Memorandum to our Investment Management Clients and Friends
The United States Tax Court recently issued a ruling (the “Ruling”) pertaining to the possible exclusion of a limited partner’s distributive share of income from the federal self-employment tax.
I. Background
The Internal Revenue Code of 1986, as amended (the “Code”), permits taxpayers to exclude the distributive share of partnership income of a “limited partner, as such” from net earnings from self-employment. Because of this statutory exclusion, many investment fund managers structured their management companies as limited partnerships. Under this structure, the principal would take a reasonable salary (called a guaranteed payment in partnership tax parlance), and any allocation of additional profits was treated as a distributive share to the limited partner. The guaranteed payment was subject to the federal self-employment tax, but the distributive share of additional profits was not intended to be subject to the federal self-employment tax.
In recent years, there has been heightened audit activity by the Internal Revenue Service (the “IRS”) of investment fund managers that are structured as limited partnerships. Many audits have concluded, and there are a number still ongoing. Several audits have turned into cases that are pending in the Tax Court.
II. The Tax Court’s Ruling
The Ruling was not a final decision on the merits of the case. Rather, the Tax Court was deciding on cross-motions for summary judgment by the taxpayer and the IRS. The court ultimately granted the IRS’s motion for summary judgment and denied the taxpayer’s motions for summary judgment.
The taxpayer’s motion for summary judgment requested that the court rule that a limited partner’s distributive share of income is automatically excluded from self-employment net earnings solely by reason that a taxpayer is a limited partner in a limited partnership under applicable state law. This motion was denied by the court.
The taxpayer argued that the merely being a limited partner in a state law limited partnership is sufficient for purposes of the self-employment tax exclusion. The IRS argued that a so-called functional analysis should be conducted to determine if a limited partner qualifies for this exclusion from self-employment. By applying a functional analysis, the Tax Court is interpreting the statute to apply to a limited partner who is ‘functioning’ as a limited partner. In other words, the Tax Court is looking at the passive nature of a limited partner for purposes of satisfying the “limited partner, as such” standard.
Because Code Section 1402(a)(13) excludes distributive shares of a “limited partner, as such” from the imposition of the self-employment tax, the Tax Court found that this phrasing had meaning beyond mere status as a limited partner in a state law limited partnership. The Ruling addresses this by finding that this is a factual determination that cannot be ruled upon under a summary judgment standard.
However, in arriving at this finding, the Tax Court’s analysis is not friendly to the taxpayer. The Tax Court reasons that the legislative history behind Code Section 1402(a)(13) implies that Congress did not intend for this exclusion to apply to all distributive shares of limited partners. Rather, the Tax Court suggests this language is meant to apply to “certain earnings of an investment nature.” Therefore, limited partners that are actively involved in the business operations of a limited partnership may not be able to exclude their distributive share from self-employment tax.
The IRS asked in its motion for summary judgment that this determination of a partner’s functional roles in a partnership be treated as a “partnership-level item” for purposes of the partnership audit rules. This motion was granted by the Tax Court. It should be noted that this aspect of the ruling is only moderately favorable to the IRS because of the change in the audit rules for partnerships which is effective for taxable years beginning on or after January 1, 2018 (the taxable years in front of the Tax Court were 2016 and 2017). Under these new audit rules, all audit proceedings are conducted at the partnership level and there is no need for separate partner level proceedings.
III. Implications for Fund Managers
There is no doubt that this ruling is unfavorable to fund managers which are structured as limited partnerships. The dicta in this case adopts the historic IRS interpretation of Section 1402(a)(13).
There may not be a final ruling in this case if the taxpayer settles with the IRS. Even if there is no final ruling in this or other similar cases, fund managers may want to consider the risks associated with excluding income from a limited partnership from self-employment tax.
Final Remarks
Seward & Kissel LLP actively monitors tax changes and their impact on the investment management industry. For additional information on this Ruling, please contact a member of Seward & Kissel’s Tax Group.
