Tax News
ILM 201436049: An Unknown Hedge Fund Gets a Self-Employment Tax Slap from the IRS
September 08, 2014
Administrative Actions
Apparently some investment funds continue to take the position that their 2% service fee income is exempt from the self-employment tax (“SET”) under the “limited partner” exception of Sec. 1402(a)(13). These positions are often based on advice by counsel that there is a material distinction among an LLC, LP and LLP when it comes to this issue. I have reasoned here that in light of the proposed regulations and the Renkemeyer decision, these arguments are rather aggressive.  In the above-quoted ILM, the IRS tacitly seems to disagree with the view that the type of entity matters as long as the entity is treated as a partnership for US federal tax purposes.  This approach is in line with the existing proposed regulations which do not distinguish between the various entities.

In the ILM we have a hedge fund with a relatively common structure of 2-20 and a separate management company and a GP. The management company was the recipient of the fee income and the GP was the recipient of the carry allocation. The management company was an S corporation prior to its conversion to an LLC and housed all the service performing fund execs. The investment manager took two positions: (1) the distributive share of the fee income should be excluded from SET under the Sec. 1402(a)(13) exception and (2) because the manager had the same role and business as the S corporation it succeeded, it could continue to apply the same “reasonable compensation” wage rules applicable to corporations.

The IRS disagreed with both arguments. In my mind, the important issue here is (1). The IRS extensively quoted the Section 1402 legislative history and the Renkemeyer decision in ruling that the LLC members of the manager were not “limited partners.” The reason was, just as in Renkemeyer, that the LLC members’ earnings were not in the nature of a return on a capital investment, even though the members paid more than a nominal amount for their units. Rather, the earnings of each member from the manager were a direct result of the services rendered on behalf of the manager by its members. Notably, the law firm in Renkemeyer was an LLP. This did not stop the IRS from applying the same logic to the LLC manager and nowhere in the ILM did the IRS indicate that it views the state law classification of the entity as material to the analysis.

Would the result have been different if the entity was an LP? I’d venture to say, no, unless it was a true LP where the limited partners were restricted from participating in the business, which obviously is counterintuitive to the hedge fund manager business. The principal difference among an LP, LLC and an LLP is that, to put in the words of the Renkemeyer court, “it is generally understood that a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership.” Now, the Tax Court in Renkemeyer looked at the Revised Uniform Partnership Act of 1976 when it made that statement.  This was the law during the time Sec. 1402(a)(13) was enacted.  However, the latest Uniform Limited Partnership Act (2001) eliminates this requirement.  The notes to the Act provide that

“RULPA provides only a restricted liability shield for limited partners. The shield is at risk for any limited partner who "participates in the control of the business." RULPA Section 303(a). Although this "control rule" is subject to a lengthy list of safe harbors, RULPA Section 303(b), in a world with LLPs, LLCs and, most importantly, LLLPs, the rule is an anachronism. This Act therefore eliminates the control rule and provides a full, status-based shield against limited partner liability for entity obligations. The shield applies whether or not the limited partnership is an LLLP.”

So, if you form a limited partnership in a ULPA (2001) state, relying on the mere fact that you are a limited partner under state law does not fit the bill. It is difficult to argue that you should be treated as a limited partner only because you are a “limited partner” for state law purposes because simply ULPA was not contemplated by Sec. 1402(a)(13). A Renkemeyer court would reason that all partners of a ULPA limited partnership (just as an LLP) enjoy limited liability protection and may have management powers, and thus, are not “limited partners” for purposes of Sec. 1402.  .Conversely, if you are in a RULPA based state like Delaware, you may try to distinguish Renkemeyer but you could be violating the RULPA statute and eliminating the limited liability protection of the LP partners.  In any case, judging by this ILM and the apparent IRS interest in the issue, if you go this route, it is not a bad idea to prepare for controversy.

As a separate common sense point, the view that an LP, LLC and LLP should be treated differently for SET purposes is very specious considering that they are treated exactly the same (i.e. partnerships) for federal tax purposes.  At least to me, such treatment would introduce an illogical incongruity that could be explained only by aggressive tax planning.
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Tags: 1402(a)(13), Renkemeyer, self employment tax, SET