Self-employment tax and the limited partner: The Soroban Capital Partners L.P. vs Commissioner 161 T.C. 12 (2023)

Section 1401 and 1402 provide that individuals are subject to self-employment tax under the Self-Employment Contribution Act (SECA) on their net earnings from self-employment derived from conducting a trade or business directly or indirectly through a partnership.
The self-employment tax rate is 15.3%, of which 12.4% is for Social Security and 2.9% is subject to Medicare. There is an additional 0.9% Medicare Tax. Interest, dividends, and capital gains are not subject to self-employment tax.

The limited partner exception is a statutory provision in the Internal Revenue Code that provides that limited partners are not subject to self-employment tax on their earnings from partnerships. Congress passed this provision to ensure that limited partners would not receive Social Security earnings benefits from this type of income. In Soroban Capital Partners, L.P. vs Commissioner, a motion for summary judgment by the plaintiff, the Tax Court for the first time addressed the scope of the limited partner exception from self-employment tax in a case involving a state law limited partnership. In this case, the partnership was a New York hedge fund organized as a Delaware Limited Partnership and was beneficially owned by three individuals for US tax purposes. On its tax return, the partnership included guaranteed payments made to the three individuals for the services as self-employment income, but excluded the three individuals’ share of ordinary income from self-employment income.

The IRS contended that the three individuals’ distributed share of partnership income should be subject to self-employment tax. The three taxpayers disagreed, claiming that as limited partners in a state law limited partnership, they are statutorily exempt from self-employment tax on their distributed share of partnership income.

The Tax Court rejected the partnership’s motion for summary judgment, holding that the limited partner self-employment tax exemption does not apply to a partner who is a limited partner in name only and that determining whether a partner is a limited partner in name only requires a functional analysis of the actual function and role played by the partner. The Tax Court indicated that such a functional analysis should focus on whether a limited partner is merely invested in the partnership or actively participating in the partnership's business operations and receiving earnings from such services.

The Tax Court did not specify what such a functional analysis would entail and did not address whether the individual limited partners in this case would qualify as limited partners under such functional analysis. This case is subject to appeal and, if not overturned, a subsequent case will decide the appropriate functional analysis test.
Based on this decision the IRS is drafting proposed regulations on how to apply the functional analysis test for the limited partner exception to self-employment income. The coming guidance is intended to let the taxpayer and their advisors know where the line is between a passive investor covered by the statutory exemption and an active partner who isn't covered by it.

Given the uncertainty of the law at this time, it behooves taxpayers and their advisors to keep a close watch on this issue. Contact us to work with a specialist. 

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.

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