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Self-employment Tax on Partners, Net Investment Income Tax, and Soroban Capital Partners LP v. Comm’r (Part II)
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A
Foreign welcome to the 12th episode of How Tax Works. I'm Matt Forman. In this episode, I will continue and conclude my discussion of Sorbonne Capital Partners LP versus Commissioner. If you've not listened to the 11th episode, I strongly recommend you do it or else it'll be like the time I read an Edgar Allan Poe story starting on page three. In my defense, I was 4 13, 13 year olds do stupid things news. I know, but I read it and I was really confused because I didn't understand why it started sort of in the middle of the story. And then I I noticed that I started on page three. So. Awesome.
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Great.
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Anyway, How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please, please, please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices that we all make. Before we get started, a few administrative things. New episodes every two weeks. Next episode we'll discuss the passive activity loss rules under section 469 of the Internal Revenue Code, which I assure you are very complex and very interesting. If you have any questions, comments or constructive criticism, you can email me at my FRB email address, which you can find via your favorite search engine on November 14, which is in two days from the date that I think this is going to be released, if my math is right, from 1 to 2:30 Eastern Standard Time. Stratford webinar so it means your CLE, CPE and CE. There is a cost to it. I don't know how much it is, but there is a cost. I'm going to talk about tax strategies for limited partner investors in private investment funds, which will include a discussion of Soro Bond Capital Partners. But I will actually talk more about structuring, pms, SEC issues and other things like that. Doing it with someone else at the firm. His name is Mike Williams. He's. He's really great and I think it'll be interesting, if nothing else. And again, you'll get continuing ED credit, which I know is really the reason you would go to it, not because you find it interesting. So now we're going to go back to discussing Sorbonne Capital Partners as a really, really, really quick overview. Okay, got a general partner, which is an LLC tax partnership that owns 1% of a limited partnership, which I'm going to call Sorbonne everyone. That's how it's referred to in the documents. Sorry about Earns money from Earns management fees. Earns cash for services in earns cash in exchange for investment manager services. I can almost talk. I promise. And that money all flows up in the form of guaranteed payments to the three individuals to about $1.2 million per year. And in addition to that they received fairly significant allocations of income. 70, $60 million, about $140 million total. If you don't round it into being about 140 million to through those three individuals the question becomes are they subject to payroll taxes? So section 1402 A13 excludes income earned by limited partners as such from net earnings on self employment partners who actively participate in state law. Limited partnerships are not necessarily limited partners as such you are subject to self employment tax. The partner is subject to self employment tax if they are a limited partner in name only.
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Right?
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Sounds like something else, right? Something in name only. And then you are not subject to the self employment taxes if you are functioning as a limited partner. But of course tax court did not propose a test. They just said, no, no, it's this, don't worry about it, wave it, you know, wave the hand. The self employment earnings are excluded if they are a mere investment.
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Right?
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This is why we're not talking about the true LPs, we're talking about the three individuals that own the general partner that earn guaranteed payments and are limited partners and earned income. And that income itself flows up. And that is the subject of it. That $140 million is the base. Other cases of note, Renkmeyer and Castiglia, which are law firms, law partners, which are all also limited partners. Those the taxpayers lost their subject to. And there's Hardy, which was a surgeon who was also a partner, had no managerial control. Managerial control seems to be fairly important. It is a functional test before the functional test was done. So now we are going to talk about the IRS's brief. The IRS's brief is incredibly direct. Soroban's brief is pretty direct. Then kind of dances a little shimmies, you know. It's like watching Barry Sanders sweeping, right? See someone coming out of his eye. All of a sudden he's done a 360. That guy's lost a shoe and he's 15 yards downfield. Don't know how it happened, but that's, that's what's going on. Very adept drafting. The IRS's brief is Christian Okoye, if you remember Christian Okoye. Okay, if you don't remember Christian Okoye, it's probably because you're younger than I am. And you aren't missing much, but he was an extremely large man. I think he was actually born in Nigeria. His nickname, if I'm remembering correctly is a Nigerian nightmare. This is purely coming from memory. I did not look this up before. And his running style was to attempt to run over you. Sort of like LeBron James and you know, going down the court in transition, he's just going to go this way. And he strongly recommends you don't go, you know, where he, you don't stand where he's about to go. Very different style than Barry Sanders. Both played the same position. Barry Sanders, by the greatest of all time, Christian Okoye was a very good running back. Nowhere near it. So anyway, other than my random thoughts on Kansas City Chiefs running backs in the 1990s, let's talk about Sorbonne Capital Partners and the IRS is brief. The core argument is that Soroban is a registered investment advisor Ria that provides advice about securities in exchange for compensation. All of Sorobond's income is for investment related services and advice. The tax returns themselves call the income other income which is service income. It's not a rent, it's nothing else. It's service income. That's it. That is the Mack truck Christian Okoye running straight through you. All right, so Sorbonne's brief, right, says that its income was from the work of its employees. But they never really explained it, right? You know, given the work performed by representations made about the principals. They never really actually said this is what the IRS is saying. They actually said what the employees do. And, and if you look at the job titles of the employees, I know they only really mentioned three but you go on LinkedIn, you see it. These are people who work for registered Invested Advisor providing advice on IT traders, risk analysis, things like that. This is serious finance on MBAs. A lot of people worked at companies we've all heard of, etc. Etc. So you know, look, because soar this the IRS what they're saying because Sorbonne never really explained what other people did. This is. This is Rankemeyer. This isn't hardy, right? The three individuals that we're talking about here, yeah, there were employees but hard, you know, Renke Meier probably had employees. That what we're saying is these three people, they controlled it, right? The principals functioned like self employed persons, not passive investors. These were not someone who happened to own an ownership interest and did a job right? Day to day control, overall control, overall management, day to day management, day to day operations, overall management decision making day to day, overall I'm repeating myself on purpose because I think it's important to note that. And look, Soroban never really disputed that, but they said, look, yes, that is the general partner. That's its function through the general partner. This is the same person doing two jobs also as a limited partner. And the IRS really said they didn't really suggest a functional test. What they actually said was look at the function of the partners. We're not going to give you factors. We don't think you really need factors. Look at the function, look at the actions, look at what they did. This is an obvious test running right straight at you. We're not even going to try to dance. And I don't even think Soroban's brief, when they talked about the nine factors was dancing. I think they're actually pretty reasonable factors. Make them quibble, but I think they're pretty reasonable. But this one, they're just like, we don't even need to tell you what they are. You, you know what they are. Read our brief. They also said that state law formalism does not prevent the imposition of self employment tax. It's important to note that SoroBond Capital Partners LP was an LLC a couple years prior to 2016. It operated exactly the same. This leads to a question, right? Can an LLC have limited partners for this purpose?
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Right.
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You know, look like my answer is maybe I'd want to think about it. I want to look at what people do. It's not a fact pattern I love, but I don't think it's totally ridiculous. I also think that if the IRS is to be believed as far as they are and you have to look at the function, the function, the function, and ignore state law formalism, I'm not sure that you can't. Because if you sort of take the IRS at its very literal word and keep going.
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Right.
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Go beyond what they're really saying, maybe.
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Right.
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And the final point that I think the IRS makes, I think it's a good point, is limited partners cannot be limited partners in name only. When what they're saying is it is impossible to separate. Sorry, here my chair. It is impossible to separate what they're doing as limited partners from what they're doing as owners of the general partner, basically as general partners. And because of that you really have to look at what they do and how they do it. And because they are so deep involved.
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Right.
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If this were Hardy, Hardy did not have the control, did not have day to day or overall control. Sure. As a surgeon.
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Right.
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He had Some level of control of how things were done. I suspect as a partner, they consulted him, but this is not that, right? The three individuals, they had control. Their fingers were everywhere. They were doing everything. And I think that's really important to note. So now who, who is right? Who is right again? Three cases rank Meyer Law Partners, limited partners, that is subject to self employment tax. Castiglia, same facts, right? Self employment tax. Hardy partner performed surgery, but no managerial control, not subject to employment tax. I suspect Hardy had a guaranteed payment there. So that was subject. So are they Both correct? The IRS's arguments are so literal, incredibly literal. But for the most part, as I said, so are sorrow bots, right? This is really kind of going through the same basic thing. Sorbonne, I'm going to kind of reposition and sort of summarize. Principals are only doing things that the limited partners are allowed to do in their capacity as limited partners. Hardy, they have employees. This is like Hardy, right? They have employees who do the actual work, including significant employees. This is not just a bunch of administrative staff running around or doing administrative things. These are people. The tansy, the guy who's the CFO coo, I mean he's a, he's an economist. He's a fairly well known economist. He has a thing called the Tanzi effect. I forget what it is. I read it. I don't remember it as his tradition. I don't remember things like that. But you know, it's not like he's a true nobody. This isn't Matt Foreman, your CFO coo. This is someone who's a name who really does work, who provides value. The capital accounts drive returns, not contributions, Right? Even though there wasn't a whole lot of cash contributed. Look, this is a service partnership. It was built by three buddies who worked together previously and all left the same company to go start it, right? You don't need a huge amount of money to start a service partnership. There was money put in because you, you do need stuff and you need sort of to pay yourself for a while and you need some Runway. But it's not like this, you know, you were buying a building or whatever. And finally, I think the important, final, important point that Sorba made is the law clearly anticipates a situation in which individuals are the general partner and limited partner. IRS's response? Simple, right? This is services for compensation. This is self employment income. This is what they were trying to do. Soroban's own documents say that the principals are generating this revenue. They're the one doing it. The PMs are like, look at our principals. They're wonderful. They're amazing, right? If you ever met a pm. The only people who describe the individuals in the PPM more glowingly are like their parents, maybe a spouse, you know, kids. Definitely not like, my dad's an idiot, you know, whatever. But I think it's important to know that the own documents were tough because they were. Look, they're sales documents. I know that, you know, you know, not to be relied upon and there's all the SEC stuff. But let's be honest here. You know, they saying the great things. This, the IRS is like, no, no, this is Rank Meyer. This is Castigliola.
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Right?
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Principals perform services, have control. Self employment tax should be imposed. And they said it is impossible to separate the role between the general partner which receives a guaranteed payment and the limited partner which receives a distributor share. And Soroban really didn't try to allocate between the principals and the employees. Plus guaranteed payments were very small.
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Right.
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They very directly pointed out that they didn't actually try to allocate value between the principals.
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Employee.
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Again, I suspect there was some other reason for it. I also think there's. They probably don't know how to do it. You know, how do you say. Especially when you're in a situation where the principles are so important, right. And the guaranteed payments were small. The IRS kind of danced around that issue. I don't think they wanted to make it a ratio issue, but I think they wanted to point out the fact that there was a huge discrepancy between the two. And I think that that's really important. So what do I think? You know, I've talked a lot, you know, I'm 45 or so minutes recording on this, so a little less. It gets edited a bit. But what do I think?
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Right.
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I think Soroban's arguments are sometimes a bit cute. A bit too, you know, pay no attention to the man behind the curtain.
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Right.
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You know, don't, don't worry about that. Pay no attention.
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Right?
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You know, the dog's pulling it back. So I think that that's really important to say. Like, look like you can say what things are, but your documents are saying otherwise. The facts are kind of saying otherwise. And it's tough. I think they're not given a great hand. I think had they known this was going to get litigated, right. This is an issue that just seemed to be a sleeper issue. And the IRS passed three, five years has really focused on it. I think because the Numbers are bigger. I had, I had a colleague joke, maybe they're not joking that the way that they're going to deal with the fact that Social Security is underfunded is by more aggressively auditing. Maybe. You know, this is not the only audit I know of. You know, S Corporation Reasonable Compensation. A lot of audits there, but so, so are here. I've heard of at least a handful. So. And I'm sure there's a lot more that I don't know are happening or were settled kind of quickly. The irs, their argument's a bit too formalistic.
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Right.
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And I'm going to quote south park here if you can find the episode. It relates to an election. It was one of the really early south park episodes that went political. And it deals with a vote inside the school, theoretically inside this into the school in South Park Elementary. And the quote is, I would hope that those students and their parents who question my qualities will simply look at my opponent. And the IRS is actually really saying, look, like we don't actually know what the answer is. But they don't either. An argument is okay and their argument is stinky.
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Right.
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It is a turd sandwich. So don't, don't worry about that. Don't worry about us. I don't think either of them really explain totally what the answer is. They're both kind of treading water and creating things. And I think the whole formal, the functional analysis is a bit, it's a little iffy at times, but I don't think it's wrong. I think looking at how they function, I think both of them, Sorman and the IRS at their core are looking at, you know, how the function is. They, they, they really have to answer the question. So this was compensation for services, but so what? The, the income in Renk, Myer, Castiglia, Castigliola and Hardy were all compensation for services. Capital gains are not subject to self employment taxes.
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Right.
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So the capital gains fair to sell actual equities. That's different. This is only compensation for services. It's not always done. Hardy worked out okay. You know, there are clearly situations where this is allowed to happen. The issue is that Soroban's reliance on state law formalism is generally just kind of antithetical to the tax law's preference of substance over form.
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Right.
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Soroban's argument is, listen, this is a limited partnership, therefore its partners are limited partners as such. So I think that that's always done, you know, and that leads to my question. I know I talked about it before, but regarding whether LLC members should be eligible for the income exemption under 1402 A13 and I think there's at least an argument. I don't know if it's a good argument. I don't know if it's a really bad argument. I really just don't know the answer. But I think there's some facts that could lead to a conclusion where it may be a position, it may be a crappy position, I don't know. I haven't totally thought it through yet. But I think that the state law formalism is a really weak argument. And Sorbonne was definitely hammering, but it was, it was a rubber hammer. Didn't work all that well. Perhaps Sorbonne should have presented the following evidence or analysis. I am now criticizing one of the largest law firms with one of the best tax partners in the world. The value slash time of employees, work versus principal work. Maybe they don't have it, maybe they didn't want to do it. The ratio of guaranteed payments versus distributed shares. Again, I don't think it's totally a ratio play, but it's pretty stark. The dollar amount different, right? If you think about it, the whole idea of guaranteed payment and it goes to the, you know, s Corporation stuff too. They're making $400,000 a year. If these guys were to go to work for someone else, they would not make $400,000 a year. They'd make multiples of that. Could make 10 times that, I don't know. So it's kind of a question of is this guaranteed payment? Right? There's a bit of a wink and a nod there. Is it right? Wink, wink. We don't know how they determine the guaranteed payment. Again, they picked the number, they picked the amounts in 2011. They gave them single digit increase, called it a day. I think we all know inflation's above that. If you read, you read online, inflation's at 4 or 5,000% per day. So you know, it's definitely kind of interesting how they got to the number who's right. I think the irs, to be honest, has a stronger argument. That being said, I don't know if Sorbonne's going to lose because the IRS is trying to make law, make add a test that it doesn't exist. Otherwise they so far have been successful. But no matter who wins, this is the tax code again, no matter who wins here, okay? It is going to go to the second Circuit and you're going to get appeals at the second Circuit. And this litigation will not be over for four years. Something like that right, because you're not going to have a hearing. And with the hearings scheduled until 2025, you'll get decision mid-2025, you'll appeal, they'll schedule it for 2026. You know, mid, late 2026. We're more than a year out, not going to get decision until 2027. Okay, fine, three years. Great. That's, that's really exciting. So let's take a quick minute. We come back or moment, we'll talk investment income tax, which I think is an important side. So the net investment income tax. I had an accountant a couple weeks ago ask me the question, well, how does this interact? You know what, why aren't they worried about the net investment income tax? Because if they're, you know, it's not subject. If it's exempt from self employment tax, shouldn't it be subject to net investment income tax? And the answer is, well, what's talk about the net investment income tax. So it is a 3.8% tax on net investment income.
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Haha.
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Under section 1411 of the Tax code is imposed on individuals, estates and trusts. Remember, the three taxpayers it issues are individuals. It is imposed if your GROSS Income exceeds $200,000 for single or head of household, $250,000 for married filing jointly and half that 125,000 for filing separately. The amount is not indexed for inflation. This was actually intended to increase the amount of revenue that it generated. And I want to let you know how much people care about it. I'm going to make a comment. People get really annoyed. I say this. It wasn't changed as part of the 2017 tax bill. This wasn't touched. Kind of surprised people complain about non indexing, you know, the low amount for the amount that's taxed for like Social Security income, you know, when it starts getting taxed is pretty low. But this one, I was surprised they didn't get the indexing for inflation. I suspect because it is a very large number. The amount from when it was passed to now, I think it doubled the amount of revenue it generates. It's really pretty substantial. So I thought that was interesting. I also think that the fact that they lowered the individual tax rate by 2% probably, you know, it cuts the benefit in half basically.
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Right.
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3.8%, close enough to four. So I think it's important. So net investment income tax is imposed on interest, dividends, annuities, royalties and rents, sale of stock.
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Right.
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Capital gains on passive businesses.
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Right.
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So it's not imposed on income derived in the ordinary course of a trade or business, unless income derived in the ordinary course of a trade or business is in passive activity to that taxpayer. So the passive activity is defined generally consistently with section 469. I'll talk about that in two weeks. Passive activity loss limitation rules. Except, and this is the important one, right. The biggest way to get around most people meet for section 469 is material participation, which is done by participating 500 hours in a calendar year within that business. However, for purposes of the net investment income tax, okay, Treasury Reg. 1.4115 B2 Roman at 1 and 1.4695 T. C2, you actually only need to significantly participate, not materially participate. What does that mean? That means you have to do a hundred hours, not 500. One of the points in the Sorbonne Capital Partners briefs that they made is that the principles did work. That was permitted under the limited partnership statute in Delaware. That way, I guarantee you they're over a hundred hours. It really wasn't discussed. It's also services income suspect, you know, they'll do it. And so I think it's really important to note that they're, they're not too worried about it. But you could definitely have people who have it who participate 100 hours, 125 hours and still be considered limited partners.
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Right.
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Depending on what they're doing, how they're doing it, if they're doing other functions within it, regular votes, negotiate, you know, reviewing contracts, things like that. There are certain things limited partners are allowed to do, stay within it. You could actually get out of the net investment income tax as a Fairly passive investor. 100 hours is not a lot, two hours a week. So that's pretty decent anyway. So, you know, it's important to remember 469 deals with losses and 1411 deals with gains. They are trying to do opposite things, but it's referencing the same ideas. Who is passive, who is active and services income. Those that issue a store bought are generally not subject to net investment income tax unless you're passive.
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Right.
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So, you know, get, get over that hundred hours, you're not going to have net investment income. Maybe, you know, maybe that's the golden key. That's the way to go. That's the thing to think about. So I think it's really important to think about it. Think about how the net investment income tax works at some point. I'll dig into it in, in a podcast. But that's, that's going to be for a while. I don't, I don't think that's nearly as exciting as self employment taxes.
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Right.
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But we'll get there. So let's close it out up.
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Right.
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Sorry. Bond capital partners. What will happen? I don't know. If you could see me right now. I shrugged. I actually shrug every time. Just because it's. It's the natural movement.
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Right.
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I don't know who's going to win. I could see both winning. I could see the tax court saying, well, maybe you don't need a functional test. I could see if that happens. The IRS goes a little bit apoplectic, and treasury pushes for Congress to change the law. Because if that's the case, boy, oh boy howdy.
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Right.
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Every single law firm that has, you know, a bunch of associates is going to go, well, that's interesting. Let's talk about that. Let's. Let's plan around that. Let's avoid 2.9% tax. So I think that that's an important planning point.
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B
Right.
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Becomes way too easy. And I think, you know, I said it before, I think the IRS is correct as a conceptual matter. But the arguments advanced by Sorbonne are really. They're well elucidated. They're convincing, they're good, they're real. This isn't a situation where the taxpayer is like, oh, look over there. You know, I made the joke about, you know, ignore the man behind the curtain, but I don't think that's really true. That was fatuous. That was an exaggeration. I think they're really good arguments and they're not wrong.
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Right.
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Look, they're saying, Congress, when they passed this, they envisioned roughly the situation. And it is not the purview of the Internal Revenue Service or the courts to say, we don't like this. This is Congress. If you want Congress to change or you want a law that Congress, you know, has passed to be changed, you either have to say it's unconstitutional, which no one here is saying, or I think perhaps more importantly, you have to show why it should be interpreted in the way you want, you would like. And, you know, I just think that's a really tough road to hoe for the IRS to say you should really change it this way. That being said, limited partner as such, as such, suggests there's some sort of functional test that should be required or discussed or whatever in the analysis and the definition, you know, how is limited partner defined? It's definitely suggested there. And I think that that drafting that was, I think, obviously, somewhat obviously intended to be broad. Really, really, really leaves open a door to do what the IRS wants to do, should it open the door? Is the IRS correct? I don't, I don't know. But I think that that's, that's really what, you know, what we want to think about and how you're going to do this. So that was the, that was the 12th episode of how Tax Works. Can't believe we got to 12 teenager the next one, right? Hope you learned something. Two weeks. I'll be back. 13th episode. Really exciting. I'm going to talk about passive activity loss limitation rules under section 469. I'm going to go into a lot of detail on them because they're really interesting. There's a lot of tests. There's a lot of ways to get around them, a lot of ways to, you know, shimmy, shimmy like Barry Sanders.
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B
Right.
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And, and now for the best song of all time. Thank you for listening.