited partners in a partnership or entity treated as a partnership for U.S. federal income tax purposes should be subject to SECA taxes by looking at the nature of their activities in the partnership, rather than only the nature of their partnership interest; in essence, that only silent or passive investors qualify for the LP Exception. Similar challenges have emerged from other comparable entities, including Point 72 and Denham Capital Management LP.
On November 28, 2023, the U.S. Tax Court issued an opinion concerning the competing motions referenced above for summary judgment in the case of Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12 (2023), addressing the SE tax liability of limited partners in a state law limited partnership. The Tax Court denied Soroban’s motion for summary judgment, holding that a functional analysis test, similar to the test outlined in Renkemeyer, should be applied when determining whether the limited partner exception under section 1402(a)(13) applies to limited partners in state law limited partnerships. The Tax Court opined that “the limited partner exception does not apply to a partner who is limited in name only” and that Congress “intended for the phrase ‘limited partners, as such’ used in section 1402(a)(13) to refer to passive investors.” If this decision is sustained upon appeal, this will not be a positive development from a taxpayer perspective.
We will continue to monitor developments in this and other relevant and similar cases. Nonetheless, as is good business practice and based on these developments, private investment fund asset management firms currently structured as limited partnerships and availing themselves of the LP Exception for SECA tax purposes, are encouraged to review this position with their tax advisors. While this decision may be appealed, it does give us an idea of where the IRS is or wants to be with this issue.
*Anchin Observation: Private investment fund asset management firms (or professional services firms) generally make significant investments in their business such as in their employees (human capital) as well as in technology. Investments in both have increased significantly over the past few years and are expected to continue to do so in the immediate future and, most importantly, are also expected to increase profits. A potential approach to this LP Exception issue could be to have more than one class of partnership interest for each partner: a percentage deemed a return of capital investment and a percentage deemed a payment for services. The “right” percentage for each is debatable and subject to the facts of each particular situation. A distinction can and should be drawn between income from services (subject to SECA taxes) and that from capital investment (not subject to SECA taxes). A comparable analysis to this proposed approach is with S corporations, where shareholders are subject to SECA on wages, but not on any allocation of income over and above their wages.