IRS to Members of Investment Manager: Pay Self-Employment Tax

September 24, 2014

Investment management companies are frequently organized as limited liability companies (“LLCs”).  Based on recent advice from IRS Chief Counsel, members of an investment management LLC (“Management Company”) are subject to self-employment taxes on their shares of the company’s income.  The advice is significant because the application of self-employment taxes to LLC distributions has been unsettled for years, and some taxpayers take the position they are exempt from self-employment tax.  The IRS advice, issued on September 5, 2014, shows the IRS disagrees with that position, at least with respect to investment management LLCs receiving fees for services provided by its members.

Background.  Management Company was a general partner of two hedge funds to which it provided research and trading services.  All of the LLC members provided services, either to the funds directly or to the company.  Management Company received a fee from the funds, and it allocated the fee among the LLC members based on their percentage ownership.

For federal tax purposes, LLCs are typically treated as partnerships and their members as partners.  And while a partner’s share of partnership income is typically subject to self-employment taxes, there is an exception for income allocations to limited partners.  This exception precedes the popularity of LLCs and since then, there has been scant guidance on how a “limited partner” is defined for purposes of applying the exception to an LLC and its members.

Management Company opted to treat all of its members as “limited partners” for purposes of self-employment taxes.  Based on this reporting position, the members did not pay self-employment tax on their share of the company income.

IRS Analysis.  The IRS rejected the Management Company’s position that the “limited partner” exception to self-employment taxes applies.  It relied on legislative history and two recent court decisions.  The legislative history says the purpose of the limited partner exception is to exclude from taxable wages earnings that are of an investment nature, as opposed to income for services actually performed.  At the time the statute was enacted, a limited partner would lose its limited liability by providing services or participating in control of the partnership.

In the first decision, a court held that a law partner’s share of law partnership income is subject to self-employment tax.  The court’s decision hinged on the fact that, unlike limited partners, the lawyers received income from the partnership based on the legal services they provided on behalf of the firm.

In the second decision, members of an LLC took the position that because the company paid them compensation that was subject to self-employment taxes, their share of company income in excess of the compensation is not subject to self-employment taxes.  This is generally the rule for S corporations, and the taxpayers tried to extend it to LLCs.  The court rejected the position, holding that because the members actively participated in the company business, all of its income was subject to self-employment taxes, not just the part designated compensation.

In the Chief Counsel advice, the IRS applied these decisions to Management Company, and it observed that the LLC members performed extensive investment and operational management services for the company.  As a result, the IRS concluded that the LLC earnings are not of an investment nature, and that the members are not “limited partners” for purposes of the self-employment tax exemption.

Take Away.  After years of not ruling in this area, the Chief Counsel advice is a significant step forward in demonstrating how the IRS views the self-employment tax issue, and it is not a taxpayer friendly view.  The advice, however, is not binding on other taxpayers or the courts, and cannot be cited as precedent.  It is also limited in scope to LLCs taxed as partnerships who receive fee income for services provided by its members.  For example, the IRS did not apply the advice to the promote entity, which it noted did not take part in the conduct or control the activities of the funds.

Still, the advice is a good indication of how the IRS views the subject internally and how Chief Counsel will instruct field agents on the issue.  LLCs that treat distributions to service providing members should be mindful of the advice and consider other options if necessary.  For example, if the members are providing services, the activity might be conducted by an S corporation under which reasonable compensation is subject to social security tax.  In that case, allocations of company income to the shareholders in excess of their compensation are not subject to either social security tax or self-employment tax.

Click here to view the IRS memo regarding Section 1402(a)(13) and Investment Management Partnership.