While the decision directly relates to investment managers, it can also be relevant to other businesses organized as limited partnerships or LLCs.
The U.S. Court of Appeals for the Second Circuit has issued a consequential decision addressing the scope of the “limited partner” exception to self-employment tax under Section 1402(a)(13) of the Internal Revenue Code. In Soroban Capital Partners LP v. Commissioner, the court held that state-law classification as a limited partner, standing alone, is insufficient to qualify for the statutory exception. Instead, a partner must not only possess limited liability, but also refrain from running, managing or controlling the partnership’s business.
For private equity fund sponsors and investment managers, the decision is particularly important because it calls into question longstanding structures under which principals receive substantial distributive shares as limited partners while actively participating in investment, operational and management decisions. The ruling increases scrutiny of whether such income remains exempt from self-employment tax and may require sponsors to reevaluate existing partnership and compensation arrangements. While the decision directly relates to investment managers, it can also be relevant to other businesses organized as limited partnerships or LLCs.
Background
Section 1401 imposes Social Security and Medicare taxes on self-employment income. Section 1402(a)(13), however, generally excludes a limited partner’s distributive share of partnership income from self-employment income, other than certain guaranteed payments for services.
When Congress enacted the provision in 1977, a limited partner was commonly understood to be a passive investor rather than an individual actively engaged in operating a business.
Soroban involved a Delaware limited partnership engaged in investment management. Although the principals held limited partner interests under Delaware law, they worked full time for the firm, exercised managerial authority and played a central role in generating the partnership’s revenue.
The partnership argued that state-law limited partner status alone was sufficient to qualify for the exception. The IRS disagreed, and both the Tax Court and the Second Circuit sided with the government.
The Second Circuit's Functional Test
Rejecting a purely formalistic approach, the Second Circuit concluded that the exception applies only where a partner is functioning as a true limited partner. In addition to possessing limited liability, the individual must not run, manage or control the partnership’s business.
Importantly, the court did not adopt a rule that any service activity automatically triggers self-employment tax. The court distinguished between providing services and exercising managerial control. A partner may remain involved in partnership activities and still qualify for the exception, provided those activities do not rise to the level of directing or controlling the enterprise. The decision therefore does not establish a simple “services equal SECA ” rule. Instead, it requires a fact-intensive inquiry into the partner's actual role.
As a result, the analysis becomes highly fact-specific and will depend on the nature and extent of a partner’s authority and involvement.
Implications for Private Equity Fund Sponsors and Other Partnerships
The decision has immediate relevance for private equity firms, hedge funds and other investment management businesses that allocate significant distributive income to individuals who are actively involved in investment decisions, portfolio oversight, fundraising, governance or firm management.
Fund sponsors should consider reviewing whether and to what extent limited partners receiving income allocations possess meaningful authority over investment activities, operational decisions, hiring and personnel matters, strategic direction or other management functions.
The ruling also raises broader structuring questions regarding management company arrangements, partner roles, compensation design and future fund-governance models. Given the potentially substantial self-employment tax exposure associated with high-income partners, careful review of existing structures may be warranted.
The implications extend beyond investment funds as well. Professional service firms—including law, accounting, consulting and other service businesses—may have partners who enjoy limited liability while actively participating in management. The same functional analysis potentially applies to those arrangements.
Developments in Other Circuits
The Second Circuit’s decision follows the Fifth Circuit’s recent opinion in K Alain L.L.L.P. v. Commissioner, which likewise rejected a state-law-only analysis. The Fifth Circuit focused on whether a partner plays a “significant role” in management, while the Second Circuit framed the inquiry as whether the partner “runs, manages or controls” the business. Although the decisions are generally aligned, uncertainty remains regarding the precise level of participation that disqualifies a partner from the exception.
On September 26, 2026, the taxpayer in K Alain petitioned for en banc review.
The First Circuit is also considering the issue in Denham Cap. Mgmt. LP v. Commissioner, another case involving an investment management partnership.
Takeaway
Sponsors that have relied on the limited partner exception should consider reassessing their Section 1402(a)(13) positions, particularly where principals exercise substantial management authority while receiving large distributive allocations. The analysis should consider the partners’ authority over investments or operations, participation in management and governance, responsibility for hiring and firing, and role in generating the firm's revenue.
Soroban represents a meaningful shift away from treating “limited partner” as simply a state-law designation for federal self-employment-tax purposes. Yet, the Second Circuit deliberately left room for partners to provide services without automatically losing the exception.
As additional appellate courts weigh in, the treatment of active fund principals will remain a critical area of tax risk and planning.
For More Information
If you have any questions about this Alert, please contact Alan Schwartz, David A. Sussman, any of the attorneys in our Private Equity Industry Group, any of the attorneys in our Investment Funds Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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