Landmark IRS Victory Sets Stage for Increased Hedge-Fund Manager Taxes

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.

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 https://t.co/3KsxhjSwXZ https://t.co/3KsxhjSwXZ
— The Wall Street Journal (@WSJ) November 30, 2023

“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.