– Section 1401 of the U.S. Internal Revenue Code imposes self-employment tax on an individual’s self-employment income.
– Self-employment income is defined as the net earnings from self-employment, which is the gross income derived from any trade or business, less deductions.
– Section 1402(a)(13) provides an exception for an individual’s distributive share of income or loss of a limited partner, other than guaranteed payments.
– Self-employment tax is imposed at a rate of 3.8% and the effective marginal federal tax rate is about 2.9%, plus any applicable state and local tax savings. 1. Congressional proposals to address the limited partner exception for self-employment tax have not been enacted.
2. The IRS has not issued any guidance on the limited partner self-employment tax issue since 1997.
3. The IRS has prevailed in court on the issue with entities taxed as partnerships, but not state law limited partnerships.
4. There are two cases currently before the Tax Court on this specific issue.
5. The IRS has added the limited partner self-employment tax issue to its 2023-2024 Priority Guidance Plan. – The Tax Court ruled on the Soroban Capital Partners LP v. Commissioner case, determining that the limited partner exception applies at the partnership level and requires a functional analysis.
– The Court did not address whether the principals would be considered limited partners and did not provide criteria for determining this.
– New investment managers may still consider organizing as a state law limited partnership to preserve the optionality to rely on the limited partner exception. Alternatively, they could organize as limited liability companies taxed as partnerships and adjust their structure based on future developments in the law. – Existing investment managers may want to wait and see what develops in 2024 before making any significant tax decisions.
– For 2023, existing managers have the options of sticking with the status quo, filing extensions and paying tax, or paying tax and filing amended returns claiming refunds.
– Option 2 for 2023 would be the most conservative approach until there is more clarity on tax positions and potential disclosure requirements.
– For 2024, existing managers have the options of sticking with the status quo and seeing what develops, or obtaining a transfer pricing study to bolster their position on limited partner income and self-employment tax. 1. An investment manager could elect to be classified as an S corporation to potentially avoid self-employment tax by paying a portion of its income as reasonable compensation and the remainder as distributions. However, there are eligibility requirements for a valid election as an S corporation that may be problematic for an investment manager, and under some legislative proposals, distributions from an S corporation may also be subject to self-employment tax.
2. A better alternative may be to have each owner of the investment manager own its interest in the investment manager through its own S corporation to maintain flexibility in how the owners are compensated.
3. State and local taxes, including pass-through entity taxes, need to be considered if the investment manager (or its owners) are S corporations.
4. In light of the Soroban case, some managers may want to reconsider whether it is preferable to receive an incentive allocation rather than incentive fees. The industry is still considering the scope of the limited partner exception in light of the Soroban case for 2023 and beyond.
Limited Partner Exception to Self-Employment Tax – What to Do in Light of the Recent Soroban Case
Leave a Reply