In the latest self-employment tax ruling, the Fifth Circuit Court of Appeals issued a ruling in Sirius Solutions, L.L.L.P. v. Commissioner (the “Ruling”) that will ultimately permit state-law limited partners to exclude their distributive shares of partnership income from income for self-employment tax purposes. The Ruling rejects the Internal Revenue Service’s (“IRS’s”) position and other Tax Court rulings1 that apply a functional analysis that subjects limited partners who are not passive partners to self-employment tax on such income. This Memorandum provides material updates on the status of limited partnership structures for investment managers and what might happen in the coming months as other appellate level cases are decided.
For further background on the prior cases, please see our earlier memoranda: here and here. Our Private Equity Law Report article on this topic, which may be behind a paywall, is available: here.
One potential benefit of limited partnership structures for investment managers and other types of businesses has been self-employment tax optimization due to the limited partner exception, which provides that a “limited partner, as such” in a partnership is not subject to self-employment tax on its share of partnership income. The IRS has scrutinized these structures, auditing many fund managers. These audits have resulted in settled tax liabilities, and several IRS assessments have been challenged in the U.S. Tax Court.
Until the Ruling, the Tax Court has consistently ruled in favor of the IRS, denying the exclusion of a limited partner’s share of partnership income from self-employment income for limited partners who actively participate in the business of the partnership.
The Ruling stands out because it held, quite simply, that a “limited partner” is a partner with limited liability in a limited partnership. While this may broadly include LLP and LLLP structures, the Ruling includes a footnote that it only addresses limited partnerships and “[does] not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception.” However, the Ruling does not appear to preclude such an extension (which would be a departure from prior Tax Court cases that considered LLP and LLC membership), as it states that its “limited partner” interpretation “does not turn on state labels.”
The Fifth Circuit rejected the passive investor functional analysis put forth by the IRS and the Tax Court and instead focused on the plain meaning of the term “limited partner,” based in part on both the IRS’s contemporaneous and longstanding interpretation of the term. If you are a limited partner under this standard and reside in Texas, Louisiana or Mississippi (i.e., the Fifth Circuit), you can potentially benefit from excluding your distributive share of net income on a Schedule K-1 from self-employment tax.
Another noteworthy fact was that the partners in question had reported no portion of their partnership income as guaranteed payments for services. The exclusion afforded to limited partners does not extend to guaranteed payments, and the multi-factor functional analysis that has been applied by the Tax Court has considered whether amounts reported as guaranteed payments were adequate. Somewhat surprisingly, the lack of any guaranteed payments did not appear to be of any concern to the Fifth Circuit in the Ruling.
Since there are appeals pending in the First and Second Circuits, which cover New York, Connecticut and the New England states, it is possible we could see a split among the circuits. Where the Circuit Courts disagree on an issue, the Supreme Court may hear the case and resolve the split or leave it to Congress to address legislatively. Limited partners outside the Fifth Circuit should continue to exercise caution in determining whether to claim the limited partner exclusion from self-employment income and be aware that significant risk remains in light of the IRS position and Tax Court decisions. An appellate level decision is certainly helpful for establishing a reasonable cause defense if your partnership is ever audited, but we are not at a point of certainty on this issue yet.
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.
