RIAs with private funds may need to pay self-employment taxes

Registered investment advisory firms that actively manage a private fund as limited partners must pay Uncle Sam for self-employment taxes on their profits, according to a court decision.

The Tax Court ruling last month in Denham Capital Management LP v. Commissioner will face a challenge in the Fifth Circuit Court of Appeals. In the meantime, the principals of RIAs or other advisory practices that also manage private funds should review the decision to see how it affects any possible taxes on their distribution of profits, according to Brett Cotler, a partner in the Taxation Group of law firm Seward & Kissel. An exclusion had previously shielded limited partners from taxes on their distributed shares in the form of net earnings from self-employment.

"The tax savings were definitely one reason why fund managers would structure their businesses — and wealth managers, too — as an LP structure," Cotler said in an interview. "If it's not the final nail in the coffin, we're pretty close to it. … We're thinking of a couple ideas that potentially would retain these tax savings for clients, but we're still thinking through the pros and cons of those."

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At the end of 2023, at least 5,560 RIAs that were registered with the Securities and Exchange Commission managed private funds — or 36% of the total count, according to the annual industry snapshot from the Investment Adviser Association and compliance firm COMPLY. 

Over a third of those firms that manage private funds do so as their exclusive form of business, but many of the rest are retail-focused RIAs that operate their own investment vehicles. Larger RIAs are especially likely to do so: 71% of firms with at least $100 billion in client assets, 67% of those with $5 billion to $100 billion and 54% with $1 billion to $5 billion manage hedge funds, private equity vehicles or investments focused on areas such as venture capital, real estate or other securitized assets. Some smaller RIAs operate specialized "exempt-reporting" vehicles that don't need to register as private funds, the snapshot noted. 

RIAs had been bracing for a series of private fund reforms under an SEC rule adopted in 2023, but a court decision last year vacated the regulation entirely after industry pushback.   

"Over the past 10 years, the number of advisors offering private funds, the number of private funds and the assets in private funds have grown consistently," last year's snapshot said.

In the Tax Court case, a limited liability corporation that was the general partner and five limited partners who were owners of the investment manager received guaranteed payments and other distributions out of the profits generated by the fees from the private funds. The judge applied a test known as a "functional analysis" to decide whether the exclusion for limited partners from self-employment taxes applied to the distribution. In essence, the determination revolves around the question of whether the limited partners more closely resemble passive investors or employees, according to an analysis of the decision by Seward & Kissel.

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The limited partners got "reasonable compensation" as part of a base salary separate from the profit payments that was far lower than the pay of other employees of the fund company, the judge ruled.

"The Tax Court found that each of the limited partners were actively involved in the activities conducted by the investment manager, were held out as active partners in audited financial statements and prospectuses, devoted substantially all of their working time to the investment manager and actively directed and strategically guided the investment manager," according to the law firm's analysis of the decision.

"This opinion is the second Tax Court decision holding that a limited partner under state law who is actively involved in an investment manager's business activities is subject to self-employment tax, notwithstanding the statutory language of the limited partner exception," the analysis continued. "It has been publicly reported that one taxpayer is appealing the holding of an earlier Tax Court case on this issue to the Fifth Circuit Court of Appeals. The decision by the Fifth Circuit will provide more clarity on the ultimate application of the self-employment tax to limited partners. Management companies that are structured as limited partnerships should consider the application of these recent Tax Court decisions for the current and future taxable years."

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The exemption from self-employment taxes usually works out to savings of about 4% off the total hit — a number that sounds small but gets much bigger "when you multiply it out" over millions of dollars in annual profit over several years, Cotler noted. RIA owners who manage private funds should speak to their certified public accountant or another tax professional to assess the potential impact of the ruling on their 2024 taxes and moving forward, he said.

"The tax effectively puts the owner in more or less the same position as the employee who's subject to W-2 wage withholding," Cotler said. "I do anticipate there will be some reactions within the industry in terms of ways to restructure."