Certain Insights on Important 2023 Tax Cases for Private Funds

At a Glance

• YA Global v. Commissioner: Sponsors of non-U.S. funds should carefully consider the terms of their management agreements and the conduct of the fund and its investment manager to address agency risks and ensure that the investment manager’s activities that may be attributed to the fund are limited in order to avoid engaging in a U.S. trade or business.
• Soroban Capital Partners LP v. Commissioner: This ruling is concerning for private fund sponsors that are state law limited partners and take the position that their share of the partnership’s earnings is not subject to self-employment tax.
• ES NPA Holding, LLC v. Commissioner: Continued careful consideration of the details of profits interests in tiered structures would be prudent.

The year just past, 2023, brought three significant U.S. Tax Court decisions that raise important ongoing tax considerations for private funds. These cases addressed: whether a non-U.S. credit fund had income effectively connected with the conduct of a U.S. trade or business (ECI) as a result of actions taken by its U.S. investment manager (YA Global); the definition of a “limited partner” for purposes of the exclusion of limited partners from self-employment tax on partnership net income (Soroban Capital Partners); and questions related to profits interest grants in a tiered partnership structure (ES NPA Holding, LLC). Taken together with the partnership audit rules currently in effect and the partnership audit enforcement campaign that the IRS announced following its receipt of increased funding under the Inflation Reduction Act of 2022, these decisions illustrate the importance of careful planning by private funds as the IRS devotes more resources to partnership-related enforcement efforts. 

YA Global v. Commissioner

The Tax Court found that a Cayman Islands fund focused on lending through “standby equity distribution arrangements”¹ and convertible securities was engaged in a U.S. trade or business. While the YA Global case did involve fairly unique facts, a number of takeaways merit continued consideration in structuring private funds with non-U.S. investors in mind. The Tax Court made much of the fund’s U.S. investment manager’s designation as an agent of the fund and obligation to comply with interim direction from the fund, ultimately concluding that the investment manager was an agent of the fund as a legal and tax matter and attributing its activities to the fund. Because the Tax Court determined that those activities extended beyond investing and included the provision of services to portfolio companies, they were not covered by the trading safe-harbor or an exception for the management of investments. The Tax Court further concluded that the activities attributed to the fund were those of a dealer, all of the income of the fund was ordinary income, and all of it constituted ECI. Sponsors of non-U.S. funds should carefully consider the terms of their management agreements and the conduct of the fund and its investment manager to address agency risks and ensure that the investment manager’s activities that may be attributed to the fund are limited in order to avoid engaging in a U.S. trade or business. 

Of additional note, certain fees paid to the investment manager by portfolio companies were remitted to the fund. ECI-sensitive funds will want to avoid receiving fees for services provided to portfolio companies and will want to consider what types of charges may be characterized as such a fee for these purposes. Even the implications of management fee offsets should be considered carefully, particularly the treatment of offsets in excess of management fees owed.

The statute of limitations on the required ECI-related withholding from the fund never started, because the fund never filed IRS Form 8804. The filing of the partnership return on Form 1065 was not sufficient to notify the IRS of the fund’s withholding obligation. Partnerships taking a position that they are not obligated to withhold on the basis of not having ECI for foreign partners may want to consider filing a protective Form 8804 so that the statute of limitations will begin running. 

In addition to its general partnership audit enforcement campaign, the IRS’s Large Business and International Division announced a tax examination campaign focused on whether non-U.S. investors (including private funds) involved in U.S. lending transactions are engaged in a U.S. trade or business. The IRS’s success in YA Global may result in increased support for this campaign and encourage additional future audits and examinations regarding this issue. 

Soroban Capital Partners LP v. Commissioner

The Tax Court declined the taxpayer’s motion for summary judgment on whether state law-designated limited partners are exempt from self-employment tax under the plain meaning of the relevant Internal Revenue Code provision, holding that a functional analysis will be applied to determine whether a partner is a “limited partner” for purposes of qualifying for such exemption. Since the IRS’s Large Business and International Division announced its self-employment tax compliance campaign in 2018, the IRS has generally been more active in challenging taxpayers on the position that limited partners are in all instances exempt from self-employment tax solely by virtue of their state law classification. Other cases are pending, and the Soroban case must still be decided on the merits. This ruling is concerning for private fund sponsors that are state law limited partners and take the position that their share of the partnership’s earnings is not subject to self-employment tax. 

ES NPA Holding, LLC v. Commissioner

In a generally taxpayer-favorable decision, the Tax Court affirmed a position that has been taken by practitioners for many years — i.e., that a profits interest can be granted by an upper-tier entity in a tiered structure that is not the entity to which the recipient has directly provided services. Some nuances in the decision suggest that the court may have viewed certain particular facts of this case as important in coming to its conclusion. Continued careful consideration regarding the details of profits interests in tiered structures would be prudent. 

Additionally, although the issuance of profits interests was made in the context of an arm’s length transaction and the valuation used to establish the profits interest hurdle was based on the agreed value of the business in such transaction, the IRS asserted that the hurdle was lower than the actual fair market value of the business, thus creating a capital interest rather than a profits interest. Although the IRS lost this argument, it is a distinct reminder of the importance of using a proper and supportable valuation for the issuance of profits interests generally.