Article by Mark H. Leeds1
Keywords: IRS, tax audit memorandum, social security taxes
It's probably fair to speculate that there were significant numbers of tax aficionados (including the author of this article) among the audience for Ken Burns' recent public television extravaganza on the Roosevelt dynasty. Unfortunately for this segment of the audience, the intersection of tax and FDR was not highlighted, with the passage of the Social Security Act receiving only scant mention. Social security taxes have risen dramatically since the enactment of the law. As a result, these taxes have a more prominent role in tax planning than Mr. Burns gave them in his not-so-mini-series. A recent Internal Revenue Service ("IRS") audit ruling highlights planning traps that can dramatically affect when Social Security taxes can be imposed.
On September 5, 2014, the IRS released Chief Counsel Advice 201436049. This CCA addresses an all-too-common structure employed by hedge fund managers to hold the management fee interest in the fund. The structure employed by the funds in CCA 201436049 resulted in the IRS arguing that the full management fee should be subject to Social Security taxes. An alternate structure would have lessened the likelihood of this assertion. This article describes the facts presented by the CCA and the assertion made by the IRS. It also examines an alternate structure and how the use of the alternate structure could mitigate the possible imposition of self-employment tax imposed by Section 1402(a) of the Internal Revenue Code of 1986, as amended (the "Code") and the Medicare Tax imposed on net investment income ("NII") by Code § 1411.
The facts described in CCA 201436049 should sound familiar to any tax person who has spent time structuring hedge funds. At the bottom of the structure was a limited partnership (the "Master Fund").2 Third party investors purchased limited partnership interests in the Master Fund.
The Master Fund had two general partners: (1) Management Company and (2) Profits GP.3 The Management Company was organized as a limited liability company (an "LLC") taxable as a partnership. The Management Company had the "full authority and responsibility to manage and control the affairs and business" of Master Fund. This included all investment activities, such as the purchasing, managing, restructuring, and selling of the Master Fund's investment assets. Employees and members of the Management Company conducted these operations. The Master Fund paid a management fee to the Management Company in exchange for these services. The management fee constituted all of the Management Company's gross receipts in the years under IRS audit.
CCA 201436049 recites that all of the members (partners) in the Management Company were individuals. Certain members paid significant sums for their Management Company equity units. Although redacted, it appears that each of such members spent more than 500 hours per year on the business of the Management Company which, as stated above, was conducting investment activities for the Master Fund. The Management Company paid wages to its members4 and employees, but the facts of the CCA show that the payment of wages did not zero out the income of the Management Company. Accordingly, the Management Company had residual income that it allocated to its members. This income was allocated pro rata by the number of Management Company equity units held by each of its members.
The Management Company did not withhold Social Security taxes on the distributive share of the Management Company net income that was allocated to its members. This failure by the Management Company to withhold Social Security taxes was the subject of CCA 201436049. The IRS asserted that the Management Company should have withheld these taxes.
Code § 1402 and Net Earnings from Self- Employment
Under current law, Federal Insurance Contribution Act ("FICA") taxes are imposed on wages, i.e., income from employment paid by an employer. Under a complementary regime, Self- Employment Contributions Act ("SECA") taxes are imposed on earnings from self- employment. For individuals who receive compensation for services from entities taxable as partnerships in which they hold partnership interests, SECA taxes apply. The IRS has ruled FICA does not apply to a partner's partnership income because a partner cannot be an employee of a partnership of which he is a partner.5
SECA has three components:
The OASDI tax, imposed at a 12.4% tax on net earnings from self-employment ("NESE") up to $117,000 for 2014 (the "OASDI cap"). The OASDI cap is indexed annually for inflation. The Hospital Insurance ("HI") tax. The HI tax is imposed at a 2.9% rate on NESE. There is no cap on the HI tax and it applies to every dollar of NESE. The HI High Earner Surtax. The HI High Earner Surtax is a .9% tax that applies to NESE in excess of $200,000 ($250,000 for married individuals filing a joint return). Code § 1401(a), (b)(1). NESE is defined in Code § 1402(a) and can include an individual's distributive share of income from any trade or business carried on by a partnership in which he is a partner. NET EARNINGS FROM SELF-EMPLOYMENT AND LLCS AND LLPS
Code § 1402(a)(13) excludes "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) ... for services actually rendered to or on behalf of the partnership, to the extent that those payments are established to be in the nature of remuneration for those services" from the definition of NESE. Congress added Code § 1402(a)(13) in 1977 in order to prevent individuals from grossing-up their NESE by their distributive share of partnership income from partnerships when the allocation of partnership income was not compensation for the performance of services.6 Thus, Code § 1402(a)(13) carves out a limited partner's distributive share of partnership income from the definition of NESE. The enactment of Code § 1402(a)(13) preceded the rapid growth in popularity of LLCs and other limited liability pass-through entities.7 As noted in the CCA, the scope of activities of the typical limited partner back then was significantly limited compared to the modern limited partner of a LLC. Under the Revised Uniform Limited Partnership Act of 1976, if a "limited partner" took part in the control of the partnership's business, such person would lose limited liability protection.
Over time, however, as national incomes approached and then exceeded the Social Security cap described above, the focus of the government changed. The IRS, instead of seeking to prevent individuals from including partnership income in their Social Security tax base, wrote rules that curtailed the ability of limited partners to exclude partnership income from NESE. Specifically, in January 1997, the IRS proposed regulations (the "1997 Proposed Regulations") that generally would have prevented partners (including LLC members) who, among other things, provided more than 500 hours of service to the partnership from being treated as "limited partners" for Code § 1402(a)(13) purposes.8 However, in August 1997, Congress imposed a one-year moratorium preventing the Treasury from adopting regulations dealing with the employment tax treatment of limited partners (the "1997 Moratorium").9 The moratorium expired on July 1, 1998. The 1997 Proposed Regulations were never adopted, even after the 1997 Moratorium expired. CCA 201436049 briefly discusses the 1997 Proposed Regulations in passing, but focuses its analysis on legislative history and case law.
The legislative history of Code § 1402(a)(13) demonstrates a shift from subjecting all of partner's distributive share to self-employment tax, regardless of such partner's role and responsibilities in his capacity as a partner, to a recognition that "certain earnings which are basically of an investment nature" should be exempt.10 However, Congress drew a line: "The exclusion from [Social Security] coverage would not extend to guaranteed payments (as described in 707(c) of the Internal Revenue Code), such as salary and professional fees, received for services actually performed by the limited partner for the partnership."11 In CCA 201436049, the IRS concluded that the intent of the statute was to exempt individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations.
The IRS in CCA 201436049 grounded its assertion that income allocated by the Management Company to its member should be subject to NESE on the decision in Renkemeyer, Campbell & Weaver, LLP.12 The taxpayers at issue in that case were attorney-members of a Kansas LLP engaged in the practice of law. Each LLP member was provided with the same liability protection as a limited partner. The LLP reported business revenues from its law practice on IRS Forms 1065 for the relevant tax years, but no portion of those revenues was included on the law firm's tax returns as NESE. The IRS asserted that the attorney-partners' distributive shares of the law firm's business income for the relevant tax years was subject to self-employment tax. As in the CCA, the Renkemeyer court's decision turned on whether the attorney-partners were "limited partners" under Code § 1402(a)(13).
The taxpayers in Renkemeyer claimed their respective interests in the law firm shared the characteristics of limited partnership interests because (i) their interests were designated as limited partnership interests in the law firm's organizational documents and (ii) the partners enjoyed limited liability pursuant to Kansas law. Hence, they argued, their distributive shares of the law firm's business income qualified for the Code § 1402(a)(13) exception. The Tax Court distinguished general partners from limited partners by explaining that "[g]eneral...