When is an Investment Manager Subject to Self-Employment Tax?
November 17, 2014
By Ansgar Simon
A recent internal advice memorandum from the IRS should be of interest to our fund clients. The IRS memorandum, CCA 201436049 (Sept. 5, 2014), concluded that all of the management fees earned by an investment manager organized as a limited liability company (LLC) and treated as a partnership for U.S. federal tax purposes were subject to self‑employment tax. The memorandum has increased concern among tax lawyers about whether an exemption from employment tax for certain income derived by a “limited partner” applies to LLC members. Fortunately, a potential way to address this risk should remain available for a number of investment managers.
The “Limited Partner” Exclusion
Self-employment taxes are imposed on an individual's “net earnings from self-employment” (NESE) and consist of old age, survivors, and disability insurance tax (12.4 percent of NESE up to a cap of currently $117,000) and hospital insurance tax (3.8 percent of NESE above $250,000 for married couples filing joint returns and 2.9 percent of NESE up to $250,000). Although NESE includes a person’s share of income or loss from a partnership that is attributable to a trade or business carried on by the partnership, it excludes the distributive share of the income or loss of a “limited partner.” This LP Exclusion, enacted in 1977, does not apply to “guaranteed payments . . . to the partner for services actually 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 statutory language, in other words, unmistakably countenances that a limited partner may render services to or on behalf of the limited partnership, yet still qualify for the LP Exclusion for payments other than these guaranteed payments.
But what is a “limited partner”? Neither the Internal Revenue Code nor Treasury regulations are of any help here. In 1997, the IRS proposed to disqualify partners (including LLC members) from the LP Exclusion if, for example, they provide more than 500 hours of service to the partnership in a year. Congress did not like that and imposed a one-year moratorium that prevented the IRS from adopting regulations addressing the employment-tax status of limited partners. Nothing happened after the year had passed, and the IRS has not offered any binding guidance since.
The issue is pressing because of the proliferation of LLCs, limited liability partnerships (LLPs), and similar entities since the LP Exclusion was enacted. These entities are not in the form of limited partnerships for commercial law purposes, but they afford limited liability to their members and usually elect to be treated as partnerships for purposes of U.S. federal tax law. This has created substantial uncertainty about when their partners or members qualify for the LP Exclusion.
When Is a Partner a “Limited Partner” for U.S. Tax Purposes?
Recent case law has already put taxpayers on notice that being a partner for U.S. federal tax purposes and having limited liability for the debts of the entity is not enough to qualify for the LP Exclusion. In Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), the Tax Court ruled that lawyers who were partners of a Kansas LLP had management powers and therefore acted in the manner of self-employed persons regardless of their limited liability. Accordingly, they were held liable for self-employment taxes on their entire shares of the LLP’s income. Citing Renkemeyer, a district court came to the same conclusion the following year regarding two members of an LLC, finding in Riether v. United States, 919 F. Supp. 2d 1140, 1159 (D. N.M. 2012) that they “are not members of a limited partnership, nor do they resemble limited partners, which are those who ‘lack management powers but enjoy immunity from liability for the debts of the partnership.’”
The IRS memorandum does not focus on the LLC members’ management powers. The members apparently worked in excess of 500 hours annually for the investment management company, for which they received a salary in addition to their distributive share of the investment manager’s net taxable income. At least some of the members had purchased their membership units. The IRS’s argument that the LP Exclusion did not apply to their distributive shares principally relied on legislative history. Congress stated that the LP Exclusion “is to exclude for coverage purposes certain earnings which are basically of an investment nature.” The IRS concluded that the distributive share of the fees was not passive in nature because the members provided services for the investment manager, regardless of the fact that units were purchased for cash, not in exchange for services.
Life After the IRS Memorandum
The sweeping logic of the IRS memorandum goes beyond the recently decided cases and would affect management companies organized as limited partnerships, not just LLCs and LLPs. While an internal IRS memorandum does not constitute binding legal authority, it indicates the IRS’s current view. Traditionally, tax lawyers considered the use of a limited partnership rather than an LLC as an investment manager to strengthen the position that the LP Exclusion should apply. But the IRS’s focus on the services the members provide raises the risk that such an arrangement might be challenged by the IRS, and, if not settled on audit, end up before a court.
The issue would not arise for an investment manager that elects to be treated as an S corporation for U.S. federal tax purposes. The IRS has previously acknowledged that not all of the income of an S corporation shareholder who provides services is NESE, and the IRS memorandum does not affect this position. S corporations are subject to several restrictions, however, including a maximum of 100 shareholders − all of whom must be U.S. citizens, resident individuals, or certain limited types of trusts − and the requirement that only a single class of shares be issued. Also, shareholders who provide services for the S corporation investment manager would have to receive reasonable compensation, which would be subject to employment taxes.
In most cases, the new 3.8 percent “net investment income” tax also would not apply to the distributive share of the investment manager’s fee income, regardless of whether the manager is a limited partnership or an S corporation, even if the distributive share is exempt from self-employment taxes. For both limited partners and S corporation shareholders, net investment income tax applies to income derived from a trade or business only if it is (1) a “passive activity” or (2) trading of financial instruments or commodities. A member who worked for the investment manager in excess of 500 hours annually, however, would not be engaged in a passive activity, and his or her share of the net fee income should not be subject to net investment income tax.
In light of the sweeping approach to self-employment taxes in the IRS Memorandum, investment managers should carefully review whether their current structure continues to serve them well for self-employment tax purposes. We can provide expert advice to help managers evaluate their current structure and to convert to an S corporation if they consider it advisable.
Related Lawyer: Ansgar A. Simon
Related Practice: Tax