On December 27, the U.S. Tax Court issued an opinion declining to revisit its holding from 13 months earlier that a partner's formal status as a "limited partner" under state law does not determine whether the partner is eligible for the "limited partner exception" for Self-Employment Contributions Act ("SECA") purposes.
Under SECA, income derived by an individual from a trade or business—including trade or business income allocated to a partner in a partnership—is generally subject to self-employment tax. One exception to this rule is income "of a limited partner, as such," which is not subject to tax under SECA. In 2023, the Tax Court held that merely holding the status of a limited partner under state law would not alone qualify a partner in a limited partnership for this limited partner exception. Rather, the Tax Court adopted a "functional analysis" to distinguish between passive investors in a partnership (the role historically associated with "limited partners" at the time of SECA's enactment) and partners who play an active role in the partnership's business operations (who are denied the exception). The Tax Court first adopted this "functional analysis" in a 2011 decision applying the limited partner exception in the context of limited liability companies (which do not generally distinguish between "limited" and "general" partners as a state law matter). The 2023 decision, however, was the first time the Tax Court extended that analysis to taxpayers who were (as a matter of state law) "limited partners" of a limited partnership.
This latest case involved a different limited partnership that had similarly claimed the limited partner exception for its limited partners. The Tax Court, citing stare decisis principles, stated that it sees "no special justification to revisit [the 2023 decision's] reasoning." It went on to again apply the functional analysis test to hold that the partners of the partnership at issue were ineligible for the limited partner exception.
These two cases are far from the only cases pending in the courts regarding the scope of the limited partner exception. As discussed in prior issues of Brass Tax, the IRS has in recent years sought to challenge the use of the limited partner exception by a number of investment management companies organized as limited partnerships. One such case, involving Sirius Solutions, is currently pending before the Fifth Circuit Court of Appeals. Given the importance of this issue to both investment managers and the IRS, it is likely that other appellate courts will also have an opportunity to weigh in on the question.
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.
