Self-employment tax is imposed on individuals’ trade or business income. Net investment income tax (“NIIT”) generally applies to high-income individuals’ investment income. Both taxes generally apply to income earned directly or through flow-through entities, and for most fund managers are applied at a marginal rate of 3.8% (although the self-employment tax has a lower effective marginal rate because it is partially deductible and is imposed on a generally smaller base).
There is a statutory exception from self-employment tax for income earned as a limited partner, excluding certain guaranteed payments. There is some uncertainty as to whether this exception applies to members of limited liability companies, or to limited partners who are active in the underlying business. Under current law, self-employment tax also does not apply to income flowing through an S corporation to its shareholders.
Many hedge fund management companies are structured as limited partnerships, and income flowing through to their owners may be treated as exempt from self-employment tax pursuant to the statutory exception for limited partners noted above.
President Obama’s 2017 proposed budget would change the self-employment tax and NIIT rules in order to “ensure that all trade or business income of high-income taxpayers is subject to a 3.8 percent tax” whether self-employment tax or NIIT.
The budget would seek to achieve this goal by eliminating the exceptions from self-employment tax for limited partners or S corporation shareholders of professional service businesses, although non-active owners would only be subject to self-employment tax on their “reasonable compensation, if any, for services provided to the business”. It would extend the NIIT as a “catch all”, capturing flow-through trade or business income that is not subject to self-employment tax, and to apply to the sale of business property.
It is not clear whether these proposals will be adopted, as the budget includes many changes that Congress has rejected in prior years, and it may be particularly unlikely that the proposals are adopted in an election year. These changes are proposed to be effective beginning after 2016, and if enacted could significantly increase the tax imposed on deferred fees in 2017.