Feb. 15, 2024

IRS Wins Round One Over Meaning of “Limited Partner” for Self-Employment Income Purposes

On November 28, 2023, the U.S. Tax Court (Court) issued a significant ruling in Soroban Capital Partners, LP v. Commissioner (Soroban), which portends to widen the applicability of self-employment taxation to state law limited partners of flow-through operating businesses, such as private fund managers. In denying the taxpayer’s motion for summary judgment, the Court ruled that the determination of who constitutes a “limited partner” for purposes of the exception to self-employment taxation requires a “functional analysis test.” Before this ruling, many taxpayers – including numerous private fund managers organized as state law limited partnerships – expected the limited partner exception to apply to partners who qualify as “limited partners” for state law purposes. It remains to be seen what factors the Court will consider for purposes of a functional analysis test. This guest article by Schulte attorneys David S. Griffel, David S. Wermuth and Sarah J. McNeill explains how Soroban may affect how fund managers structured as limited partnerships will report their income for self-employment tax purposes for tax years 2023 and beyond. See “Key Tax Issues Fund Managers Must Consider” (Jun. 10, 2021).

Navigating the New FinCEN Beneficial Ownership Reporting Regime

On January 1, 2024, a new beneficial ownership reporting rule (Rule) issued by the U.S. Department of the Treasury’s Financial Crimes Enforcement Network took effect. The Rule will affect a broad range of businesses, from startups to established entities, and creates particular challenges for investment management firms, noted Seward & Kissel partner Patricia A. Poglinco in a recent program devoted to the Rule. Poglinco, who moderated the discussion with fellow partners Sophia A. Agathis, Noelle Indelicato and Danielle Lemberg, discussed the key components of the Rule, including which entities are subject to it, who is a “beneficial owner,” what information companies are required to report and the practical implications of the Rule for fund managers. This article synthesizes the key takeaways from the program. See “FinCEN Issues First AML/CFT Priorities” (Aug. 26, 2021).

Driven by AI, Private Funds’ Use of Alternative Data Continues to Grow, Survey Finds

Lowenstein Sandler recently issued its fourth annual alternative data survey, which took the pulse of more than 100 hedge funds, private equity firms and venture capital firms. “The use of alternative data is here to stay; it continues to strongly influence the decision-making of investment professionals across all areas of the investment management industry,” Lowenstein Sandler partner Scott H. Moss told the Hedge Fund Law Report. “The emergence of generative artificial intelligence (AI), with its potential to help firms process enormous quantities of information, is one of the most significant factors driving this continued use.” The survey covered the industry’s use of alternative data; data sources; alternative data budgets; key concerns over alternative data; use of AI; and use of alternative data in connection with the incorporation of environmental, social and governance factors in the investment process. This article distills the survey results, with additional commentary from Moss. For Lowenstein Sandler’s 2022 study, see “Use of Alternative Data Continues to Grow, Says New Survey” (Mar. 2, 2023). See also our coverage of its 2021 and 2019 alternative data studies.

SEC Settles Five Additional Enforcement Proceedings for Custody Rule and Form ADV Violations

The SEC had been conducting a targeted sweep of private fund advisers for compliance with Rule 206(4)‑2 under the Investment Advisers Act of 1940, commonly known as the “Custody Rule.” One key provision of the Custody Rule requires an adviser with custody of client assets to undergo a surprise annual custody examination. In lieu of that requirement, however, an adviser to a private fund may obtain and distribute to investors an annual audited financial statement for the fund. Many Custody Rule violations occur when advisers fail to comply with the requirements of that exception. In September 2022, the SEC resolved nine enforcement proceedings alleging violations of the Custody Rule and associated requirements for amending Form ADV to provide accurate information about fund audits. A year later, it resolved five additional enforcement proceedings arising out of that sweep. This article discusses the new settlements. See “SEC Settles Nine Enforcement Proceedings Over Custody Rule and Related Form ADV Violations” (Feb. 2, 2023); and “Compliance Corner Q4‑2022: Regulatory Filings and Other Considerations That Hedge Fund Managers Should Note in the Coming Quarter” (Oct. 6, 2022).

No Longer a Slap on the Wrist: SEC Penalties and Sentences on the Rise

A global shift in the regulatory approach to penalties is leading to greater fines across more geographies and the use of a wider variety of recourse against a bigger cross-section of targets, notably individuals and executives. Not even annual bonuses, stock shares and promotions are safe under the broadening definitions of clawbacks being sought. “We’re recalibrating and looking at how we can have penalties that don’t just punish the misconduct that occurred but also deter future misconduct,” said Stacy Bogert, Associate Director of the SEC’s Division of Enforcement, at a session in the Global Enforcement & Compliance series presented by the Women’s White Collar Defense Association in Washington, D.C. The discussion, “The Penalty Phase: Developments in Sentencing, Forfeiture, and Clawbacks on the Global Stage,” featured Deborah Connor, partner at Morrison & Foerster; Claire Murray, Vice Chair of the U.S. Sentencing Commission; Steven Fitzpatrick, Senior Attorney in the Proceeds of Crime and International Assistance Division of the U.K.’s Serious Fraud Office; and Evelyn Sheehan, partner at Kobre & Kim. See our two-part series “Why, When and How Fund Managers Should Self-Report Violations to the SEC”: Part One (Jan. 10, 2019); and Part Two (Jan. 17, 2019).

James Munsell Joins Akin in New York

Akin has expanded its investment management practice with the addition of James Munsell as a partner in the New York office. Munsell’s practice is focused on the formation and operation of hedge funds and other private funds, ranging from start-ups to large global financial institutions. For insights from Munsell, see “Evolving Practices Regarding Hybrid Structures, Co‑Investments, Separate Accounts, ESG Challenges and Expense Allocations” (May 19, 2022).