Investment Service Partners' Income Subject to Self-Employment Tax

UILC: 1402.01-03

LEGEND:

Managed Fund = * * *

Each Fund has two general partners for State 2 law purposes: Profits GP and Management Company. Profits GP generally does not take part in the conduct or control of the activities of the Funds, but has a substantial interest in each Fund's gains and losses. Management Company, not Profits GP, is the subject of this advice.

Management Company generally has full authority and responsibility to manage and control the affairs and business of each Fund. Thus, Management Company is primarily responsible for carrying out the extensive market research and trading activity of each of the Funds. Thus, it carries on all investment activities, such as the purchasing, managing, restructuring, and selling of the Funds' investment assets. Partners of Management Company and its employees provide these extensive services to the Funds. Management Company's primary source of income is from fees for providing management services to the Funds. In addition to its small ownership interest in each of the Funds, Management Company's assets consist primarily of cash, office equipment, and an aircraft.

In consideration of Management Company's services, the limited partnership agreements of each the Funds provide for payment of a quarterly management fee from the Fund to Management Company based upon each Fund's assets under management, and generally calculated as a percentage of each Limited Partner's capital account in the Fund.

Management Company is under examination by the Internal Revenue Service (IRS) for Year 3 and Year 4. In the years at issue, Management Company's gross receipts were entirely attributable to management fees for providing services to the Funds, and Management Company's net ordinary business income was comprised entirely of income from the management fees, rather than a distributive share from the Funds.¹

In Year 3 and Year 4, Management Company had C and D Partners, respectively, all of whom were individuals.² Each Partner of Management Company worked full time, in excess of F hours each year, for Management Company. Partners performed a wide range of professional services, including investment management services, analyst services, trading services, portfolio management services, accounting services, tax services, information technology services, settlement services, legal services, human relations services, client services, and administrative support services. Some Partners performed trading and analysis services directly for the Funds on behalf of Management Company, while other partners performed operational and support services for Management Company itself. Each of the Partners received Forms W-2 for both Year 3 and Year 4 from Management Company for wage amounts received which ranged from $G to $H.

Several of Management Company's Partners have been partners since Management Company was formed. Other Partners were formerly non-partner employees who were given an opportunity to buy interests (Units) in Management Company. From time to time, select existing Partners are given the opportunity to purchase additional Units in Management Company. Management Company states that the offer to purchase Units in Management Company at the net asset book value of Management Company is extended by Management Company's senior management to Partners based upon current performance, tenure, and future potential performance. Restrictions apply to the Units held by Partners; in particular, Management Company's LLC agreement provides that Partners must sell their Units back to Management Company upon death, disability, retirement, or termination of employment.

Management Company issues Units classified as Class A Common Units, Voting Class B Common Units, and Non-Voting Class B Common Units. As a result of their ownership of Units, each Partner of Management Company is allocated a distributive share of Management Company's taxable income, including the ordinary business income attributable to the management fees. Although Management Company has several different classes of Units outstanding, Management Company's taxable income is allocated pro rata based on each Partner's total Units, regardless of class.

In Year 3 and Year 4, Management Company treated all of its Partners as limited partners not subject to self-employment tax on their distributive share. The only amount reported as subject to self-employment tax were guaranteed payments which represent health insurance premium and parking benefits paid on behalf of Partners by Management Company.

Management Company states that the "wage" amounts represent "reasonable compensation" for each Partner, and that each Partner is a limited partner with respect to their distributive share. Management Company reasons that because Management Company has the same role and business as the S corporation it succeeded, it can continue to apply the same "reasonable compensation" wage rules applicable to corporations.

Section 1402(b) generally provides that the term "self-employment income" means the net earnings from self-employment derived by an individual during any taxable year.

Section 1402(a) generally defines the term "net earnings from self-employment" as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in § 702(a)(8) from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions.

Section 702(a)(8) provides that in determining his income tax, each partner shall take into account separately his distributive share of the partnership's taxable income or loss, exclusive of items requiring separate computation under other paragraphs of § 702(a).

Section 1402(a) provides several exclusions from the general self-employment tax rule. In particular, § 1402(a)(13) provides:

The legislative history for the exception in § 1402(a)(13) clarifies that Congress did not intend to allow service partners in a service partnership acting in the manner of self-employed persons to avoid paying self-employment tax. In creating the exclusion for limited partners, Congress stated,

In Renkemeyer, Campbell, and Weaver LLP v. Commissioner, 136 T.C. 137 (2011), the Tax Court ruled that practicing lawyers in a law firm organized as a Kansas limited liability partnership (LLP) were not limited partners within the meaning of § 1402(a)(13) and thus were subject to self-employment taxes. The court discussed Kansas state law under which an LLP is considered a general partnership. The court discussed the ordinary meaning of the term "limited partnership." The court stated:

The Renkemeyer court then turned to the facts of the case and concluded that the partners were not limited partners within the meaning of § 1402(a)(13) and that their distributive share of the partnership's fee income was subject to self-employment tax:

In Riether v. United States, 919 F.Supp.2d 1140 (D. N.M. 2012), the District Court granted the government's motion for summary judgment on the issue of whether a husband and wife (the Plaintiffs) were subject to self-employment tax on their distributive shares from an LLC partnership. The Plaintiffs asserted two arguments: first, they argued that because the LLC issued them each a Form W-2 in addition to the Schedule K-1, they were not self-employed, but rather were employees of the partnership; second, they argued that the income from the LLC was "unearned income not subject to the self-employment tax."

The court addressed the Plaintiffs' first argument as follows:

The court was also dismissive of the second argument:

Revenue Ruling 69-184, 1969-1 C.B. 256, provides that bona fide members of a partnership are not employees of the partnership under the usual common law rules applicable in determining the employer employee relationship. The revenue ruling provides that a partner who devotes his time and energies in the conduct of the trade or business of the partnership, or in providing services to the partnership, as an independent contractor, is in either case a self-employed individual rather than an individual who has the status of an employee.

In general, a partner must include his distributive share of partnership income in calculating his net earnings from self-employment. Fees for services, like those generated by an investment management company, are part of the partners' distributive shares under § 702(a)(8). Consequently, such fees are included in calculating net earnings from self-employment, unless an exclusion applies.

Management Company has taken the position that Partners are limited partners for purposes of the exclusion in § 1402(a)(13).

Management Company is an LLC. Partners perform extensive investment and operational management services for the partnership in their capacity as partners (i.e., acting in the manner of self-employed persons) and Management Company derives its income described in § 702(a)(8) from the investment management services performed by Partners. The income earned by Partners through Management Company is not income which is basically of an investment nature of the sort that Congress sought to exclude from self-employment tax when it enacted the predecessor to § 1402(a)(13). Accordingly, Partners of Management Company are not limited partners within the meaning of § 1402(a)(13) and they are subject to self-employment tax on their distributive shares of Management Company's income described in § 702(a)(8).

Like the situation in Renkemeyer, Partners' earnings are not in the nature of a return on a capital investment, even though Partners paid more than a nominal amount for their Units. Rather, the earnings of each Partner from Management Company are a direct result of the services rendered on behalf of Management Company by its Partners. Similar to Reither, Management Company cannot change the character of its Partners' distributive shares by paying portions of each Partners' distributive share as amounts mislabeled as so-called "wages." Management Company is not a corporation and the "reasonable compensation" rules applicable to corporations do not apply.

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views.

Please call Jeanne Royal Singley at * * * or Benjamin Weaver at * * * if you have any further questions.

²E Partners held interests through grantor trusts.

³ In 1997, the Treasury Department and the IRS promulgated proposed regulations defining "limited partner" for § 1402(a)(13) purposes. They generally provide that an individual is treated as a limited partner unless the individual: (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership; or (3) participates in the partnership's trade or business for more than 500 hours. The 1997 proposed regulations also provide exceptions for certain holders of classes of interest that are identical to those held by limited partners. Additionally, the 1997 proposed regulations provide that service providers in service partnerships (e.g., law firms, accounting firms, and medical practices) may not be limited partners. The 1997 proposed regulations applied to all partnerships (including LLCs). Congress imposed a temporary moratorium on finalizing the 1997 proposed regulations, which expired in 1998; however, the 1997 proposed regulations were never finalized.