IRS Court Win Paves Way for Higher Taxes on Hedge-Fund Managers

The Internal Revenue Service scored a significant win over the hedge-fund and asset-management industries this week in a case that could bring higher taxes for many fund managers.

The U.S. Tax Court’s ruling could require managers to pay self-employment taxes of more than 3% on much of their income. If the opinion survives additional legal battles and is applied broadly, it would close off a popular technique that lets them exclude millions of dollars in income from self-employment taxes and related levies that others must pay.

Even though many fund managers are considered “limited partners” under state laws, that doesn’t automatically mean they qualify for an exception that limited partners get from federal self-employment taxes, ruled Judge Ronald Buch.

The ruling was a loss for Soroban Capital Partners, a roughly $10 billion New York-based hedge-fund firm. The government has made similar arguments in other cases, including one against Point72 Asset Management, run by New York Mets owner Steve Cohen.

“This is what the government is trying to argue all along,” said Karen Burke, a tax-law professor at the University of Florida. “Potentially, it’s quite big, but there’s going to be more litigation obviously.”

Spokespeople for Soroban, Point72 and the IRS declined to comment.

In the Soroban case, fund managers Eric Mandelblatt and Scott Friedman and then-fund manager Gaurav Kapadia all paid self-employment taxes on certain guaranteed payments of less than $1 million each. But the IRS said they also should have paid those taxes on their shares of the firm’s profits—a combined $78 million for the trio in 2016 and $64 million in 2017, according to court records.

Soroban had argued that fund managers qualified for the limited partners’ exception and shouldn’t have to pay those taxes, and it sought a ruling affirming that stance, which could have effectively ended the case. Judge Buch rejected that argument, however. The Tax Court case is continuing, and there is no final answer on how much tax, if any, the Soroban managers will owe.

In the case against Cohen’s firm, the IRS said Point72 should have reported $125 million in self-employment income in 2015 and $219 million in 2016 instead of $0 both years.

Self-employment taxes come on top of income taxes, and they are part of the payroll tax system that helps finance Social Security and Medicare. Self-employed workers pay both the employer and employee portions of payroll taxes; they can get an income-tax deduction for part of the tax.

Congress created the exception for limited partners in 1977 to prevent investors from gaming the Social Security system. The idea was that passive investors shouldn’t be able to count those earnings as self-employment income that would help them qualify for retirement benefits intended for workers.

But the tax system and investing landscape changed significantly after that.

In the 1970s, payroll taxes were capped for high-income taxpayers, so top earners had no incentive to avoid them. But by 2013, Congress had removed some of the income caps in a bid to tax the rich, and top earners faced up to 3.8% in self-employment taxes.

So for people making tens of millions of dollars annually, the advantages of avoiding those taxes far outweighed any government benefits they might obtain. Funds organized themselves as limited partnerships where managers could work and receive the bulk of the firms’ profits without paying self-employment taxes.

The IRS has been challenging investment funds over the issue in audits for the past few years. The agency has also been working on regulations that would more clearly define a limited partner. The IRS attempted to write regulations in 1997 but backed off after pressure from Congress.

Judge Buch said that whether fund managers count as limited partners for federal self- employment tax purposes depends on what they actually do for the fund. His ruling drew on the portion of the 1977 law that applied the exception to “limited partners, as such.”

“If Congress had intended that limited partners be automatically excluded, it could have simply said ‘limited partner,’ ” he wrote. “By adding ‘as such,’ Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner.”

Firms have been regularly using the exception from employment taxes for limited partners, and the ruling creates significant uncertainty, said Eric Sloan, a partner at law firm Gibson, Dunn & Crutcher whose clients include affected firms.

The tax code, as written, supports the idea that limited partners are excluded from self-employment taxes, he said. If government officials think that is the wrong policy, that is a problem with the statute, not something the courts should resolve this way.

“I don’t think it’s a particularly strong opinion,” Sloan said of the judge’s ruling. “It’s up to Congress. Congress has to fix its own messes.”

Under the ruling, limited partners would be taxed more like wage earners and sole proprietors, correcting an inequity in the tax system, said Richard Winchester, a tax-law professor at Seton Hall University.

“It inches it toward more progressivity,” he said.

If the opinion stands, it would create a divergence between members of partnerships and owners of closely held S corporations, who often don’t have to pay self-employment taxes on their profits. Some politicians, including President Biden, have routed speech and book income through S corporations in ways that avoided self-employment taxes.

The Biden administration has asked Congress to tax both limited partners and S corporation owners by applying a 3.8% investment-income tax to those who currently don’t pay self-employment or investment taxes on their earnings. That proposal, which hasn’t advanced in Congress, would raise $306 billion over a decade, according to the Treasury Department.

Write to Richard Rubin at richard.rubin@wsj.com and Peter Rudegeair at peter.rudegeair@wsj.com