As part of its broader scrutiny of asset management firms, the IRS in 2018 launched a Self-Employment Contributions Act (SECA) compliance campaign targeting individual partners who claim “limited partner” exemptions from SECA tax in various forms of partnerships. While the IRS has successfully challenged these self-employment tax exemptions made by owners of some pass-through entity types, no court has addressed this issue with respect to partners of a state law limited partnership (LP).
A partner’s share of partnership income is generally subject to self-employment tax, except in the case of partnership income allocated to limited partners (LP Exception). Although the LP Exception has been part of the Internal Revenue Code since 1977, there is no statutory or administrative definition of a limited partner. In response to aggressive positions concerning this definition, the IRS is focusing its compliance campaign on LPs, limited liability companies (LLCs), limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) within the asset management, private equity, hedge fund and financial services industries.
Limited partners often are passive investors in these partnerships; however, many states’ laws now allow these limited partners to provide services to the partnership without losing their limited partner status. While limited partners are subject to self-employment tax on their guaranteed payments, the IRS contends that they also should pay SECA taxes on their distributive share of income from the partnership. The IRS maintains that the LP Exception only applies to partnership interests held in an investment capacity and is unaffected by a state’s legal definition for limited partners.
Several asset management companies and hedge funds are challenging the IRS in court over the limited partner exception tax law.
Court Challenges Center on Definition of Limited Partner
The law doesn’t clearly define “limited partner,” which has been further complicated by the array of new business entity types introduced among the states since the time this provision was added to the Internal Revenue Code. Asset managers are arguing that the LP Exception applies to the distributive share of income earned by limited partners based on state law classification, even though such partners are also providing services to the partnership. Several cases are pending in Tax Court, including Soroban Capital Partners LP v. Commissioner, involving a New York hedge fund manager and Point72 Asset Management LP et al v. Commissioner, filed by a Connecticut-based hedge fund manager.
As noted earlier, the IRS continues to argue that the LP Exception should only apply to passive or “silent” partners in a partnership who hold partnership interests as mere investors. It proposes that a functional test should be applied to determine whether a limited partner would be exempt, in keeping with this judicial standard previously established in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. The litigants counter that this judicial standard does not apply to state law LPs.
In Sirius Solutions, LLLP v. Commissioner, the IRS argues that because there is not a general partner as a matter of state law, the members cannot truly be “limited partners” and should therefore not qualify for the LP Exception.
U.S. Tax Court to Determine Path Forward for Limited Partners
Although the IRS temporarily paused its SECA compliance campaign for new examinations, it will continue its SECA tax audits for partnership exams already underway. The recent emphasis by both the IRS and the Biden administration on increased examinations of large partnerships, coupled with the additional funding of the IRS, could result in an increase of SECA tax examinations once these legal proceedings conclude.
The outcome of the cases in Tax Court will be instructive to asset managers in understanding how self-employment taxes might apply to their own limited partner structures. They also highlight the importance of monitoring evolving interpretations of tax law regarding partnership structures. In the meantime, firms should be taking proactive steps to document their position on the LP Exception, including focusing on the nature of their business operations and any limitations applying from a regulatory or contractual perspective.
Limited Partner Exception Included in New Treasury-IRS Priority Guidance Plan
The Treasury and IRS have responded to the tax community’s call for clarity on the SECA exclusion in a new guidance project released Sept. 29, 2023. The 2023-2024 priority guidance plan is welcome news for taxpayers opposed to the IRS’s decision to aggressively audit partnerships after the fact, rather than giving pre-emptive clarifying guidance on the definition of “limited partner” concerning SECA. Details remain to be seen about the scope of coming guidance on the matter.
We will continue to monitor these developments and will provide updates as decisions are made.
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