By: Cale McDowell, William H. Hornberger and Ronald D. Kerridge

The Office of Chief Counsel of the Internal Revenue Service (the "IRS") recently issued internal guidance in the form of a Chief Counsel Advice (the "CCA") indicating that the IRS has taken the position that the "limited partner" exception to the self-employment tax is not available to members of an investment management company earning fee income from investment funds under its management.¹

Background

The Internal Revenue Code ("IRC") provides consistent tax compliance rules for wages earned by an employee, which are taxed under the Federal Insurance Contribution Act ("FICA"), and earnings from self-employment, which are taxed under the Self-Employment Contribution Act ("SECA"). FICA is comprised of a 12.4% tax on wages, up to an annual cap, and a 2.9% uncapped Medicare tax on wages (or 3.8% for wages over a threshold amount).² One half of the FICA tax is borne by the employer and is deductible, while the other half is borne by the employee and may not be deducted. SECA follows a parallel structure, with a 12.4% tax on net earnings from self-employment ("NESE"), up to an annual cap, and a 2.9% uncapped Medicare tax on NESE (or 3.8% for NESE over a threshold amount).³ One half of the SECA tax may be deducted by self-employed individuals.

In addition to the 0.9% increase in the uncapped Medicare component of the FICA and SECA taxes, IRC Section 1411 now imposes an additional 3.8% net investment income tax ("NIIT") on unearned income that would not have previously been taxable as wages under FICA or as NESE under SECA. With the potential for a significantly increased tax burden as a result of these recent changes, many private equity and hedge fund managers have struggled to understand the extent to which the SECA and NIIT taxes apply to the various forms of income that are typical in their businesses. The CCA sheds some light on the position taken by the IRS with respect to fees earned for investment management services.

The Chief Counsel Advice

The subject of the CCA is a family of hedge funds (the "Managed Fund") with the following attributes:

• Each partnership comprising the Managed Fund has two general partners:
• A state law limited liability company treated as a partnership for Federal tax purposes (the "Management Company") serves as a general partner of the Managed Fund and as its investment manager. The Management Company is responsible for carrying out the investment activities of the Managed Fund and is entitled to a quarterly management fee calculated on the basis of assets under management. The management fee is the Management Company's primary source of income.
• A separate entity (the "Profits GP") serves as a general partner of the Managed Fund and generally does not take part in the conduct or control of the Managed Fund's activities but has a substantial interest in the Managed Fund's gains and losses by virtue of its carried interest.⁴
• A group of individuals (the "GP Principals") are partners in the Profits GP and the Management Company. Each of the GP Principals works full time for the Management Company and, together with employees of the Management Company, provides investment management services to the Managed Fund on behalf of the Management Company.
• The limited partners of the Managed Fund are passive investors and have no right to participate in the control of the Managed Fund.

The question at issue in the CCA is whether a GP Principal's distributive share of the management fee income earned by the Management Company is subject to the SECA tax.⁵ Specifically, the CCA is an interpretation of the "limited partner" exception to the SECA tax set forth in IRC Section 1402(a)(13).

History of the Limited Partner Exception

NESE, the net self-employment earnings subject to the SECA tax, is generally defined as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions attributable to such trade or business, and generally includes the individual's distributive share of income or loss from any trade or business carried on by a partnership of which that individual is a member.⁶ Thus, a GP Principal's distributive share of the Management Company's fee income would have clearly been included within the meaning of NESE, and therefore subject to the SECA tax, were it not for IRC Section 1402(a)(13) (the "limited partner exception"), which excludes from NESE the distributive share of any item of income or loss of a limited partner, other than IRC Section 707(c) guaranteed payments in the nature of remuneration for services rendered.

The IRC does not define the term "limited partner," and there has for many years been substantial uncertainty surrounding the use of that term. Section 1402(a)(13) was enacted in 1977, when the Revised Uniform Limited Partnership Act of 1976 ("RULPA") and most state limited partnership statutes provided that a limited partner would lose its limited liability protection if it took part in the control of the partnership's business. Since that time, the Uniform Limited Partnership Act of 2001 ("2001 ULPA") has eliminated this rule in favor of broad protection for limited partners against entity obligations, taking the position that "in a world with LLPs, LLCs and, most importantly, LLLPs, the rule is an anachronism."⁷ As the drafters of the 2001 ULPA suggested, the landscape of business entities has evolved significantly since the publication of RULPA, notably through the proliferation of entities such as limited liability companies, which are generally treated as partnerships for federal income tax purposes but provide limited liability protection for all members, regardless of the level of participation in and control over the entity's business. Thus, if the original rationale for the limited partner exception in IRC Section 1402(a)(13) was to exclude from NESE the income of a partner that is essentially passive investment income, then the IRS may take the view that reliance on a person's state law classification as a "limited partner" for that purpose is unworkable given the approach of the 2001 ULPA and the increased popularity of limited liability companies, which offer no such bright-line distinctions between those who may participate in the control of the business and those who may not.

In 1997, the IRS promulgated proposed regulations attempting to define "limited partner" for Section 1402(a)(13) purposes. The proposed regulations generally provide that an individual should be treated as a limited partner unless the individual: (i) has personal liability for the debts of or claims against the partnership by reason of being a partner, (ii) has authority to contract on behalf of the partnership, (iii) participates in the partnership's trade or business for more than 500 hours, or (iv) is a service provider in a "service partnership" (e.g., a law firm or accounting firm). The proposed regulations would have applied to all tax partnerships, including limited liability companies. However, in response to widespread criticism of the proposed regulations, Congress imposed a temporary moratorium on finalizing the proposed regulations, and, even after the expiration of the moratorium in 1998, the proposed regulations have not been finalized.

In the absence of final regulations, the limited partner exception has been interpreted largely by the courts. In Renkemeyer, Campbell & Weaver, LLP v. Commissioner, practicing attorney partners in a law firm organized as a limited liability partnership were found not to be "limited partners" within the meaning of Section 1402(a)(13), due in part to their active participation in the business generating the income at issue, and were therefore subject to self-employment taxes with respect to their distributive shares of such income.⁸ In Riether v. United States, the district court held that two members of a limited liability company "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 debts of the partnership," and therefore granted the government's motion for summary judgment, finding that the members were subject to the self-employment tax with respect to their distributive shares of the LLC's income.⁹

The CCA represents another effort by the IRS to clarify its position with respect to the interpretation of IRC Section 1402(a)(13). In analyzing the legislative history of the limited partner exception, the IRS finds that it was the intent of Congress to exclude from the SECA tax "earnings which are basically of an investment nature," but not earnings deriving from a partner's active participation in the partnership's business operations.¹⁰ Because the income earned by the GP Principals from the Management Company is not in the nature of a return on a passive capital investment, the IRS determines that the GP Principals are not "limited partners" for purposes of Section 1402(a)(13) and are therefore subject to the SECA tax on their distributive shares of the management fees. In so doing, the IRS appears to follow the general approach of the 1997 proposed regulations, which focus on the nature of the taxpayer's interest and participation in the partnership rather than state law entity classifications.¹¹

The CCA also disregards certain practices of the GP Principals that would have heretofore been viewed by some practitioners as reducing the risk associated with reliance on Section 1402(a)(13). For example, the CCA indicates that the GP Principals made material capital investments in the Management Company¹² and received portions of their earnings as wages reported on Form W-2 and as guaranteed payments, thus paying at least some amount of SECA tax and withholding tax under FICA.¹³ However, the IRS appears to consider these factors largely irrelevant and instead focuses almost exclusively on the active participation of the GP Principals in the business of the Management Company.

Conclusion and Potential Impact 

Legal advice memoranda such as the CCA do not constitute binding precedent. However, if definitive authority were ultimately to indicate that a management company principal's distributive share of a management company's fee income is NESE, then those amounts would be subject to the SECA tax, including the uncapped Medicare component thereof.¹⁴

Given the non-binding nature of the CCA and the existence of several competing proposals for reform of the limited partner exception,¹⁵ it is impossible to determine how any definitive authority might eventually develop. In the meantime, it may be advisable for fund managers to revisit their existing management company structures to determine whether the use of an alternative structure would better facilitate their tax planning objectives.

For additional information on this e-Alert, please contact Cale McDowell (cmcdowell@jw.com or 512.236.2057), Willie Hornberger (whornberger@jw.com or 214.953.5857) or Ron Kerridge (rkerridge@jw.com or 214.953.5774 ).

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¹ ILM 201436049, Office of Chief Counsel, Internal Revenue Service (September 5, 2014). Available here.

² The capped 12.4% component is known as the Old-Age, Survivors, and Disability Insurance Tax. The uncapped 2.9% component is known as the Medicare Hospital Insurance Tax. Beginning in 2013, the uncapped 2.9% component was increased by 0.9% to 3.8% for income over a threshold amount (currently $250,000 for a joint return, $125,000 for a married taxpayer filing separately and $200,000 for a single return). The additional 0.9% is not deductible under FICA or SECA.

³ The basic structure and threshold amounts referenced in note 2 with respect to FICA are also applicable to SECA.

⁴ The bifurcation of the management fee and carried interest in separate entities is a common state tax planning strategy for fund managers with significant operations in jurisdictions whose tax laws are sensitive to the organizational structure of the fund (such as the New York unincorporated business tax or the Texas margin tax). However, the analysis set forth herein would be similar in the case of a single general partner receiving both the carried interest and management fee income.

⁵ Importantly, the CCA does not address the applicability of the SECA tax or the NIIT to a general partner's carried interest.

⁶ IRC Section 1402.

⁷ Uniform Limited Partnership Act (2001), Prefatory Note. However, this approach has not been adopted in every state. Notably, both Texas and Delaware retain some version of RULPA's limited partner control rule, though with numerous safe harbors that tend to limit its practical application.

⁸ 136 T.C. 137 (2011).

⁹ 919 F.Supp.2d 1140 (D. N.M. 2012).

¹⁰ H. Rept. 95-702 (Part 1), at 11 (1977).

¹¹ While the facts under review in the CCA involved GP Principals who were state law limited liability company members, and the CCA does not expressly indicate that its conclusions would apply to state law limited partners, the nature of the analysis in the CCA may be independent of state law classifications and intended for application with respect to all tax partnerships regardless of their organizational form under state law.

¹² The lack of material capital investments was cited in Renkemeyer as a relevant factor in the court's determination.

¹³ While the treatment of part of the GP Principals' respective shares of management fees as wages was inappropriate under Revenue Ruling 69-184, 1969-1 C.B. 256, which provides that a partner cannot be an employee of his own partnership, the IRS did not focus on this issue, likely because the classification of a portion of the fee income as wages would have resulted in the Management Company withholding FICA taxes with respect to such wages.

¹⁴ It seems clear, however, in light of IRC Section 1411(c)(6), that no such amounts should be subject to both the NIIT and the SECA tax.

¹⁵ For example, a proposal by the House Committee on Ways and Means would treat only 70% of the distributive share of income to a limited partner who materially participates in the trade or business of a partnership as subject to the SECA tax.