Second Circuit Affirms IRS Position, Resulting In Setback For New York Resident Limited Partners On Self-Employment Tax

Key Points

• The Court of Appeals for the Second Circuit affirmed the Tax Court holding that a partner must lack managerial control over a partnership before it can qualify for the “limited partner exception” from self-employment taxes.
• New York and Connecticut based asset managers who previously have claimed the exemption may no longer be able to take the same reporting positions going forward.
• Asset managers operating in states outside the jurisdiction of the Second and Fifth Circuits (e.g., Florida or Illinois) should consult their tax accountants as to whether the weight of authorities currently present permits them to continue to take the LP exception position.

In a significant decision for the investment funds industry, the U.S. Court of Appeals for the Second Circuit upheld the Tax Court’s decision in Soroban Capital Partners LP v. Commissioner, concluding that the three principals of Soroban Capital Partners LP were not “limited partners” (LPs) for purposes of claiming the exemption from the U.S. federal self-employment tax (SECA) on their distributive share of self-employment income. The court rejected Soroban’s claim that the term refers to any partner of a limited partnership with limited liability, ruling that the term “limited partner” excludes partners who run, manage or control the partnership’s business. The decision directly affects fund managers operating in New York, Connecticut and Vermont (the states comprising the Second Circuit) and is broadly in line with a recent decision of the U.S. Court of Appeals for the Fifth Circuit that already affected managers operating in Texas, Louisiana and Mississippi (the states comprising the Fifth Circuit).

The Controversy: The “LP Exception” and Three Key Cases

For decades, many taxpayers have operated with the understanding that Section 1402(a)(13) of the Internal Revenue Code contains an exception for limited partners intended to exclude from self-employment tax certain partnership income allocated to limited partners. (The self-employment tax is generally imposed on self-employed taxpayers at a social security tax rate of 12.4% (capped) plus Medicare tax at a rate of 2.9% plus an additional 0.9% for high income earners (uncapped). For high income earners, the limited partner exception therefore potentially presents a tax savings of 3.8%). The Internal Revenue Service (IRS) has aggressively challenged this view, including in an audit campaign that continues to be active, arguing that the term limited partner means what it meant in 1977 when the exemption was enacted. Namely, the IRS argues that the exception should only apply to passive-type limited partners, i.e., those who do not materially participate in the partnership’s business, determined based on a functional analysis of the partner’s role in the partnership.

This debate has been defined in recent years by three major cases. In Soroban, the Tax Court sided with the IRS, ruling that a “functional analysis” of a partner’s activities is required to determine if they are passive, which as discussed above, the Second Circuit has now affirmed. The Tax Court followed this decision in late 2024 in Denham Capital Management LP v. Commissioner, reiterating that active limited partners cannot claim the exception. This decision is still pending appeal before the Court of Appeals of the First Circuit. Finally, on January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit in Sirius Solutions LLLP v. Commissioner initially rejected the IRS’s “passive investor” test for the limited partner self-employment tax exception, holding that any limited partner in a state-law limited partnership who enjoys limited liability qualifies for the exclusion of their profit shares from SECA taxes. However, on August 12, 2026, the Fifth Circuit subsequently withdrew its prior opinion and substituted it with a new opinion, concluding that a “limited partner” means “a partner who plays no significant role in managing or running a business.” With the re-issued opinion in Sirius there does not appear to be a split between the circuit courts on this issue thereby making Supreme Court review of the issue less likely.

Consult our previous report on these cases here.

Practical Consequences

For taxpayers currently in the middle of a SECA audit or settlement negotiations, the IRS’s leverage has likely been significantly reinforced by the Soroban ruling as well as the reissued Sirius opinion, especially for taxpayers located in the Second and Fifth Circuits.

Other taxpayers should consult with their tax accountants or other tax advisers as to the positions they may be able to take going forward based on their particular facts and circumstances and the jurisdiction involved.

Finally, it should be noted that, even after the apparent series of IRS favorable case law, it remains a question of fact whether a limited partner meets or fails the managerial control test in a particular situation. Truly “passive” partners should continue to be able to claim the LP exception, including for example in the context of a general partner (GP) stakes transaction. It would be prudent for so-called “dual role” limited partners—who do not play a significant role in managing the business but perform at least some management services—to consider their particular facts with the assistance of counsel.