Alternative Investment

“Active” Limited Partners may be Subject to Self-Employment Tax

Tax Court Ruling, Soroban Capital Partners LP v. Commissioner Tax Court

Management companies structured as LPs, with some of their GPs also serving as limited partners, need to be aware of the potential tax implications of this recent US Tax Court Ruling. Due to the assumption of “active participation” in the partnership, distributable income may be subject to self-employment tax. As a result, actively participating limited partners could face significant tax consequences.

On November 28, 2023, the US Tax Court in Soroban Capital Partners, L.P. v. Commissioner granted partial summary judgment in favor of the Internal Revenue Service (IRS) that limited partners in the fund could be subject to self-employment tax on their distributive share of partnership net income if they are actively involved (“materially participate”), notwithstanding IRC Section 1402(a)(13) “limited partner” exception.

On Soroban’s returns for the years in issue for this case, Soroban reported as net earnings from self-employment its guaranteed payments to its limited partners plus the general partner’s share of ordinary business income. The Commissioner adjusted Soroban’s net earnings from self-employment by increasing it to include the shares of ordinary business income allocated to the limited partners, taking the position that they were limited partners in name only.

Soroban contends that their limited partners are state law limited partners and therefore their distributive shares of income are excluded from net earnings from self-employment under section 1402(a)(13). Soroban argues that because Soroban is a state law limited partnership and its Limited Partnership Agreement identified their partners as limited partners, their limited partners should meet the “limited partner” exception under section 1402(a)(13). The Commissioner disagrees, arguing that the distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from self-employment income. The Commissioner asserts that the Court must apply a functional analysis test, similar to the test outlined in Renkemeyer v. Commissioner, 136 T.C. 137 (2011) and subsequent cases, to determine whether individuals are limited partners pursuant to section 1402(a)(13).

The court finds that the limited partner exception does not apply to a partner who is limited in name only. The court states that 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. 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.

The IRS has been aggressive in pursuing self-employment tax audits for limited partnerships since initiating the Self-Employment Contributions Act (“SECA”) “compliance campaign” in 2018, and the Court’s position in Soroban will likely provide the IRS with additional incentive to audit taxpayers. There are several other limited partnership cases with this issue at hand which will be monitored closely.

Under Soroban, it appears that the IRS can require that any active limited partner pay self-employment tax on its distributive share of partnership net income, and we advise consulting with your tax professional and legal counsel to ensure your fund and your limited partners are prepared in case of a tax audit. We will continue to monitor this case and other related cases closely as the Tax Court develops a functional standard.