In ILM 201640014 (the ILM), the Internal Revenue Service (IRS) determined that the exclusion from "self-employment income" (SEI) available to allocations by a partnership to a "limited partner" under Section 1402(a)(13) was intended to apply only to those who "merely invested" in a partnership and not to those who "actively participated" and "performed services." Accordingly, a person who was the Operating Manager, President, and Chief Executive Officer, as well as a member, of a limited liability company treated as a partnership for US federal income tax purposes was not a "limited partner" within the meaning of Section 1402(a)(13) and thus was subject to self-employment tax on his full distributive share of the limited liability company's income from restaurant operations.

Facts

"Taxpayer" purchased several franchise restaurants. He contributed the restaurants to "LLC," a limited liability company treated as a partnership for US federal income tax purposes, which owned and operated them. LLC's gross receipts and net ordinary business income were almost entirely attributable to the preparation and sale of food products. The members of LLC were Taxpayer, his wife and his wife's irrevocable trust. The franchise agreements required Taxpayer to personally devote full time and best efforts work to the operation of the restaurants. Taxpayer served as LLC's Operating Manager, President, and Chief Executive Officer. Taxpayer directed the operations of LLC and conducted day-to-day business affairs in managing LLC in his capacity as a member of LLC. Taxpayer made strategic and succession decisions as well as LLC's investment and planning decisions, such as acquisitions, sales transactions and real estate activities. Taxpayer had ultimate authority over hiring and firing decisions, as well as oversight of all employees of the business.

For each of the years the ILM addressed, LLC had paid Taxpayer a guaranteed payment and the Taxpayer had received a distributive share. LLC argued that the guaranteed payments represented "reasonable compensation" for the services it received from Taxpayer, so these guaranteed payments may have served as Taxpayer's "salary" from LLC. These guaranteed payments were treated as SEI. LLC treated Taxpayer as a "limited partner" for purposes of Section 1402(a)(13), so that his distributive share from LLC was not SEI. LLC argued that Taxpayer had contributed the restaurants to it in exchange for membership interests, and that Taxpayer's distributive share of LLC net income and net loss represented a reasonable return on the Taxpayer's capital investment that was not SEI and not subject to self-employment tax.

Analysis

Section 1401 generally imposes a tax on the SEI of every individual for a tax year. Section 1402(b) generally provides that SEI means an individual's net earnings from self-employment.

Section 1402(a) generally defines net earnings from self-employment, including some items and excluding others. Section 1402(a)(13) excludes from SEI the distributive share of partnership income of a "limited partner," other than payments to the limited partner for services to the partnership, including guaranteed payments. Section 1402(a)(13) does not define the term "limited partner." The legislative history to P.L. 95-216, the 1977 statute that enacted Section 1402(a)(13), describes Congress' thinking in enacting it. In most relevant part, that thinking was that, "[t]he bill would exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership. This is to exclude for coverage purposes certain earnings [that] are basically of an investment nature."

In the ILM, Associate Chief Counsel noted that all of the distributive share of partnership income allocated to an individual who is not a "limited partner" within the meaning of Section 1402(a)(13) is SEI, regardless of the extent of the individual's participation in the partnership's business or the capital-intensive nature of the partnership's business. The ILM found Taxpayer was the only partner of LLC who was involved with LLC's business. It found that Taxpayer was not a "mere investor" in LLC's business but rather actively participated in LLC's operations in his capacity as a partner, which it compared to "acting in the manner of a self-employed person." Accordingly, Associate Chief Counsel concluded that Taxpayer's distributive share of LLC income was not received by him as a "limited partner" of LLC within the meaning of Section 1402(a)(13), but was SEI in its entirety.

Implications for hedge fund managers

The ILM stands as evidence of the government's ongoing concern regarding the application of Section 1402(a)(13) to partners of partnerships who substantively participate in the activities of their companies. The ILM analysis was focused on the level and nature of such activities.

The SEI issue has been raised several times in the recent past. CCA 201436049, released in late 2014, had a similar fact pattern to this ILM, in which a hedge fund management company's LLC members were responsible for managing investment funds in their structure. Each management company member was allocated a pro rata share of the LLC's taxable income. The LLC reported that only the guaranteed payment portion of the members' share of taxable income was SEI. The IRS concluded that the management company's full distributive share of fee income is not the type of income Congress sought to exclude from SEI and thus all management company members' income was subject to SEI. In 2011, this issue was litigated in Renkemeyer, Campbell, and Weaver LLP v. Commissioner. Here, the Tax Court held that the partners of a law firm organized as a Kansas limited liability partnership were not limited partners within the meaning of Section 1402(a)(13) and thus were subject to self-employment taxes on their distributive shares of partnership income. It was decided that, as the limited partners had management power, they lost their limited liability protection and therefore could not be considered passive investors, resulting in SEI. With this most recent ILM, the IRS is taking what it views as a consistent position in stating that, if income attributable to an LLC interest is derived from management activities, it is SEI.

The ILM and previous cases did not involve state law limited partnerships and whether this fact may have changed the outcome remains unanswered. The IRS may be making a broader statement with its all or nothing view. These cases have focused on material participation and management functions of members as being the determining factor as to whether SEI applies.

Currently, the laws of several states allow for limited partners to have an active role in the partnership's business while retaining their limited liability protection. As the term "limited partner" is not defined in Section 1402(a)(13), many taxpayers have interpreted the states definition for federal purposes and have not considered the partner's involvement in the "limited partner" determination. The guidance provided by the new ILM does not address this issue due to its fact pattern, but it is possible that the IRS could apply the same analysis to limited partnership entities at a future time. For the time being however, it seems a more viable option for the IRS to focus on LLCs since statutorily there is no explicit exemption in the regulations for LLC members, as opposed to an entity structured as a state law limited partnership.

———————————————