Legal Developers

Impactful Tax Court Decision May Now Subject “Limited Partners” to New Self-Employment Tax Burden

A U.S. Tax Court ruled on November 28, 2023, that limited partners in a partnership may be obligated to remit self-employment tax if they are not actually “limited” with respect to their involvement and relationship to a partnership, which now requires an involved factual analysis to determine. The blanket exception contained in Internal Revenue Code (“IRC”) Sec. 1402(a)(13) excluding limited partners from such tax will no longer apply merely because a partner is labeled a “limited partner”.

I. Background Law:

IRC Sec. 1401(a) imposes self-employment tax on the “self-employment income” of all individuals. Self-employment income is the net earnings from self-employment in a given tax year, while net earnings from self-employment, in relevant part, include that individual’s distributive share of income or loss stemming from the business undertaken and carried on by a partnership. In other words, income allocated to a partner from a partnership is subject to self-employment tax.  However, an exception to this rule applies pursuant to IRC Sec. 1402(a)(13), commonly referred to as the “limited partner exception”. This exception excludes a partner’s share of income or loss of a partnership from self-employment tax where the partner is a “limited partner” (the term “limited partner” is not defined in the IRC). IRC Sec. 1402(a)(13) initially was subject to a variety of restrictions under state laws, providing that a partner would lose their status as a “limited partner” if they actively participated in the management and control of a partnership, however, those restrictions were slowly eliminated over time. As a result, “limited partners” could increasingly participate actively in the partnership business while still availing themselves of “limited partner” treatment under IRC Sec. 1402(a)(13).

II. Arguments:

Soroban Capital Partners LP, a Delaware limited partnership operating as a hedge fund, (“Soroban”) argued that its limited partners’ respective shares of the ordinary business income generated by the partnership should not be subject to self-employment tax because the partners are “limited partners” within the meaning of IRC Sec. 1402(a)(13). The IRS contended that the partners’ mere designation as “limited partners” was not a sufficient basis to qualify as a limited partner under IRC Sec. 1402(a)(13). The IRS articulated to the court that a functional analysis of the limited partners’ specific activities, roles and position in the partnership should be necessary to determine their eligibility for the limited partner exception, which should apply only to partners who were limited in their involvement with, and management of, the partnership. In short, the IRS advocated that an analysis of the factual circumstances must be undertaken on a partner-by-partner basis to determine whether a partner is a “limited partner” under IRC Sec. 1402(a)(13).

III. Court’s Legal Reasoning and Ruling:

The Court ruled on November 28, 2023, in favor of the IRS. The Court interpreted IRC Sec. 1402(a)(13) to exclude partners who are “limited in name only” and emphasized the importance of a fulsome factual analysis to determine the nature of the relevant partners’ “functions and roles” with respect to the partnership. At the heart of the Court’s ruling was an interpretation of the legislative history of IRC. Sec. 1402. The Court highlighted that Congress had intended for the limited partner exception in IRC Sec. 1402(a)(13) to apply specifically to earnings of an “investment nature” which “necessarily requires an inquiry into the functions and roles of the limited partners.” The Court did not outline what such an inquiry would entail.

IV. Key Take-Aways:

In the wake of the Soroban decision, partnerships and partners must now assess the following considerations:

1. Re-thinking whether a partner is a “limited partner”: The Soroban ruling establishes that limited partners actively involved in a partnership may be subject to self-employment tax. The current blanket application of the IRC Sec. 1402(a)(13) exception regardless of the exact nature of a partner’s involvement in a partnership is no longer acceptable. Partners and partnerships will need to determine whether a limited partner’s involvement in a partnership is reflective of a “limited partner” – little guidance exists as to the exact nature of this inquiry at this juncture.
2. Aggressive pursuit of business entities: Looking ahead, the Soroban case is emblematic of the IRS’s larger initiative to heavily scrutinize self-employment tax compliance for various entities. This is an ideal opportunity for partners and managers of both partnerships and multi-member LLCs to consult with experienced tax counsel and review their U.S. federal and state tax profile and overall tax strategies.
3. Potential future developments: While Soroban is a significant departure from the previous application of IRC Sec. 1402(a)(13), and represents a significant victory for the IRS, we note that subsequent decisions (g., on appeal) could materially limit its impact. We also note that the IRS may issue formal guidance for taxpayers following the outcome of Soroban, at a minimum laying out the parameters of the limited partner inquiry that must now be undertaken.

V. Conclusion:

Soroban is a decisive shift in the interpretation of the limited partner exception under IRC Sec. 1402(a)(13). The Soroban decision requires both partners and partnerships to undertake a functional analysis of each partners’ role to determine whether a partner is really a “limited partner” for self-employment tax purposes. Taxpayers (partnerships and multi-member LLCs, both referenced in the Soroban decision) should carefully process the implications of this decision and are strongly encouraged to meet with tax counsel to review the appropriate status of any limited partners and, more broadly, assess current overall tax strategies.

The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.