Certain limited partners in venture capital and private equity will likely see an increase in their tax liability due to a recent U.S. Tax Court decision. Generally, partners in a partnership and members in a limited liability company (LLC), taxed as a partnership, are subject to self-employment tax on their earnings from the partnership or LLC. However, a limited partner is not traditionally subject to this Self-Employment Tax due to the investment nature of their involvement. However, the recent decision from the U.S. Tax Court will likely result in additional tax to limited partners when the limited partner has an active role in the business, performs services for the business, or acts as more than a mere investor.
The IRS imposes three types of self-employment taxes: Social Security Tax, Medicare Tax, and Additional Medicare Tax (collectively, “Self-Employment Taxes”). Under Section 1401(a) and Section 1402(b) of the Internal Revenue Code (the “Code”), an individual is subject to self-employment tax on the net earnings derived from self-employment, subject to the applicable yearly wage cap (“Social Security Tax”). The Social Security Tax, imposed under Section 1401(a), is 12.4%; however, a taxpayer can take a tax credit equal to 6.2% of the tax. Under Section 1401(b)(1) of the Code, the IRS imposes a Medicare tax on the same net earnings at a rate of 2.9% but with no wage cap. Furthermore, under Section 140(b)(2) of the Code, the IRS assesses the Additional Medicare Tax on net earnings above $200,000 ($250,000 married filing jointly) at a rate of 0.9%.
Self-Employment Tax Exclusion for Limited Partners
Traditionally, limited partners are not subject to self-employment taxes on their net earnings. This limitation has been applied to limited partners because they generally have no “active” role in the trade or business and are usually only investors. However, under the recent ruling, the U.S. Tax Court has reaffirmed its prior reading of the statute and provided a road map for when a limited partner is subject to self-employment taxes.
Under Section 1402(a) of the Code, net earnings generally means the gross income obtained by an individual operating a trade or business or the distributive share of income received as a partner in a partnership. While the tax code defines “net earnings from self-employment” as gross earnings, the code allows taxpayers to reduce their tax obligation by allowing certain deductions or excluding certain income from the applicable calculation. Specifically, Section 1402(a)(13) of the Code allows a limited partner to exclude from the self-employment tax calculation the distributive share of income received in their capacity as a limited partner except for any guaranteed payments for services rendered.
Under the Tax Court’s analysis, a limited partner does not automatically receive the exemption solely by filing documentation with the Secretary of State and entering into a limited partner agreement. A limited partner can only receive the exemption when:
- The limited partner is merely an investor in the partnership.
- Does not actively participate in the business operations of the partnership.
- Does not perform services for the partnership.
The Court found that limited partners can only receive the exception when they are passive investors and not limited partners “in name only.”
Limited partners must actively limit their role within the organization to qualify for the self-employment tax exemption. This limitation must include evaluating the role they play in the business operations. In addition, in situations where a guaranteed payment is contemplated, then the partnership must carefully structure the limited partnership relationship to ensure that not all net earnings are subject to self-employment taxes.
For limited partners in venture capital, private equity, and other situations, the impact of this recent ruling can have significant negative consequences. If a limited partner does not meet the exception, the partnership risks additional exposure, and the limited partner could see their tax liability increase by 15%. To decrease risk, general partners must complete an inquiry into the roles and functions of the limited partners to ensure that the relationship is of an investment nature only. In addition, limited partners should consider how they are setting up their legal entities to avoid a situation where they are performing services for the partnership but are also an investor in an entity disregarded for tax purposes. Limited Partners will need to be prudent in their deals to avoid the potential for additional taxation.
To understand your risk as a limited partner or how to set up your legal structure better, please get in touch with KJK’s Tax Practice Chair, Demetrius Robinson (614.427.5749; DJR@kjk.com) or another member of our Tax Practice Group.