The IRS recently took a shot across the bow of limited partners of investment management companies with respect to the application of self-employment tax (or, SE tax, for short). In fact, the ruling could potentially affect limited partners (including LLC / LLP partners) in every industry. While this tax issue has been fought on several levels over the past 20 or more years, it had gone dormant since 1997. Now, an IRS Chief Counsel Advice (ILM 201436049 (05/20/2014)), released on September 5, 2014, (the “ILM”) demonstrates that the IRS may be ready to renew the fight.
Currently, limited partners of limited partnerships and shareholders of Subchapter S corporations routinely take the position that their distributive shares of entity profits are exempt from SE tax. The uncapped Medicare hospital insurance portion of the SE tax for high income taxpayers is now 3.8%, thanks to a 0.9% increase brought in at the close of 2012 to match up with the new Net Investment Income tax. In the S corporation world this tax exemption is tempered by a requirement to pay reasonable compensation to S corporation shareholders (the compensation, unlike stock distributions, is subject to SE tax). In the world of limited partnerships the SE tax exemption does not extend to guaranteed payments for services which, for partners, are akin to salary.
The ILM deals with a fairly large investment management company (likely in New York City based on its structure), which acts as an investment manager for a family of funds (each treated as a separate limited partnership). The IRS did not attack the allocations to the GP which held the profits interest in each underlying fund. The Service was interested in only the management company and its treatment of the management fee income. The management company in the ILM was structured as a limited liability company or LLC which was treated as a partnership for tax purposes. It was stated that the LLC was a successor to a previous management company that was organized as an S corporation (this fact was not material to the analysis but did help explain why the management company was taking the tax positions it was). Each partner in the management company received a salary (erroneously reported on a Form W-2) and guaranteed payments, both of which were subject to SE tax. In addition, each partner received allocations of partnership profits which were not subject to SE tax. Some of the partners were investment managers but others were legal, human resources, information technology services and other infrastructure personnel.
The IRS pointed out that Section 1402(a)(13), which exempts limited partners from SE tax, was enacted in 1977 prior to the proliferation of LLCs. It also cited case precedent indicating that LLC members were not limited partners and were not entitled to the benefits of Section 1402(a)(13). However, the Service went much further and pointed to the legislative history of the statute to advocate that the statute was not intended to shield limited partners from SE tax to the extent they were providing services to the partnership. Rather, the Service claims, the statute was merely intended to exempt passive investors from SE tax. The ILM also cites extensively to Renkemeyer vs Commissioner, 136 T.C. 137 (2011), in which the Tax Court unsurprisingly found that partners in a law firm formed as a limited liability partnership were subject to SE tax on their earnings. The Tax Court also utilized broad language and cited to the intent of the statute and its related legislative history. The ILM ultimately found that every partner of the management company was subject to SE tax on their allocations of earnings because the “Partners’ earnings are not in the nature of a return on a capital investment … [but rather]… are a direct result of the services rendered on behalf of Management Company by its Partners.”
This fight over SE tax related to limited partners and LLC members began in the early 1990s. In 1994, Treasury issued proposed regulations that would have exempted LLC members from SE tax but only if the member lacked authority to make management decisions necessary to conduct the business of the LLC. In January of 1997, Treasury withdrew the regulations and re-proposed new regulations. The 1997 regulations would treat individuals as limited partners and able to take advantage of the SE tax exclusion unless the individual (i) had personal liability for the debts of the partnership, (ii) had authority to contract on behalf of the partnership, or (iii) participated in the activities of the partnership for more than 500 hours during the taxable year. Importantly, the 1997 proposed regulations were not limited to LLC members. Rather, it would have changed the SE tax situation for all partnerships.
Shortly after the 1997 proposal, Steve Forbes called the proposed regulations, “a major tax increase by a stealth regulatory decree.” Others soon joined in a national campaign to kill the regulatory proposal including the then Speaker of the House, Newt Gingrich and radio talk-show host, Rush Limbaugh. In June 1997, the Senate passed a nonbinding resolution declaring the proposed regulations outside the scope of Treasury’s authority, urging Treasury and the IRS to withdraw the proposal. Congress ultimately imposed a 12-month moratorium on Treasury’s authority to issue guidance regarding the definition of “limited partner” for purposes of Section 1402(a)(13). Since that time Treasury and the IRS have remained silent on the issue.
Fourteen years later, the Renkemeyer decision threatened to open the debate again but since the IRS agreed with the decision and such decision was limited to LLC members within a very specific (and egregious) fact pattern, the argument remained dormant. Now, seventeen years after Congress thrashed the IRS for overstepping its bounds with regards to limited partners they are at it again.
In June 2014, Curtis Wilson, IRS associate chief counsel (passthroughs and special industries), said that the IRS had been thinking about the extent to which individuals who are limited partners under state law might be prohibited from relying on the SE tax exemption. Additionally, in the 2014-2015 joint Treasury-IRS priority guidance plan released August 26, 2014, the agencies announced they would tackle guidance on the application of Section 1402(a)(13) to limited liability companies.
The ILM is a clear indication that the Service has decided to go back on the attack against limited partner / LLC member utilization of the Section 1402(a)(13) exemption from SE tax. This may be another act of regulatory fiat that Congress will once again quash, as in 1997, but let the taxpayer beware. The IRS is of the opinion that active LPs should pay SE tax on their full allocation of management fee income. Management companies may be better off as S corporations which have a different statutory genesis for their SE tax exemption. But, of course, this begs the question. Why should different forms of passthrough entities receive different SE tax results? Stay tuned on this issue.
Authored by Anthony J. Tuths, JD, LLM, Partner