IRS Issues Chief Counsel Advice on Imposition of Self-Employment Tax on Members of a Fund Manager
Recently, the Internal Revenue Service (“IRS”) issued Chief Counsel Advice 201436049 (the “CCA”), which discusses whether members of a fund management company structured as a limited liability company can be treated as limited partners for purposes of the self-employment tax exclusion of Section 1402(a)(13) of the Internal Revenue Code of 1986, as amended (the “Code”), when those members perform extensive services for the management company. The CCA concludes that all members of the limited liability company (the “Company”) are subject to self-employment tax on their distributive shares of income of the Company. Although the status of “limited partners” for purposes of the self-employment tax has been an open issue for years, the CCA potentially implies that the IRS might raise the self-employment tax issue when it is auditing fund managers that are structured as limited partnerships and might question whether limited partners of such entities can avoid self-employment tax on the partnerships’ earnings.
Generally, an individual must include his or her distributive share of partnership income or loss from any trade or business carried on by a partnership (or limited liability company treated as a partnership for tax purposes) of which he or she is a partner when calculating net earnings from self-employment and the associated self-employment tax liability. There are, however, certain exclusions to this rule. Section 1402(a)(13) of the Code provides that the distributive share of partnership income or loss is excluded from the net earnings from self-employment if the partner receiving the distribution is a “limited partner.” However, this section does not define what a limited partner is and such “limited partner” exception was enacted before the use of limited liability companies became common. Many principals of investment managers that are structured as limited partnerships for federal income tax purposes rely on this exception under Section 1402(a)(13) of the Code in taking the position that they are not subject to self-employment taxes on their distributive share of the investment manager’s fee income because they are “limited partners” of those partnerships.
Facts and Analysis of the CCA
In the CCA, the Company, an investment manager to several investment funds, was formed as a state law limited liability company and taxed as a partnership for federal income tax purposes. The Company earned management fees for providing investment management and administrative services to those funds. The individual members of the Company performed a variety of personal services for the Company directly and for the Company on behalf of the funds. The Company paid wages to these members which, the Company stated, were reasonable compensation, and the Company also allocated distributive shares of the Company’s income to the members. The Company took the position that its members were “limited partners” for self-employment tax purposes, and therefore were not subject to the self-employment tax on their distributive shares of the Company’s management fee income.
The CCA analyzes whether Section 1402(a)(13) of the Code applies to the income allocated to the members of the Company. The CCA first looked to the legislative history of this Code section and concluded that the history provides that the exclusion was originally intended to apply only to earnings that are of an investment nature. The CCA further relied on certain Tax Court cases in which the Tax Court concluded that limited partners of a partnership (in these cases, lawyers who were partners in a law firm) were not “limited partners” within the meaning of the exclusion from the self-employment tax, and that their distributive shares of the partnership’s fee income were subject to the self-employment tax. The CCA concludes that the members of the Company are not limited partners, because they perform extensive investment and operational management services in their capacity as members and the Company derives income from such services.
Impact of CCA
The impact of the CCA is difficult to determine at this time. A “Chief Counsel Advice” memorandum is not binding or precedential on taxpayers, and conveys only the legal interpretation of the IRS Office of Chief Counsel. No regulations or rulings have been issued. The CCA refers to regulations which were proposed in 1997; however, Congress imposed a temporary moratorium on finalizing those regulations and they expired and were never finalized. However, the CCA does indicate the IRS’ view on the legal matters discussed therein, and provides some guidance to taxpayers on how IRS field agents are likely to approach these matters in an audit.
The CCA does not address how its analysis would apply if the entity in question was a limited partnership and its members were “limited partners” under the applicable state law, but the CCA does not restrict its conclusion solely to limited liability companies. It is unclear whether the courts would support the IRS’ position (either with respect to limited liability companies or limited partnerships). It is too soon to determine whether managers should change their tax return position based merely on the CCA, but managers should be aware that the position regarding self-employment tax and Code Section 1402(a)(13) may be subject to challenge by the IRS on audit. We will keep you updated as to any further developments in this area.
U.S. Treasury Circular 230 Notice: U.S. Treasury Regulations require us to inform you that any U.S. tax advice in this communication cannot be used by you (i) to avoid tax penalties or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.
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