On September 5, 2014, the Internal Revenue Service (“IRS”) issued Chief Counsel Advice 201436049 (the “CCA”), concluding that members of an investment manager were subject to self-employment (“SE”) taxes with respect to their earnings from the investment manager.1 Although the status of certain “limited partners” for purposes of the SE tax has been an open question for a number of years, the CCA makes clear, at least with respect to members of a limited liability company, that the IRS Office of Chief Counsel would advise field agents to challenge the status of such members for SE tax purposes.
Generally, SE taxes are imposed on an individual’s distributive share of income or loss from any trade or business carried on by a partnership of which he is a member. There are, however, certain exclusions to this rule. Chief among them is that the distributive share of a “limited partner” is generally not subject to SE tax. Neither the relevant section of the Internal Revenue Code nor the underlying Treasury Regulations specifically define what constitutes a “limited partner” and the limited partner exception was enacted before the use of limited liability companies (which do not have equity owners formally called “limited partners”) became common.2
Many investment management professionals who are members of investment managers that are treated as partnerships for U.S. federal income tax purposes have taken the position that they are not subject to SE taxes on their distributive share of the investment manager’s fee income because they are “limited partners.”
The facts underlying the CCA are that an investment manager (the “Company”) was formed as a state law limited liability company3 and taxed as a partnership for federal income tax purposes. The Company earned management fees from various funds for providing management services to those funds. The services provided by the Company ranged from investment management services to administrative support services. The Company took the position that its members were “limited partners” for SE tax purposes, and therefore were not subject to the SE tax on their distributive share of fee income earned by the Company.
In analyzing whether the members were eligible for the exclusion from the SE tax, the CCA noted that Congress did not intend that a service partner in a service partnership acting in the manner of a self-employed person would be able to avoid the SE tax. The legislative history to the statutory language at issue provides that the exclusion is intended for earnings that are basically of an investment nature. The CCA further relied on Renkemeyer, Campbell and Weaver LLP v. Commissioner, 136 T.C. 137 (2011) in which the Tax Court ruled that limited partners of a partnership (in this case, lawyers who were partners in a law firm) were not “limited partners” within the meaning of the exclusion from the SE tax, and that their distributive share of the partnership’s fee income was subject to the SE tax. In Renkemeyer the law firm in question was organized as a Kansas limited liability partnership, which under Kansas state law is considered a general partnership. Some commentators have noted the specific facts of the case and concluded that Renkemeyer should be read narrowly and the holding should only apply to similar factual scenarios and not, for instance, to partners in an entity treated as a limited partnership under state law or to members of a limited liability company.
The CCA, consistent with the approach of the proposed regulations, expands on the holding of Renkemeyer, finding that members of the Company performed extensive investment and operational management services in their capacity as members (i.e. acting in the manner of self-employed persons) and the Company derived income from such services. The income earned by the members through the Company, the IRS reasoned, is not income which is basically of an investment nature. Therefore the members are not “limited partners” for purposes of the exclusion to the SE tax and are subject to the SE tax on their distributive share of the Company’s management fee income.
The scope and impact of the CCA is difficult to assess. A “Chief Counsel Advice” memorandum is not binding on taxpayers, and conveys only the legal interpretation of the IRS Office of Chief Counsel. It may not be used or cited as precedent and is not definitive authority. However, such a document does provide an indication of the internal view of the IRS with respect to the legal matters discussed therein, and provides at least illustrative guidance to taxpayers on how IRS field agents are likely to approach similar questions.
In this case, the CCA does not address how its analysis would apply if the entity in question was a limited partnership and its members were “limited partners” under the applicable state law. On the other hand, neither the proposed regulations nor the CCA indicate that the distinction between the two types of legal entities is a material factor in the analysis, and the CCA does not restrict its conclusion solely to limited liability companies. It is unclear whether the courts would support the IRS’s position (either with respect to limited liability companies or limited partnerships) and if so, whether Congress would step in to change the outcome.
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1 Chief Counsel Advice documents are legal advice, signed by executives in the National Office of the IRS Office of Chief Counsel and issued to IRS field or service center employees. The documents generally are issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues.
2 In 1997 the Treasury did propose regulations that would treat individuals as limited partners, and therefore take advantage of the SE tax exclusion, unless the individual (i) had personal liability for the debts of the partnership, (ii) had authority to contract on behalf of the partnership, or (iii) participated in the activities of the partnership for more than 500 hours during the taxable year. In addition the proposed regulations provided that that service providers in service partnerships may not be limited partners. These proposed regulations applied to all partnerships, including LLCs. After an outcry from the business community, Congress imposed a moratorium preventing the IRS from finalizing these regulations until July 1, 1998. The IRS never finalized the proposed regulations and has never withdrawn them.
3 The Company was formerly organized as an S corporation. A shareholder of an S corporation can be an employee of the S corporation whereas a partner of a partnership generally cannot also be an employee of that partnership.