Compensation Considerations for First-Time Fund Managers

Becoming a first-time investment fund manager is a challenging and rewarding endeavor that involves a deep understanding of investment strategy, regulatory compliance, fundraising, operations, administration and investor relations. One often overlooked element is compensation — specifically, how a first-time fund manager is allowed to receive compensation from the management company.

Generally, management companies tend to be structured as either a Limited Liability Company (LLC) or Limited Partnership (LP). Many first-time fund managers who were previous employees and accustomed to receiving a Form W-2 may be surprised to learn that now as members in an LLC or partners in a partnership, they are no longer eligible to be treated as employees and can no longer have payroll taxes withheld on their behalf and receive a W-2.

In a partnership, compensation for partners differs significantly from how employees are paid in a corporation. Instead, partners receive compensation in several ways, which is reported differently for tax purposes. Here’s a breakdown:

• Guaranteed payments: These payments to partners are made for services rendered or for the use of capital and are reported on the partner’s Schedule K-1. Guaranteed payments are also reported as ordinary income and are subject to self-employment taxes.
• Share of profits and losses: Partners receive a share of the partnership’s profits and losses, which is also reported on the partner’s Schedule K-1. This income is generally subject to self-employment tax and must be reported on the partner’s individual tax return.
• Draws: Draws or advances against future profits are not considered wages and are not reported on a W-2. They are simply distributions of the partner’s equity in the partnership.

It’s essential for the partnership agreement to clearly outline the compensation structure to avoid disputes and ensure transparency. The agreement should cover how profits and losses are divided, the method for calculating guaranteed payments, the process for draws and any other compensation-related provisions.

First-time fund managers should be aware that in a partnership, each partner is typically responsible for reporting their share of the partnership’s income, deductions and credits on a personal tax return. Because partnerships themselves do not pay income tax, the income is passed through to the partners, who must then pay taxes on their share.

Here are some key points to remember:

• Estimated taxes: Partners may need to make estimated tax payments throughout the year, as taxes are typically not withheld by the partnership. This includes federal, state and local estimated taxes, if applicable. This is generally in sharp contrast to having had federal, state and local taxes withheld from their salaries by previous employers as employees who received a W-2 prior to becoming first-time fund managers.
• Self-employment taxes: Partners are considered self-employed for tax purposes. This means they must pay self-employment taxes (Social Security and Medicare) on their share of the partnership’s earnings.
• K-1 Form: The partnership issues a Schedule K-1 to each partner, which details their share of the partnership’s income, deductions and credits. This information is used to prepare their individual tax returns.

It’s essential for partners to keep good records and consult with a tax professional to ensure all tax obligations are met correctly. Weaver’s team of experienced professionals is here to guide you through partnership compensation, tax planning and compliance, helping you focus on growing your fund. Contact us today to learn how we can support your success and keep your financial strategies on track.

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