The Medicare and NII Tax: How are your funds affected?
If you manage a fund and you live in New York City (or other high tax locale), your combined effective tax rate is currently toping 50%. There have been substantial changes in the past few years that have worked against you via your tax rate. The year 2013 brought back the old 39.6% tax rate (in place of 35%), the Medicare portion of self-employment tax rose to 3.8% and a new net investment income tax (“NII Tax”), also of 3.8%, was enacted. Plus, restrictions on the full use of allowable deductions have come back into force. Given this relatively high rate of taxation you may be looking for any break that can legitimately be had.
In this post I want to focus in on the 3.8% taxes mentioned above – both the Medicare tax as well as the NII Tax. The point of enacting the NII Tax was to tax passive investment income similarly to earned income (and, obviously, to raise revenue). So, it is not by mistake that the NII Tax and the Medicare portion of self-employment tax have the same 3.8% rate. The general concept was that income would be subject to either one or the other tax and all but a few specifically enumerated classes of income would be taxable.
However, like everything tax related, there are exceptions to the rule and you may find it worthwhile to explore these exceptions. For instance, income received as a distribution with respect to a limited partnership interest is not subject to self-employment tax. Thus, many investment management companies have been set up as limited partnerships to receive the management fee with a 99%:1% split in income between the limited partners and general partner, as only the general partnership interest is subject to the self-employment tax (although it is highly recommended that the management company pay the managers reasonable compensation which is taxed as ordinary income and subject to self-employment tax). Similarly, distributions with respect to a carried interest have been exempt from self-employment tax.
Interestingly, going forward, distributions with respect to LP interests in the management company may also not be subject to the NII Tax. Note, final regulations have not been issued and such regulations may change this result. But, as of now, the LP distributions will continue to be exempt from self-employment tax and may also be exempt from the NII Tax. The same cannot be said for the carry. Distributions on a carried interest typically take the form of a distribution of trading income from the master fund to one of the general partner entities. Such income will generally be subject to the NII Tax.
Thus, funds may want to consider switching from a carried interest paid to a general partner to a fee agreement paid to the management company. To the extent the fund is a trader (as opposed to an investor producing Section 212 expenses); the fund investors should be indifferent. A similar benefit is available if the management company is a Subchapter S corporation. In fact, the argument for the exemption from self-employment taxation is even stronger. Converting the management company to an S corporation may be worth considering in certain situations.
As noted earlier, final regulations under the NII Tax are yet to be released and may alter the conclusions above. Stay tuned for futures posts when the final regulations are released. In the meantime, if you or your funds are concerned about optimizing your self-employment or NII tax position contact a WithumSmith+Brown partner.
Tony Tuths
