Active Members of an Investment Adviser LLC Are Subject to Self-Employment Tax

By David H. Kirk, CPA/PFS, CFP, LL.M., and Bryan Rimmke, J.D., LL.M., Washington

Editor: Michael Dell, CPA

Partners & Partnerships

In Chief Counsel Advice (CCA) 201436049, the IRS Office of Chief Counsel (OCC) determined that actively working members of an investment management company formed as a limited liability company (LLC) were not limited partners within the meaning of Sec. 1402(a)(13), and, thus, their net distributive shares of management fee income were subject to self-employment tax.

Facts

The LLC, Management Co., was treated as a partnership for federal income tax purposes. It served as the investment manager for a managed fund. The managed fund conducted its activities through a number of state law limited partnerships (the funds) that were also treated as partnerships for federal tax purposes. Each fund carried on extensive trading and investing activity and had passive investors that were limited partners under state law. Each fund had two general partners: Profits GP and Management Co.

Management Co. had full authority and responsibility to manage and control the affairs and business of the funds and carried on all investment activities through its partners and employees. Management Co. had a small amount of assets, in addition to an ownership interest in each fund. Management Co.'s primary source of income was from management fees, which were based on the assets under management of the funds. In the years at issue in the CCA, Management Co.'s gross receipts and net ordinary business income consisted of fee income rather than a distributive share from the funds.

Management Co.'s members were all individuals and performed a wide range of professional services, including in the areas of investment management, analyst services, trading, portfolio management, accounting, taxes, information technology, settlement, legal services, human relations, client services, and administrative support.

Under Management Co.'s operating agreement, each Management Co. member was allocated a distributive share of Management Co.'s taxable income pro rata, based on each member's total units. In the years at issue, Management Co. treated all of its members as limited partners under Sec. 1402(a)(13), and, consequently, Management Co. reported only the members' guaranteed payments as being subject to self-employment tax.

Law and Analysis

Sec. 1401 imposes taxes on an individual's "self-employment income." Sec. 1402(a) defines "net earnings from self-employment" as the gross income derived by an individual from any trade or business, less deductions allowed that are attributable to the trade or business, plus a partner's distributive share of partnership trade or business income. Sec. 1402(a)(13) provides that, except for guaranteed payments for services rendered to the partnership, a limited partner's share of partnership income is generally not subject to self-employment tax, but it does not define the term "limited partner." However, the legislative history indicates that it was only intended to apply to "certain earnings which are basically of an investment nature" (H.R. Rep't 95-702 (part 1), 95th Cong., 1st Sess. at 11 (1977)).

Holding

After describing the relevant cases and statutes, the OCC concluded that Management Co. derived its income from the investment management services performed by the members. Thus, the members' distributive shares of Management Co. income were not income of an investment nature, which Congress was seeking to exclude from self-employment tax when it enacted Sec. 1402(a)(13). Thus, the Management Co. members were not limited partners under the statute, and they were subject to self-employment tax on their distributive shares of Management Co. income.

The OCC explained that, like the earnings of the taxpayers who claimed they were limited partners in Renkemeyer, Campbell, and Weaver LLP, 136 T.C. 137 (2011), the members' earnings were not in the nature of a return on a capital investment, even though they paid more than a nominal amount for their units. Rather, the earnings of each member were a direct result of the services rendered on behalf of Management Co. by the members. In addition, the OCC found that, similar to the situation in Riether, 919 F. Supp. 2d 1140 (D.N.M. 2012), Management Co. could not change the character of the members' distributive shares by paying portions of each member's distributive share as amounts improperly labeled as wages.

Implications

In an apparent attempt to address some of the uncertainty in the area, Treasury's 2014-15 Priority Guidance Plan, released on Aug. 26, 2014, includes a new project titled "Guidance on the Application of §1402(a)(13) to Limited Liability Companies." The analysis in this CCA may provide insight into the approach Treasury and the IRS are considering under this new project. On the other hand, because a CCA is merely a response by the OCC to a field office request for assistance, it is possible that future guidance could deviate from the CCA. A CCA cannot be used or cited as precedent.

Moreover, it is not clear what will happen to the current proposed regulations under Sec. 1402(a)(13) (pertaining to LLC members and state law limited partners) issued in 1997 (REG-209824-96). Under these proposed regulations, the state law characterization of an individual as a limited partner is not determinative for Sec. 1402(a)(13) purposes. The 1997 proposed regulation project has, generally, remained in suspension since Congress placed a temporary (and since expired) moratorium on the regulations' adoption. In addition, the self-employment tax treatment of owners of passthrough entities—both partnerships and S corporations—has been the subject of several legislative proposals originating from Congress and the Barack Obama administration.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

Newsletter Articles

SPONSORED REPORT

Year-End Tax Planning and What’s New for 2016

A look at year-end tax planning strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

PRACTICE MANAGEMENT

CPAs Contend With Tax ID Theft

Tax-related identity theft fraud remains a widespread problem that is often difficult for victims and their tax preparers to correct.