Finance That Matters Fall 2014
Limited Partners May Be Subject to Self-Employment Tax
[author-style]By Anthony J. Tuths, JD, LLM, Partner [email protected][/author-style]
While this tax issue has been fought on several levels over the past 20 or more years, it had gone dormant since 1997. Now, an IRS Chief Counsel Advice (ILM 201436049 (05/20/2014)), released on September 5, 2014, (the “ILM”) demonstrates that the IRS may be ready to renew the fight.
Currently, limited partners of limited partnerships and shareholders of Subchapter S corporations routinely take the position that their distributive shares of entity profits are exempt from SE tax. The uncapped Medicare hospital insurance portion of the SE tax for high income taxpayers is now 3.8%, thanks to a 0.9% increase brought in at the close of 2012 to match up with the new Net Investment Income tax. In the S corporation world this tax exemption is tempered by a requirement to pay reasonable compensation to S corporation shareholders (the compensation, unlike stock distributions, is subject to SE tax). In the world of limited partnerships the SE tax exemption does not extend to guaranteed payments for services which, for partners, are akin to salary.
The ILM deals with a fairly large investment management company (likely in New York City based on its structure), which acts as an investment manager for a family of funds (each treated as a separate limited partnership). The IRS did not attack the allocations to the GP which held the profits interest in each underlying fund. The Service was interested in only the management company and its treatment of the management fee income. The management company in the ILM was structured as a limited liability company or LLC which was treated as a partnership for tax purposes. It was stated that the LLC was a successor to a previous management company that was organized as an S corporation (this fact was not material to the analysis but did help explain why the management company was taking the tax positions it was). Each partner in the management company received a salary (erroneously reported on a Form W-2) and guaranteed payments, both of which were subject to SE tax. In addition, each partner received allocations of partnership profits which were not subject to SE tax. Some of the partners were investment managers but others were legal, human resources, information technology services and other infrastructure personnel.
The IRS pointed out that Section 1402(a)(13), which exempts limited partners from SE tax, was enacted in 1977 prior to the proliferation of LLCs. It also cited case precedent indicating that LLC members were not limited partners and were not entitled to the benefits of Section 1402(a)(13). However, the Service went much further and pointed to the legislative history of the statute to advocate that the statute was not intended to shield limited partners from SE tax to the extent they were providing services to the partnership. Rather, the Service claims, the statute was merely intended to exempt passive investors from SE tax. The ILM also cites extensively to Renkemeyer vs Commissioner, 136 T.C. 137 (2011), in which the Tax Court unsurprisingly found that partners in a law firm formed as a limited liability partnership were subject to SE tax on their earnings. The Tax Court also utilized broad language and cited to the intent of the statute and its related legislative history. The ILM ultimately found that every partner of the management company was subject to SE tax on their allocations of earnings because the “Partners’ earnings are not in the nature of a return on a capital investment … [but rather]… are a direct result of the services rendered on behalf of Management Company by its Partners.”
This fight over SE tax related to limited partners and LLC members began in the early 1990s. In 1994, Treasury issued proposed regulations that would have exempted LLC members from SE tax but only if the member lacked authority to make management decisions necessary to conduct the business of the LLC. In January of 1997, Treasury withdrew the regulations and re-proposed new regulations. The 1997 regulations would treat individuals as limited partners and able to take advantage of the SE tax exclusion unless the individual (i) had personal liability for the debts of the partnership, (ii) had authority to contract on behalf of the partnership, or (iii) participated in the activities of the partnership for more than 500 hours during the taxable year. Importantly, the 1997 proposed regulations were not limited to LLC members. Rather, it would have changed the SE tax situation for all partnerships.
Shortly after the 1997 proposal, Steve Forbes called the proposed regulations, “a major tax increase by a stealth regulatory decree.” Others soon joined in a national campaign to kill the regulatory proposal including the then Speaker of the House, Newt Gingrich and radio talk-show host, Rush Limbaugh. In June 1997, the Senate passed a nonbinding resolution declaring the proposed regulations outside the scope of Treasury’s authority, urging Treasury and the IRS to withdraw the proposal. Congress ultimately imposed a 12-month moratorium on Treasury’s authority to issue guidance regarding the definition of “limited partner” for purposes of Section 1402(a)(13). Since that time Treasury and the IRS have remained silent on the issue.
Fourteen years later, the Renkemeyer decision threatened to open the debate again but since the IRS agreed with the decision and such decision was limited to LLC members within a very specific (and egregious) fact pattern, the argument remained dormant. Now, seventeen years after Congress thrashed the IRS for overstepping its bounds with regards to limited partners they are at it again.
In June 2014, Curtis Wilson, IRS associate chief counsel (passthroughs and special industries), said that the IRS had been thinking about the extent to which individuals who are limited partners under state law might be prohibited from relying on the SE tax exemption. Additionally, in the 2014-2015 joint Treasury-IRS priority guidance plan released August 26, 2014, the agencies announced they would tackle guidance on the application of Section 1402(a)(13) to limited liability companies.
The ILM is a clear indication that the Service has decided to go back on the attack against limited partner/LLC member utilization of the Section 1402(a)(13) exemption from SE tax. This may be another act of regulatory fiat that Congress will once again quash, as in 1997, but let the taxpayer beware. The IRS is of the opinion that active LPs should pay SE tax on their full allocation of management fee income. Management companies may be better off as S corporations which have a different statutory genesis for their SE tax exemption. But, of course, this begs the question. Why should different forms of passthrough entities receive different SE tax results? Stay tuned on this issue.
Whistleblower Program
[author-style]By Donna Nevolo, CPA [email protected][/author-style]
The regulations require the Commission to pay awards to certain whistleblowers that voluntarily provide original information to the SEC about violations which lead to the successful enforcement and monetary sanctions received by the government in excess of $1 million. The program specifies that, at the discretion of the Commission, the awards paid to the tipsters should fall between 10% and 30% of the amount the agency recovers. Such awards are tied to the amount recovered by the government which can be less than the amount ordered in a case.
The regulations also require that the SEC’s Office of the Whistleblower provide an annual report to Congress, detailing its annual activities. Based on that report for the fiscal year 2013, the program experienced a steady increase in activity during its second full year. The SEC received 3,238 tips in 2013, 8% more than received in 2012. Most of the tips came from within our 50 states; however, approx. 400 tips originated from individuals in other countries, mainly the United Kingdom, Canada and China. The report also disclosed that in fiscal year 2013, the SEC paid out over $14 million in awards including the following:
Approximately $150,000 was paid to an individual, the first-ever whistleblower, who also received funds in 2012 for the same case involving an unnamed multimillion dollar fraud. The penalties in that case amounted to more than $1 million, but only $150,000 was collected by the agency during 2012. As additional funds were collected by the SEC during 2013, they made additional payments to the recipient, as required. That individual has now received a total of $200,000 in award payments. As the whistleblower was awarded 30% of the sanctions, it is anticipated that as more money is collected from the defendants through a court ordered payment schedule, the tipster could receive an additional $100,000.
The second-ever whistleblower award was announced in June of 2013. This case involved a sham hedge fund and its chief executive, Andrey Hicks, and there were three whistleblowers that assisted in the investigation which ended with the closure of the fund. The tipsters were awarded 15% of the amount collected, and the first installment was made in August of 2013.
The largest whistleblower award was announced in October of 2013 for $14 million and involved Anshoo R. Sethi and his two companies which collected funds from 250 foreign investors after presenting fraudulent plans to build a hotel and conference center. The SEC determined that the whistleblower deserved 10% of the $147 million returned to the defrauded investors.
The SEC announced another award in October of 2013 for $150,000 representing 30% of the money expected to be collected. In early 2014, they announced an award for $875,000 to be split between two whistleblowers.
Additionally, the Commodity Futures Trading Commission (CFTC) announced its first-ever whistleblower award in May of 2014. The recipient was awarded approximately $240,000 for providing specific, timely and credible information regarding numerous violations of the Commodity Exchange Act.
No further details were provided regarding the whistleblower awards as the regulations protect the identity of the tipsters. It is believed that the protection of the whistleblowers is paramount to the success of the Whistleblower Program.
As acknowledged by SEC Chair Mary Jo White, the Program has generated high quality tips and persuades people to step forward and alert the SEC of wrong doings. The CFTC’s Director of the Whistleblower Program, Christopher Ehrman, dubbed the Program a “necessary enforcement tool for the agency”.
Based on the increase in the activity of the Program since its revision in 2010 as well as the increase in the awards given to date and the comments from regulators, it appears that the incentive awards of the Whistleblower Program are effective in exposing fraudulent conduct leading to enhanced investor protection.
Net Capital Requirement for Broker-Dealers
[author-style]By Brian Wallace, CPA, Partner [email protected][/author-style]
In general, BDs can be segregated into two broad categories: those that “carry customer accounts” and those that do not. The term “carry customer accounts” involves maintaining accounts for individuals or other brokers or dealers and also receiving and holding funds and/or securities.
BDs that carry customer accounts are required to maintain net capital of at least $250,000, subject to the following exceptions:
- An introducing broker that introduces their accounts on a fully disclosed basis to a clearing firm will be subject to a minimum net capital requirement of $50,000. In order to qualify, the BD must have an agreement with a clearing firm that supports the fact that the customers are customers of the clearing firm and not the BD. All aspects of the customer relationship, including account statements, must be directly between the clearing firm and the customer.
- A prime broker is required to maintain minimum regulatory net capital of $1.5 million.
- BDs that self-clear or clear prime broker transactions on behalf of an introducing executing broker is required to maintain net capital of $1 million.
- A carrying BD claiming a (k)(2)(i) exemption, which provides that all transactions between the BD and its customers are conducted through a bank account designated as “Special Account for the Exclusive Benefit of Customers of XYZ BD,” has a minimum net capital requirement of $100,000.
BDs that do not carry customer accounts have minimum regulatory net capital requirements ranging from $5,000 to $100,000, as follows:
- Dealers are required to maintain net capital of $100,000, which includes entities that endorse or write options (other than on a national exchange) or transact more than ten transactions for their own investment account(s) in any one calendar year. This requirement is often troublesome for non-carrying BDs that would otherwise be subject to a lower minimum net capital requirement. Furthermore, this rule is commonly violated when a BD receives securities as compensation for services and sells those securities, or when a BD establishes a policy of investing excess cash on a periodic basis.
- As noted above, introducing brokers that meet the disclosure requirements are subject to a minimum net capital requirement of $50,000.
BDs that only engage in the sale of redeemable shares of mutual funds or interests in an insurance company separate account are subject to a minimum net capital requirement of $25,000.
All other BDs that do not carry customer accounts and do not receive funds or securities are subject to a $5,000 minimum net capital requirement. This includes BDs that act as investment bankers or receive commissions in conjunction securities offerings.
In addition to the regulatory net capital requirements set forth in 15c3-1, BDs will also be subject to other net capital thresholds based upon their aggregate indebtedness (liabilities). BDs also need to be aware of additional net capital requirements that may be mandated by their specific designated examining authority and other regulatory bodies that the BD is a member of, such as the Commodities Futures Trading Corporation (“CFTC”). The net capital rules are complex, but when understood and properly applied can become a useful tool for managing the financial strength of the BD.
If you have concerns that your firm’s activities might cause a violation of the net capital rules and a reclassification of the firm subjecting it to higher-unattainable thresholds, feel free to contact a member of the WS+B Broker-Dealer Team. Our experts can advise and help establish a system to ensure compliance.
Industry Provides Feedback to FINRA’s Notice Regarding Introduction of Limited Corporate Financing Brokers
[author-style]By Jessica Offer, CPA [email protected][/author-style]
As part of the notice, FINRA solicited specific feedback regarding the appropriateness and applicability of the rules, customer protection, and whether qualifying registrants would apply. Based upon the number of responses and their corresponding comments, it appears there is more work to be done to these proposed rules for the LCFB registrant type to be a success.
Overall the comments have commended FINRA for taking steps in the right direction which will offer a limited set of rules for LCFBs which would eliminate some of the burden placed on fully registered broker-dealers; However, a majority of the comment letters note that further adjustments to the proposed rules would be required for them to be successful. The costs to make the transition at this time appear to outweigh the benefits. There is a potential risk that LCFBs may lose business due to the confusion surrounding the regulation around them and if they are subject to less stringent requirements, investors may feel that they are less qualified or higher risk to do business with. Additionally, LCFB’s are limited in the types of investors that they can do business with which could cause operations to plateau with a smaller available customer base. On the contrary, one respondent questioned the effect on competition since LCFB’s could be more competitive in the M&A space if they have less of a financial and compliance burden. A majority of the comment letters echoed the same themes. The following is a top-10 summary of proposed changes which respondents feel would make the LCFB title more appealing:
- Adjusting fidelity bonding requirements since LCFB’s do not hold customer securities.
- Relaxing the definition of accredited inventors under the LCFB rules which are more stringent than the Securities and Exchange Commission’s Regulation D.
- Expanding the licenses/registrations offered to representatives of LCFB — as this may limit the ability of a broker to change organizations from a LCFB to a registered full broker-dealer or vice versa. Additionally the same organization may change status depending on its activities and lines of business.
- Clearly defining and removing the uncertainty in the definition of “customer” and “investor”.
- Ability to change status from full service broker-dealer to LCFB (and change back if applicable) without a fee.
- Changes to the FOCUS Report, Calculation of Net Capital and Supplemental Statement of Income (SSOI) to be tailored towards a LCFB’s lines of business.
- Exempt LCFBs from having mandated audits by PCAOB registered public accounting firms.
- Exemption from Securities Investor Protection Corporation (“SIPC”) as LCFBs do not carry customer accounts.
- Enhancements to the current anti-money laundering (AML) and suitability rules.
- Reduction in FINRA membership/registration fees as a result of less oversight.
Based upon the feedback provided, it appears that unless significant economic benefits are to be provided by LCFB registration such as implementation of some of the aforementioned suggestions including but not limited to: exemption from PCAOB audit, exemption from SIPC (or at a minimum SIPC’s assessment fee), and registration and de-registration fees, there will not be a “mad rush” for members vying to become LCFBs.
The Regulatory Notice 14-09 and corresponding comment letters are available on FINRA’s website at:
https://www.finra.org/Industry/Regulation/Notices/2014/P449587
Finance That Matters is published by WithumSmith+Brown, PC, Certified Public Accountants and Consultants. The information contained in this publication is for informational purposes and should not be acted upon without professional advice. To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Please contact a member of the Financial Services Group with your inquiries.
Learn More About our Financial Services>> 