On September 5, 2014, the Office of Chief Counsel, Internal Revenue Service (IRS) released an internal generic legal advice memorandum (available here) advising an IRS field agent that the statutorily provided “limited partner” exception to self-employment tax is not available to members of an investment management company whose income was from fees for managing investment funds. The memorandum’s analysis is contrary to the long-standing common interpretation and generally accepted practice that investment managers are eligible for the statutory exception.
The IRS’s position in the memorandum is not entirely unexpected, given recent increased scrutiny of the self-employment tax issue in connection with management company audits. There have also been at least two cases in the past few years, both of which were cited and discussed at length in the memorandum, which invalidated the use of the limited partner exception by active partners in a professional services limited liability partnership (LLP) and limited liability company (LLC), respectively.1
If the limited partner exception were no longer available, then all profits of a management company attributable to limited partners would be subject to the 3.8 percent Medicare portion of the self-employment tax.2
The management company described in the memorandum was operating as a state law limited liability company during the years at issue. As released, the memorandum does not specifically address the applicability of its conclusion to investment professionals who are state law “limited partners” of a management company that is a state law “limited partnership,” which is the organizational form more commonly used by investment professionals seeking to avail themselves of the limited partner exception.
Nonetheless, the memorandum’s analysis clearly suggests that it would apply to investment professionals who are limited partners in a management company limited partnership,3 and dismisses as irrelevant common features such as the making of guaranteed payments to, and the investment of capital by, investment professional partners.4 If its conclusion were successfully applied to limited partnerships, the memorandum would push the boundaries of the existing case law that it cites beyond that of LLPs and LLCs to state law limited partnerships—thereby impairing a common management company planning technique.5
However, the two-page “Case Development, Hazards and Other Considerations” section of the memorandum is redacted, and the unredacted portion of the memorandum does not address the significant arguments supporting the use of the limited partner exception within the context of a management company limited partnership. Therefore, at this point, it is unknown how the IRS assesses the strength of the memorandum’s conclusion and whether it believes that its position is strong.
It is also unknown whether the memorandum addressed the prior congressional moratorium on Treasury regulations regarding the limited partner exception, or whether the memorandum considered recent Obama administration and Congressional proposals that would provide a partial exemption from self-employment tax to active partners in a partnership.6 Most importantly, it is unknown whether eligibility for the limited partner exception will become a key issue on audit that the IRS is unlikely to settle on terms favorable to taxpayers.
Generic legal advice memorandums are issued to IRS field agents who have questions as to points of law during the course of an audit and specifically may not be used or cited as precedent, and do not constitute definitive authority. Taxpayers generally are not required to disclose on their tax returns that they are taking a position contrary to a memorandum in order to avoid penalties.
The conclusion of this memorandum is nonetheless significant for many management companies and their investment professionals and we will continue to monitor developments with respect to the memorandum and IRS audit practice on this issue. Depending on future developments, investment professionals seeking to limit exposure to self-employment taxes ultimately may consider using an S corporation7 (to which the memorandum suggests that a different and potentially more favorable legal analysis could apply) as the management company, among other potential alternatives, in order to distinguish themselves from the facts of the memorandum. However, it is too early to determine how this issue will develop and whether and when investment professionals—particularly those conducting their management business through a limited partnership—would be served to reconsider their current management company structure.