The 5th Circuit just provided some welcome clarity to an issue many limited partners have faced over the years and it has a particular impact on how fund managers may want to organize their management companies. In a ruling that overturned a Tax Court decision, the 5th Circuit has held that limited partners, as classified under state law, qualify for an exemption from self-employment tax on their distributive share of income from their limited partnership. As it stands for now, at least in the 5th Circuit, fund managers may want to consider organizing their management companies as limited partnerships. This should put these state law limited partners in a much better position to exempt their distributive shares of income from the management company from self-employment taxes, including the 3.8 percent Medicare tax under the Affordable Care Act. We note that the general partner will still be subject to such taxes.
The case began with the IRS increasing the net income subject to self-employment for Sirius Solutions, LLLP, a Texas limited partnership (“Sirius”), a management consulting firm based in Houston, Texas. The IRS based this adjustment on the fact that the limited partners of Sirius were actively participating in the business of Sirius. Under Internal Revenue Code (“Code”) Section 1402(a)(13) a limited partner’s distributive shares of income from a partnership are exempt from self-employment tax if such income is received in the capacity of a “limited partner, as such”. The IRS construed, and the Tax Court had agreed, that the phrasing of a “limited partner, as such” meant that such limited partner had to be “passive” in order to avail themselves of the exemption. The Tax Court went on to apply a multi-factor test and ultimately determined that Sirius’ limited partners were not passive and therefore their net income from Sirius was subject to self-employment tax.
Sirius appealed the decision and the 5th Circuit ultimately overruled the Tax Court’s decision, adopting a more common-sense rule to apply. If a limited partner is classified as such by state law, then such limited partner’s distributive share from a limited partnership is exempt from self-employment tax. The IRS’ arguments (and the Tax Court ruling) primarily hinged on separating limited partners into two categories for Code Section 1402; active and passive. But, the 5th Circuit decided that the plain text and historical use of the term with respect to the Social Security Administration favored simple “best meaning” of limited partner, which is a “partner in a limited partnership.”
While this is a welcome victory for limited partners, and businesses organized as partnerships, there are similar appeals pending in the 2nd and 3rd Circuits. It is unknown how those cases will resolve and whether it will hinder limited partners’ ability to claim an exemption from self-employment taxes under Code Section 1402(a)(13). As a reminder, guaranteed payments remain subject to self-employment tax under Code Section 707(c).
If you have any questions, please feel free to contact Kevin Leiske.
