IRS prevails in Tax Court case limiting self-employment tax exception for limited partners

On November 28, 2023, the Tax Court delivered a highly anticipated opinion on the limited partner exception from self-employment tax under section 1402(a)(13), holding, in a case of first impression as relates to a state limited partnership, that whether a partner is a “limited partner” for these purposes must be determined by applying a functional analysis test, instead of state law.[1] The Court further held that such determination can be made in a TEFRA proceeding, at the partnership level.

The case

Soroban Capital Partners LP et al. v. Commissioner, 161 T.C. No. 12 (2023) involves a hedge fund organized as a Delaware limited partnership that was audited by the IRS. The hedge fund had three individual limited partners that were regarded for US federal income tax purposes: the Managing Partner and Chief Investment Officer, the Co-Managing Partner, and the Head of Trading and Risk Management, each of whom was entitled to receive certain guaranteed payments for services from the hedge fund. The IRS determined that the hedge fund’s limited partners were “limited partners” in name only and not eligible for the limited partner exception under section 1402(a)(13), and proposed adjustments to the amount of net earnings from self-employment reported by the hedge fund.

The hedge fund filed a Motion for Summary Judgment requesting the Tax Court to conclude that its partners qualified for the limited partner exception under section 1402(a)(13) given that they were “limited partners” under applicable state law in a state law limited partnership. The IRS cross-motioned and this opinion decided the motion in favor of the IRS,[2] in an opinion appealable to the Second Circuit.

The statute and development of the law

Section 1402(a)(13) states:

. . . there shall be excluded [from net earnings from self-employment] the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services[.]

The term “limited partner” is not defined for purposes of section 1402(a)(13).

The Treasury Department and the IRS issued proposed regulations in 1997 (the 1997 Proposed Regulations) that excluded an individual partner from claiming “limited partner” status if the partner (i) had personal liability for partnership debts, (ii) had authority to contract on behalf of the partnership, or (iii) participated in the partnership’s trade or business for more than 500 hours in the partnership’s taxable year.[3]

In response to heavy criticism of the 1997 Proposed Regulations, Congress issued a moratorium on issuing temporary or final regulations under section 1402(a)(13) before July 1998. The moratorium had a chilling effect, and the 1997 Proposed Regulations were never finalized.

This issue was reanimated in 2011, however, when the Tax Court decided Renkemeyer v. Commissioner, 136 T.C. 137 (2011). Renkemeyer raised the question of whether partners in a Kansas limited liability partnership should be considered “limited partners” under section 1402(a)(13). The Court concluded that, in the context of a limited liability partnership, that Congress intended for the exception to apply only to limited partners who were merely invested in a limited partnership, not to partners performing services in the partnership’s operations (ie, eligibility should be based on an analysis of the actions and functions of the partners, not solely on their state law titles). After noting that “Section 1402(a)(13) was originally enacted . . . at a time (1977) before entities such as L.L.P.s were contemplated,” and after analyzing the partners' actions and determining that they were performing services, the Court held that the partners in that case were ineligible for the section 1402(a)(13) exception.

The holding

In Soroban, the Tax Court concluded that even limited partners in a state law limited partnership do not automatically qualify under section 1402(a)(13) and denied the hedge fund’s motion for summary judgment.

The Tax Court interpreted the statute – in particular, the phrase “as such” – as applying to a limited partner only if the partner is functioning in the capacity of a passive investor.[4] Accordingly, it concluded that a “functional analysis test” (akin to the Court’s analysis in Renkemeyer) would be necessary to determine whether limited partners qualify.

The Tax Court’s opinion indicates that its conclusion is based on the “plain meaning” of the statute and references the “canon against surplusage” (which requires giving effect to every clause and word of a statute) in analyzing the use of the term “as such.” However, it seems that that canon should also be applied to take into account that section 1402(a)(13) by its terms anticipates that limited partners can be actively involved in a partnership’s business, as the statute is clear that limited partners' distributive shares are exempt from self-employment tax, except to the extent of guaranteed payments under 707(c) and that the IRS can establish are for services rendered by such partner for the partnership.

Practical implications

The IRS initiated a self-employment tax compliance campaign in March 2018 and has been actively auditing and litigating numerous self-employment tax cases for several years. Asset managers have been frequent users of limited partnerships and the limited partner exception for their management entities and have been considered targets in the self-employment campaign. In addition to Soroban, the Tax Court has three similar cases involving section 1402(a)(13) on its docket.[5] 

While Soroban certainly represents a meaningful trial court victory for the IRS, the full ramifications for taxpayers remain to be seen, as the Tax Court has yet to apply the functional analysis test to the hedge fund to determine the portion of its net earnings subject to self-employment tax. The Court’s subsequent rulings will likely need to address the fact that, as noted above, the statute contemplates eligibility for a limited partner that provides some level of services (as the statute merely carves out from the scope of the exception the portion of a partner’s distributive share that represents a guaranteed payment for services, as opposed to disqualifying entirely any limited partner that is entitled to a guaranteed payment for services). In the meantime, the decision is likely to inspire heightened focus and attention on the limited partner exception project referenced in the 2023-2024 priority guidance plan released by the Treasury Department and the IRS.

While some limited partnerships may forgo utilizing the limited partner exception going forward, other partnerships may consider alternative organizational structures that may be eligible for the exemption. Partnerships may consider reorganizing their operations into one or more entities so that partners can satisfy a functional analysis test with respect to income generated by certain entities in which their participation is less active.

Some taxpayers may consider establishing S corporations, which allow taxpayers to avoid subjecting all of their earnings to self-employment tax but require compliance with highly technical requirements that can significantly limit operational flexibility. Regardless, the limited partnership form will likely remain ubiquitous for many reasons, including that limited partnerships tend to be favored by investors seeking to avail themselves of treaty benefits (limited partnerships generally are fiscally transparent for treaty purposes, whereas LLCs can be fiscally opaque and trigger anti-hybrid rules).

In considering next steps, taxpayers are encouraged to consider the fact that this opinion, which is appealable, is likely not the final word on this issue. Further, while the Tax Court opinion indicates that the “plain meaning” of section 1402(a)(3) leads to the conclusion that a functional analysis test is required, it remains arguable that indeed the plain meaning of the statute is that, except as provided in the statute, “there shall be excluded [from net earnings from self-employment] the distributive share of any item of income or loss of a limited partner, as such…”

DLA Piper’s lawyers are available to assist in addressing any questions you may have regarding these and other tax-related developments.