Tax Court Finds ‘Limited Partners’ Subject to Self-Employment Taxes

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In 2023, the IRS won a summary judgment motion in a Tax Court case involving the self-employment tax liability of an investment partnership’s “limited partners.” In Soroban Capital Partners, LP, the Court adopted a “functional analysis” test that subjects limited partners to a review of their function and roles to determine if they are true limited partners. If they are not, those partners are subject to self-employment tax.

The Court only ruled on a legal point and did not actually apply the test to the partners in the 2023 case, but now has taken that step in a recently-released Tax Court memo case involving three specific limited partners. The Court now has concluded, “Functionally, Soroban’s limited partners were not acting as limited partners.” Therefore, they are subject to self-employment taxes on their distributive shares of income as well as their guaranteed payments.

Facts Relied On

During the years in issue, Soroban earned income from managing

investments. The Court noted that Soroban’s limited partners played an “essential role in generating this income.” Also, Soroban acknowledged that the limited partners’ “unique skills and experience” were indispensable to the

business. The limited partners exercised managerial control over the partnership and worked full-time. Finally, they contributed “little to no capital” relative to their shares of income, the court observed.

Although the IRS urged a nine-factor test, the Court said no specific set of factors will be applied. Instead, it is a “facts and circumstances” test that takes into account many different considerations. Distilling down the court’s analysis, though, the following specific criteria were used in the latest case:

Partner’s role in generating income
Managerial control
Time spent on partnership business
Marketing of the essential nature of the partners’ skills
Level of a partner’s capital contributions

State Labels not Relevant

The Court dismissed the role of state law labels in classifying limited partners, stating “Labels are perhaps least relevant because they may be inconsistent with the economic reality of a partner’s relationship with the entity.” The Court went on to explain that “A partner labeled a limited partner who works for the business full time, whose work is essential to generating the business’s income, who is held out to the public as essential to the business, and who contributes little or no capital, is not functioning as a limited partner regardless of the label placed on that partner.”

Cases on Appeal

In 2024, the Tax Court used the functional test to reject the limited partner label in Denham Capital Management, LP, et. al., v. Commr. That case has been appealed to the First Circuit Court of Appeals, and a third similar case is pending in the Fifth Circuit Court of Appeals. It is likely that the latest Soroban case will be appealed as well.

Outlook

Although the IRS and the Tax Court are forging ahead with the functional analysis test for limited partner challenges, the law will not be settled until the appeals courts weigh in. During this time of uncertainty, it is important for partnerships to consult their tax advisors to pre-screen limited partners’ roles to determine if they are vulnerable to a self-employment tax challenge. For now, the IRS’s position remains this: distributive shares of the income of limited partners in state law limited partnerships are not automatically exempt from self-employment income and the extra 15.3% tax that comes along with it.