In Soroban Capital Partners LP v. Commissioner,1the Tax Court held that the statutory exclusion from the imposition of self-employment tax does not automatically apply with respect to the distributive share allocable to limited partners of an investment firm organized as a Delaware limited partnership. Siding with the IRS, the Tax Court concluded that the limited partner exception does not apply to a partner who is limited merely in name, and instead requires a functional analysis.
The decision in Soroban Capital is the first of several pending cases challenging the IRS' position on the application of the statutory exception. It is expected to bolster the IRS position in auditing investment firms and other service providers. Investment fund sponsors and managers and other service providers treated as partnerships for federal income tax purposes should carefully consider their situation in light of the Soroban Capital decision.
Background
Section 1401(a) imposes tax at a rate of 12.4 percent (plus an additional 3.8 percent hospital insurance tax) on the self-employment income of individuals.2"Self-employment income" includes an individual's distributive share of income from any trade or business of a partnership of which the individual is a member, subject to certain exclusions. One such exclusion, set forth in Section 1402(a)(13), is
"the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments ... for services." (Emphasis added.)3
In 1997, the Treasury Department issued a proposed regulation defining the scope of this limited partner exception. The proposed regulation provided that an individual would not be treated as a limited partner if the individual had personal liability for partnership debts, had authority to contract on behalf of the partnership, or participated in the partnership's trade or business for more than 500 hours during the partnership's taxable year. The proposed regulation faced a great deal of criticism, leading Congress to issue a moratorium prohibiting the issuance of any temporary or final regulations with respect to the definition of a limited partner under Section 1402(a)(13) until July 1, 1998. Neither the Treasury Department nor Congress has defined the term "limited partner" for this purpose since the end of such moratorium.
In 2011, the Tax Court considered the phrase "limited partner, as such" in Renkemeyer, Campbell & Weaver, LLP v. Commissioner.4The court found that "[t]he legislative history . . . does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes."5The court therefore held that the partners in that case were not limited partners for purposes of the limited partner exception inasmuch as their distributive shares arose from legal services performed on behalf of their law firm and not as a return on the partners' investments.
In 2018, the IRS launched an audit "compliance campaign" that focuses on the qualifications of a "limited partner" for purposes of the exclusion from self-employment tax. In launching the campaign, the IRS stated that "some individual partners, including service partners in service partnerships organized as state-law limited liability partnerships, limited partnerships, and limited liability companies, have inappropriately claimed to qualify as 'limited partners' not subject to [self-employment] tax."6
Now, for the first time since the initiation of that compliance campaign, the Tax Court in Soroban Capital has ruled on the limited partner exception and its application to limited partners in a state law limited partnership. On Nov. 28, 2023, the court denied the taxpayer's motion for summary judgment and granted the IRS' motion for partial summary judgment, holding in part that the limited partner exception does not apply to a partner who is limited in name only and that such determination requires an inquiry into the functions and roles of the limited partner. Thus, state law labels do not control who qualifies as a limited partner for purposes of determining whether the limited partner exception applies.
The Case
Soroban Capital Partners LP (Soroban Capital), a Delaware limited partnership that is classified as a partnership for U.S. federal income tax purposes, is a New York-based investment firm. On its federal partnership tax returns filed in 2016 and 2017, Soroban Capital "reported as net earnings from self-employment guaranteed payments to its limited partners plus the general partner's share of ordinary business income."7 Upon audit, the IRS adjusted Soroban Capital's net self-employment earnings upward by including the shares of ordinary business income allocated to the limited partners (in addition to their guaranteed payments), taking the position that they were "limited partners in name only."8
In its motion for summary judgment, the taxpayer argued the Tax Court should conclude that the limited partners' distributive shares of income were not subject to self-employment tax pursuant to Section 1402(a)(13) merely as a result of their being labeled limited partners. In its motion for partial summary judgment, the IRS asked the court to conclude that an inquiry into the functional roles of the taxpayer's limited partners is a partnership item appropriately considered by the court in the partnership-level proceedings before it. The Tax Court denied the taxpayer's motion and granted the IRS' motion, reasoning that Congress intended for the limited partner exception to apply to "earnings of an investment nature," necessarily entailing "an inquiry into the functions and roles of the limited partners," which inquiry concerned a partnership item and was therefore within the court's jurisdiction as a partnership-level proceeding.9
The Tax Court noted that, in Renkemeyer, it had specifically applied a functional analysis test to determine whether the limited partnership exception applied. While it acknowledged that that case dealt with a limited liability partnership (LLP) rather than a limited partnership, the court concluded that such a test is equally applicable in the limited partnership context.
Having concluded that a functional analysis test applies in the limited partnership context, the Tax Court went on to consider who qualifies as a "limited partner" for purposes of Section 1402(a)(13). The court noted that the statute does not define the phrase "limited partner, as such," but that principles of statutory construction and legislative history shed light on Congress' intended meaning.
Relying on the canon of statutory construction against surplusage, the court found that
"the limited partner exception does not apply to a partner who is limited in name only. If Congress had intended that limited partners be automatically excluded, it could have simply said 'limited partner.' By adding 'as such,' Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner."10
Reference to the legislative history confirmed, in the court's view, its statutory interpretation. The House committee report accompanying the enactment of the statute indicates that the aim of the limited partner exception was to exclude from eligibility for Social Security coverage those limited partners whose distributive share of earnings from the partnership were of an investment nature. The Tax Court noted that "Congress enacted section 1402(a)(13) to exclude earnings from a mere investment. It intended for the phrase 'limited partners, as such' used in section 1402(a)(13) to refer to passive investors . . . . Congress's express text makes clear that it was looking to the nature of the earnings."11
Due to the procedural posture of the case, a determination of whether the taxpayer's partners in fact qualify as limited partners for purposes of Section 1402(a)(13) on the merits is left to future proceedings before the Tax Court.
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In applying a functional analysis test to determine whether a state law limited partner is a "limited partner, as such" for purposes of Section 1402(a)(13), the Tax Court concluded that the limited partner label does not automatically exempt such a partner's distributive share of partnership income from self-employment taxes. Partners who are limited in name only but are not otherwise passive investors in the partnership based on a functional analysis test will be subject to self-employment tax on their distributive share of business profits. Hedge funds, investment fund sponsors, their limited partners and tax professionals are well advised to consider the case's ramifications in preparing tax returns and managing their appetite for risk.
Footnotes
1. No. 16217-22, 2023 WL 8235164 (T.C. Nov. 28, 2023).
2. All section references are to sections of the Internal Revenue Code of 1986, as amended.
3. Sec. 1402(a)(13).
4. 136 T.C. 137 (2011).
5. Id. at *150.
6. See "SECA Tax" (https://www.irs.gov/businesses/corporations/lbi-active-campaigns).
7. 2023 WL 8235164 (T.C. Nov. 28, 2023), at *1.
8. Id.
9. Id.
10. Id.
11. Id. at *7.
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