On December 23, 2024, the United States Tax Court published an opinion1 (the “Opinion”), holding that limited partners that actively participated in a fund manager (the “Investment Manager”) structured as a limited partnership were subject to federal self-employment tax on their entire distributive share of income from the Investment Manager.
- Background
For background on the potential tax benefits of a limited partnership structure and the legal challenges that the Internal Revenue Services has brought, please see our prior Memorandum and our article published in Private Equity Law Report.
- The Tax Court’s Ruling
The Investment Manager was owned by a limited liability company that was its general partner (the “Investment Manager’s GP”) and five limited partners. One of the limited partners owned 100% of the capital interest in the Investment Manager’s GP.
Management and control of the Investment Manager was vested exclusively in the Investment Manager’s GP. Each of the five limited partners in the Investment Manager held voting rights in the Investment Manager’s GP.
Each limited partner was entitled to a guaranteed payment and distributive share of the Investment Manager’s ordinary income, which was comprised entirely of management fees paid by private investment funds it managed. The Investment Manager’s GP did not make any guaranteed payments.
The Opinion cites prior Tax Court rulings, which provide that a functional analysis applies to determine whether a state law limited partner is considered a limited partner for purposes of the “limited partner exception” to self-employment tax. This analysis looks at how partnership income is derived and the “roles and responsibilities” of the partners in generating such income. At its core, the functional analysis requires a determination of whether a limited partner’s relationship to the partnership is more akin to that of a passive investor or an employee.
The Tax Court found that each of the limited partners were actively involved in the activities conducted by the Investment Manager, were held out as active partners in audited financial statements and prospectuses, devoted substantially all of their working time to the Investment Manager and actively directed and strategically guided the Investment Manager. The Tax Court also noted that the guaranteed payments to the limited partners which purportedly were reasonable compensation for the services provided by limited partners to the Investment Manager were substantially below the compensation of the Investment Manager’s other employees.
- Implications for Fund Managers
This Opinion is the second Tax Court decision holding that a limited partner under state law who is actively involved in an investment manager’s business activities is subject to self-employment tax, notwithstanding the statutory language of the limited partner exception. It has been publicly reported that one taxpayer is appealing the holding of an earlier Tax Court case on this issue to the Fifth Circuit Court of Appeals. The decision by the Fifth Circuit will provide more clarity on the ultimate application of the self-employment tax to limited partners. Management companies that are structured as limited partnerships should consider the application of these recent Tax Court decisions for the current and future taxable years.
Final Remarks
Seward & Kissel LLP actively monitors tax changes and their impact on the investment management industry. For additional information on this Opinion, please contact a member of Seward & Kissel’s Tax Group.
