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IRS Refuses Investment Fund Management Partnership the Same Self Employment Tax Break It Gives S Corporations

September 11, 2014 Business & Tax Blog Self Employment Tax

In a recent ruling, the IRS confronted a partnership serving as a management company for investment partnerships and funds. Management fees were its sole source of income. The management company paid reasonable compensation subject to employment or self-employment taxes to its owner-managers. Following a planning technique available to S corporations, the partnership treated its partner distributions as being exempt from self-employment taxes. The IRS disagreed with the partnership’s position. The IRS ruled that the partner distributions were subject to self-employment taxes notwithstanding the reasonableness of compensation paid as such to its owner-managers.

The ruling is significant because distributions from an S corporation structured in the same way probably would not have been subject to self-employment tax. Indeed, the partnership in question used to be an S corporation, and the IRS specifically held that the S corporation rules do not apply to the new partnership.

The ruling underscores an evolving IRS position that treats service S corporations and service partnerships differently for self-employment tax purposes. While technically understandable because different statutory and regulatory provisions govern the different entity types, the differing self-employment tax treatment of these entities defies common sense.

Unless a sensible unified self-employment tax policy emerges, when possible it remains wise to structure management or service companies either as S corporations or as partnerships with S corporation partners, to take advantage of the more flexible self-employment tax planning options available for S corporations.

Here is link to the ruling:

E. John Wagner, II