IRS rulings tighten the rules on active limited partners — what hedge fund managers must understand now.
United States Tax Court building in Washington DC
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Hedge fund and private equity managers increasingly rely on limited partner (LP) classifications to reduce their SE/Medicare tax obligations. But recent Tax Court cases show the IRS is winning a steady stream of challenges, and many active partners are discovering that “active limited partner” status offers far less protection than expected.
Here’s a concise breakdown of what’s happening—and what managers need to watch in 2025.
Active LPs Face SE Tax Exposure
Under self-employment (SE) tax IRC §1402(a)(13), limited partners generally avoid SE tax. But that rule was written in 1954, long before modern management‑company structures.
Tax Court decisions in Soroban (2024) and Denham (2024) confirm:
If you actively provide services through a management company, LP classification does not shield you from SE tax.
Substance prevails over entity labels.
Why a Statutory Gap Exists
High-income taxpayers fall under two parallel systems:
- SE tax for earned business income
- Net Investment Income Tax (NIIT) for unearned passive and investment income
Congress intended that all income fall under a single category. But active limited partners sit at the intersection—legally LPs, but functionally service providers. Treasury acknowledged the mismatch in 2013 but never issued coordinated regulations. Courts now apply a functional test, focusing on what partners actually do.
Management‑Company Income vs. Fund‑Level Income
A critical distinction:
- Management‑company income (advisory and management fees) → generally SE Income
- Fund‑level investment income (capital gains, interest, dividends) → NIIT income
Fund managers often hold interests in both entities, but the tax treatment depends entirely on the role associated with each interest.
Carried Interest (Profit Allocation) Is Always NIIT Income
Carried interest flows from investment activity—not services. It retains fund‑level character and is:
- Always NIIT income
- Never SE income
The OBBBA left carried‑interest rules unchanged.
TTS and Section 475: Ordinary Income, Still NIIT
Few hedge funds qualify for Trader Tax Status (TTS), but those that do may elect Section 475(f) mark-to-market accounting.
Even with ordinary income under Section 475:
- Traders are not service providers
- Section 475 gains remain NIIT income, not SE income
TTS allows business‑expense treatment to reduce SEI for SE tax.
S‑Corporations: The Cleanest Medicare‑Tax Strategy
S‑Corporation elections for management companies remain a widely accepted planning tool:
- Owner/managers receive reasonable compensation, subject to payroll taxes
- Excess profits flow as S‑Corp distributions free from SE tax and NIIT.
This method is time-tested and provides a clear framework for reducing payroll tax exposure. Employee payroll tax is similar to the SE tax for the self-employed.
Key Takeaways for 2025
- LP status alone cannot shield active managers from SE tax.
- Carried interest is always NIIT income.
- Section 475 trading gains are ordinary and NIIT.
- TTS expenses for sole proprietors and partnerships reduce SEI.
- S‑Corporations remain the most defensible Medicare tax planning tool for the management company.
- Distinguish clearly between the management company’s business income and the fund LP’s investment income.
Read the full long-form white paper: https://greentradertax.com/the-hedge-fund-medicare-tax-gap-how-active-limited-partners-fall-between-se-tax-and-niit/
