General partner of private investment fund: In a trade or business?

By Brendan M. Ryan, CPA, MST, New York City, and Alan Speer, CPA, MST, Bienville Capital

Editor: Lori Anne Johnston, CPA, J.D.

Private investment funds are typically structured as limited partnerships with an entity as a general partner. That general partner is responsible for the overall management of the fund and is usually compensated by a performance fee or allocation (sometimes called a carried interest) in exchange for services rendered. Those not familiar with the industry might find it interesting that these entities are generally not treated as engaged in a Sec. 162 trade or business. In fact, it is common practice to treat them otherwise. This discussion addresses instances in which the characterization of a general partner's activity may become relevant, and it outlines the authority to consider when determining whether the general partner of an investment fund is engaged in a Sec. 162 trade or business.


The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made it less desirable to classify advisory fees and other investment expenses as Sec. 212 expenses (sometimes referred to as portfolio deductions). When classified under Sec. 212, the advisory fees and other investment expenses of the fund are now no longer deductible to fund investors that are individuals or similarly taxed entities, such as trusts. Before the TCJA's passage, individuals could deduct these expenses as miscellaneous itemized deductions, subject to a floor of 2% of the individual's adjusted gross income (AGI). The TCJA, however, eliminated miscellaneous itemized deductions for tax years 2018 through 2025.

One may wonder: Can fund-related expenses be deducted under Sec. 162? Many investment funds employ a management company that clearly qualifies as being engaged in a trade or business. The management company is often delegated authority by the general partner entity to conduct the day-to-day operations of the investment partnership in exchange for a management fee but is formally separate from the general partner. The management company almost always shares at least partial common ownership with the general partner. In addition, some private investment funds themselves receive the coveted "trader fund" status: those whose trading activity is sufficiently regular and voluminous for themselves to be considered as engaged in a trade or business. These entities properly classify their expenses as business expenses under Sec. 162, allowing individual investors to deduct their management fees and other investment expenses in full in arriving at AGI.

Less commonly examined in the industry, however, is whether the general partner entity may be engaged in a Sec. 162 trade or business. This may become relevant when the funds needed to operate and manage the investment fund are held by the general partner entity, and not the management company. For a host of reasons, it may be undesirable to distribute the cash from the general partner entity to its partners for recontributing to the management company, or to otherwise loan the funds directly to the management company. In such situations, the general partner entity now has a need to pay these expenses itself. The concern then becomes trying to maintain the same tax treatment for these expenses under Sec. 162 as they would have received if paid for with cash from the management company. This leads us to the question at hand, "Is the general partner of an investment fund engaged in a Sec. 162 trade or business?"


As stated previously, the general partner of an investment fund is typically structured as a partnership and receives compensation in the form of an incentive allocation from the underlying investment fund based on the fund's performance. The management company is also typically structured as a partnership and is usually given authority by the general partner to manage the investment fund's day-to-day operations. The management company receives its compensation in the form of management fees, which are typically assessed and charged based on the value of the assets being managed (or committed to be managed) by the fund. Often the management fees are used to "keep the lights on" for the investment fund's managers, and the fees' dependability (regardless of the fund's performance) provides for the ability to pay the costs of managing the fund with some sense of regularity.

However, as previously mentioned, there are some cases in which the general partner pays the expenses of running the fund. In such circumstances, if no consideration is given as to whether the entity is engaged in a trade or business, the individual fund managers may lose out on the deductibility of these expenses if they are classified under Sec. 212. This stands in stark contrast to the Sec. 162 treatment they would have clearly received had the expenses been paid by the management company directly. It is seemingly unfair that these expenses should receive different treatment, so it is wise to look to appropriate authority for guidance in determining whether a general partner can be considered to be engaged in a Sec. 162 trade or business.

No generally applicable definition of "trade or business" is found in either the Code or the Treasury regulations. The term's meaning has, however, been frequently addressed in various court cases. Most notably, in Groetzinger, 480 U.S. 23 (1987), the U.S. Supreme Court ruled that a specific test is not appropriate to determine qualification as a trade or business. Rather, an examination of the facts in each case is necessary. The Court further held that the taxpayer must be involved in the activity with "continuity and regularity" and that the taxpayer's primary purpose for engaging in the activity must be "for income or profit."

As far as meeting the continuity-and-regularity requirement, the partners of the general partner entity are typically involved in the day-to-day operations of the investment fund throughout the life of the business. The general partner entity is granted such authority explicitly within the partnership agreement, and although it generally has the authority to delegate certain duties to the management company, it continues to be responsible for management and decision-making matters with respect to the investment fund, in addition to sharing common ownership.

The second criterion — whether the general partner's primary purpose for engaging in the purported business activity is income or profit — must be analyzed as well. General partners of investment funds often invest some amount of their own capital in the fund, signaling to their investors that they have "skin in the game." Any gains from this investment are separate from any returns on the interest in profits received in exchange for the performance of services (the aforementioned incentive allocation).

This investment element raises potential concern under the principles espoused in, among other cases, King, 89 T.C. 445 (1987). King states that "[n]o matter how extensive his activities might be, an investor is never considered to be engaged in a trade or business with respect to his investment activities" (citing Higgins, 312 U.S. 212, 216, 218 (1941)). It is thus necessary to consider whether this investment element precludes the general partner from engaging in a trade or business.

To help determine whether the general partner would be treated as simply managing personal investments and not engaged in a trade or business, it is necessary to look to the Tax Court's interpretation in Dagres, 136 T.C. 263 (2011). Here, in a case involving a venture capitalist who was originally disallowed a business bad debt deduction under Sec. 166(a), the Tax Court held that "an activity that would otherwise be a business does not necessarily lose that status because it includes an investment function," and the taxpayer was entitled to claim the business bad debt deduction. The Tax Court further pointed out that "if the taxpayer receives not just a return on his own investment but compensation attributable to his services, then that fact tends to show that he is in a trade or business."

Additionally, although the general partner received not ordinary income but capital gain through its profits interest in the underlying venture capital funds, the Tax Court concluded that the income remained compensation, its character as capital gain notwithstanding. A typical general partner of an investment fund is indeed receiving an incentive allocation as compensation for its services, and Dagres highlights that neither the investment function of the general partner's own capital, nor the capital-gain character of the income earned, disqualifies the entity from being treated as engaged in a trade or business.

Furthermore, in a relatively recent case, Lender Management LLC, T.C. Memo. 2017-246, a taxpayer who received compensation in the form of a contingent profits interest, which depends upon the success of the investments it was managing, was held by the Tax Court to be engaged in the trade or business of providing investment management services and, therefore, could deduct its expenses under Sec. 162. The Tax Court explicitly addressed how the services provided by Lender Management (a family office investment manager) were comparable to those provided by a traditional hedge fund manager and stated that "the contingent nature of the profits interests does not negate their being compensation for services."

Carefully assess all facts in planning

It is clear from analyzing the case law that treating a typical general partner entity of an investment fund partnership as engaged in a Sec. 162 trade or business may well be permissible should the activities of the general partner entity meet the tests outlined in Groetzinger and other cases. It is imperative that taxpayers and their advisers take into account the unique facts and circumstances that govern their particular situation before making any determination regarding the classification of the activity of a fund's general partner.


Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.

For additional information about these items, contact Brendan M. Ryan, CPA, MST ( and Alan Speer (

Unless otherwise noted, contributors are members of or associated with RSM US LLP.

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