Court rulings threaten longstanding hedge fund self-employment tax strategy
Hedge fund managers face a significant change to a longstanding tax-planning strategy after recent US appeals court rulings backed the Internal Revenue Service’s position that active limited partners can be liable for the 3.8% federal self-employment tax, according to a report by the Wall Street Journal. The issue centres on a provision dating back to 1977 that has generally excluded limited…
Recent US appeals court rulings have invalidated a long-standing tax-planning strategy frequently employed by hedge fund managers, according to a report by the Wall Street Journal. This strategy, rooted in a 1977 provision, generally exempted limited partners from the 3.8% federal self-employment tax, even when they actively managed or controlled their investment businesses.
However, two recent federal appeals court decisions have challenged this interpretation, potentially affecting numerous funds and their tax liabilities. The US Court of Appeals for the Second Circuit ruled in favor of the IRS, stating that limited partners who play an active role can be held liable for the self-employment tax. This decision is particularly relevant to the hedge fund industry, given the court's jurisdiction in New York, a hub for alternative investment managers.
The ruling involved three Soroban Capital Partners and over $141 million in earnings from 2016 and 2017. The implications of these decisions extend beyond the affected funds, potentially impacting other managers with ongoing disputes or tax years under review. Notably, New York Mets owner and Point72 founder Steve Cohen, whose firm faced an IRS case, may be affected.
The developments also pose implications for Treasury Secretary Scott Bessent, who previously used the limited-partner approach while disputing tax claims. Bessent settled his self-employment tax issue with the federal government this summer. For hedge fund and private equity executives, the financial impact of this ruling could be significant, as the Medicare component of the self-employment tax, which does not have the same earnings cap as the Social Security portion, can apply to substantial amounts of income.
The IRS has been challenging this strategy since 2018, with the issue persisting across different administrations. The Tax Court had ruled in favor of the government in the Soroban case in 2023 before the litigation progressed through the appeals courts.
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