Fund Managers Reel After Court Ruling on Self-Employment Tax

The IRS got more leeway to remain laser-focused on the wealthy after a closely watched US Tax Court opinion on limited partnerships disrupted the investment fund industry this week.

Soroban Capital Partners LP, an investment firm organized as a Delaware limited partnership, wanted its founders who are classified as limited partners to be exempt from self-employment taxes on their partnership-allocated earnings. But the court ruled in the IRS’s favor Tuesday, saying that a “limited partner” label doesn’t automatically mean those earnings are exempt.

The definition of a limited partner historically has been complicated and ambiguous, leaving it open to interpretation and more intense IRS scrutiny. The Tax Court opinion concluded that partners who are limited in name only but otherwise active in the partnership aren’t exempt from the self-employment tax on their business profits.

Soroban, which didn’t immediately respond to a request for comment, could still appeal the decision. Investment funds are watching the case closely to determine their next steps.

“It will have a huge impact on partnerships,” Jerry Musi, a tax partner at RSM US, said in an interview, adding that he expects some may eventually choose to revisit partnership agreements to give limited partners less or no say in the managerial decisions. “This puts a stake in the ground.”

State law limited partnerships are a common arrangement for hedge funds, private equity, and other fund sponsors. A limited partner in a partnership is typically a passive financial investor and isn’t usually active in management decisions.

But more states are allowing these limited partners to provide services to businesses they invest in, further blurring the lines of who qualifies for the exception.

Tax professionals and industry insiders said that a newly empowered Internal Revenue Service will intensify its efforts to challenge these types of limited partnerships. The IRS said it generally doesn’t comment on ongoing litigation.

How to Define ‘Limited Partner’

Soroban reported $3.94 million in net earnings for the three limited partners for its 2016 and 2017 returns, but the firm excluded their shares of “Soroban’s ordinary business income in its computation of net earnings from self-employment,” the Tax Court said.

The court found that a “functional inquiry into the roles and activities” of those limited partners is a partnership item and appropriate for the proceedings, which Soroban argued the court didn’t have jurisdiction to decide.

The precedential ruling aligns with the IRS position that Congress intended the exemption from the self-employment tax to apply only to earnings of an investment nature. Income made when a limited partner provided additional services to the partnership does not fall under the exception and is still subject to the self-employment tax, according to the revenue code.

However, at the time Section 1402(a)(13) was written in 1977 it predated other entities such as a limited liability company and a limited liability partnership.

The IRS tried to further define a limited partner in 1997 proposed regulations but lawmakers objected, claiming it overstepped its regulatory authority. Congress subsequently issued a one-year moratorium preventing the IRS from issuing temporary or final regulations that define a limited partner.

More Wins, More Settlements

The IRS still hasn’t promulgated more regulations, two decades later. The project was recently added to the agency’s annual list of regulatory priorities, though it doesn’t detail the timing of the release of rules.

The current political landscape is vastly different, with some Democrats having an appetite to go after the ultra-wealthy, said Dawn Rhea, a partner at Weaver. The chance for the same congressional backlash to additional Treasury regulations would be smaller now, she added.

The IRS launched its Self-Employment Contributions Act compliance campaign in 2018 to focus audit efforts on limited partners, including state law limited partnerships, limited liability companies, limited liability partnerships, and limited liability limited partnerships. And with this favorable US Tax Court ruling, the agency is likely to put more resources toward examining these limited partnerships, tax professionals said.

Waiting, Watching

Petitions similar to Soroban’s were also filed by Denham Capital Management, a Boston-based private equity firm, and New York Mets owner Steve Cohen’s Point72 Asset Management. The trio of cases represent the first time a court will be ruling on the self-employment exception and its application to an active limited partner in a state law limited partnership.

“People are watching, and every case stands on its own facts,” said Miri Forster, a tax partner at EisnerAmper. “This partnership, the outcome, could be different—not on the summary judgment necessarily—but the factual determination of the functions of the limited partners could differ depending on the facts of the case.”

Hedge funds and other money managers under exam that receive similar results might seek an alternative strategy to Tax Court, such as paying tax, interest, and penalties from the allocation subject to self-employment and going to district court, which typically doesn’t specialize in federal taxes.

“There’s a lot of maneuverability but do I think this is going to change behavior? No,” Rhea said. “Do I think it’s going to change the way the firms that prepare these returns, prepare these returns and their appetite for risk on these allocations? Absolutely.”

Some tax professionals may reconsider signing off on tax returns after reviewing the facts and circumstances if a hedge fund takes a position contrary to the recent ruling, and tax and accounting firms may also start to take a firm-wide stance on how to address this ruling in returns.

“It feels like this is a big change to a filing position because it’s the first flag in the sand of, ‘This is where we’re going with this,’” said Jon Pezzi, a partner at Weaver. “Do we have to start disclosing some of this?”