that limited partners in a partnership may be obligated to remit self-employment tax if they are not actually “limited” with respect to their involvement and relationship to a partnership, which now requires an involved factual analysis to determine. The blanket exception contained in Internal Revenue Code (“IRC”) Sec. 1402(a)(13) excluding limited partners from such tax will no longer apply merely because a partner is labeled a “limited partner”.I. Background Law:IRC Sec. 1401(a) imposes self-employment tax on the “self-employment income” of all individuals. Self-employment income is the net earnings from self-employment in a given tax year, while net earnings from self-employment, in relevant part, include that individual’s distributive share of income or loss stemming from the business undertaken and carried on by a partnership. In other words, income allocated to a partner from a partnership is subject to self-employment tax. However, an exception to this rule applies pursuant to IRC Sec. 1402(a)(13), commonly referred to as the “limited partner exception”. This exception excludes a partner’s share of income or loss of a partnership from self-employment tax where the partner is a “limited partner” (the term “limited partner” is not defined in the IRC). IRC Sec. 1402(a)(13) initially was subject to a variety of restrictions under state laws, providing that a partner would lose their status as a “limited partner” if they actively participated in the management and control of a partnership, however, those restrictions were slowly eliminated over time. As a result, “limited partners” could increasingly participate actively in the partnership business while still availing themselves of “limited partner” treatment under IRC Sec. 1402(a)(13).II. Arguments:Soroban Capital Partners LP, a Delaware limited partnership operating as a hedge fund, (“Soroban”) argued that its limited partners’ respective shares of the ordinary business income generated by the partnership should not be subject to

In Soroban Capital Partners v. Commissioner, the United States Tax Court determined that entities formed as state law limited partnerships did not necessarily mean that the limited partnerships’ limited partners were limited partners for federal income tax purposes and therefore exempt from self-employment taxes.Self-Employment TaxesUnder Section 1402 of the Internal Revenue Code (“IRC”), individuals must pay a tax on net earnings from self-employment. IRC section 1402 defines “net earnings from self-employment” as the “gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus their distributive share (whether or not distributed) of income or loss described in IRC section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.”Under IRC section 1402(a)(13), a limited partner may exclude from their “net earnings from self-employment” their “distributive share of any item of income or loss,” thereby avoiding self-employment taxes.Discussion of SorobanIn Soroban, the IRS adjusted Soroban Capital Partners’ (“SCP”) net earnings from self‑employment, increasing the net earnings from self-employment to include distributive shares of ordinary business income allocated to SCP’s limited partners. The

e 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 SorobanCapital decision.BackgroundSection 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.“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.)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

HighlightsThe U.S. Tax Court recently issued a precedential opinion in Soroban Capital v. Commissioner, holding that the limited partner exception to the Self-Employed Contributions Act (SECA) in Section 1402(a)(13) of the Internal Revenue Code requires an analysis into the functions and roles of the limited partner, so a state-law limited partner does not automatically qualify for the exception to SECA.This is a significant departure from how many taxpayers and tax advisors previously have interpreted and applied the SECA limited partner exception.The U.S. Tax Court recently issued a precedential opinion in Soroban Capital v. Commissioner, holding that the limited partner exception to the Self-Employed Contributions Act (SECA) in Section 1402(a)(13) of the Internal Revenue Code requires an analysis into the functions and roles of the limited partner, so a state-law limited partner does not automatically qualify for the exception to SECA. This is a significant departure from how many taxpayers and tax advisors have interpreted and applied the SECA limited partner exception.Legal BackgroundThe self-employment income of individuals is generally subject to self-employment taxes. Section 1402(a)(13), however, excepts "the distri

SummaryOn November 28, the Tax Court, granting the Internal Revenue Service (IRS) summary judgment, held in Soroban Capital Partners LP v. Commissioner that a state law limited partner who is limited in name only, is not exempt from self-employment taxes under the limited partner exception found in Section 1402(a)(13) of the Internal Revenue Code of 1986, as amended (the Code). Rather, the court found that, for this purpose, a functional inquiry of the interest is required. Soroban is one of a handful of Tax Court cases that have been docketed concerning the application of self-employment taxes to a limited partner's allocation of partnership income. These cases address a position some fund managers take that fund managers who are limited partners under state law are not subject to self-employment taxes on their allocable share of partnership ordinary income, even though they are active in the partnership's business.The decision is considered to be a significant win for the IRS by many. The Tax Court's holding results in the potential for considerable additional taxes — generally 3.8% — payable by fund managers on ordinary business income. With the denial of summary judgment to the taxpayer and the Tax Court's holding that the functional analysis test applies at the partnership level, Soroban must now decide whether to settle with th

On November 28, 2023, the US Tax Court granted partial summary judgment in favor of the Internal Revenue Service (IRS) in Soroban Capital Partners LP v. Commissioner and held that “limited partners” are defined functionally—not by state law—for purposes of Internal Revenue Code (IRC) Section 1402(a)(13), which excludes distributions to a “limited partner, as such” from self-employment tax.Partners are generally required to include their distributive shares of partnership income in their net earnings from self-employment under IRC Sections 1402(a) and 702(a)(8). IRC Section 1402(a)(13), however, provides an exception. It excludes “the distributive share of any item of income or loss of a limited partner, as such, other than [certain] guaranteed payments” from self-employment tax. However, in the context of IRC Section 1402(a)(13), “limited partner” is not defined. The Tax Court previously held that “limited partners” are determined functionally (e.g., by what they actually do with respect to the partnership), not by their status or title under state law, in the context of a limited liability partnership. (See Renkemeyer v. Commissioner, 136 T.C. 137 (2011).) Soroban argued that in the distinct context of a limited liability partnership, plain statutory meaning, legislative history, past guidance from the US Department of the Treasury (Treasury) and the IRS, and policy considerations all pointed to the same conclusion: “limited partner” for purposes of the self-employment tax must be determined by reference to state law.The Tax

l to Derail an IRS Plan,” Bloomberg Daily Tax Report, August 18, 2023.Taxes aside, can we forgive Mr. Cohen for the Mets’ poor showing this year?Cohen’s case is not the only case before the Tax Court that raises questions about the application of the self-employment tax to limited partners. Soroban Capital Partners filed petitions on July 21, 2022 for Docket Nos. 16217-22 and 16-218-22. Likewise, Denham Capital Management LP filed a petition with the Tax Court on June 22, 2023 for Docket No. 9973-23. IRC Sec. 1401. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).For 2023, the amount of self-employment income that is subject to the Social Security Tax is capped at $160,200. There is no such cap for the 2.9% Medicare tax, though an individual may be liable for an additional 0.9% Medicare Tax if their self-employment income exceeds a threshold amount ($250,000 for a joint return, in 2023). IRC Sec. 1402(b). IRC Sec. 1402(a). IRC Sec. 1402(a)(13). So-called “guaranteed payments.” IRC Sec. 707(c). IRC Sec. 1402(a)(13).Point72 Asset Management LP et al. v. Comm’r, Docket Number 12752-23. https://s3.amazonaws.com/pdfs.taxnotes.com/2023/2023-23390_TNTCourts_Point72_Asset_petition.pdf. For income tax purposes. The petition states there were other limited partners; perhaps grantor trusts of which the taxpayer was the deemed owner for tax purposes. On Part II of Schedule E of their Form 1040.The presence of Advisor, a state law corporation that was “regarded” for tax purposes per Reg. Sec. 301-7701-2(b), ensured that Partnership would be treated as a partnership for tax purposes per Reg. Sec. 301.7701-3(b). The basis for the IRS’s claim is unclear from the petition and the attached notices. Query whether this was its entire share. The petition states that the IRS did note seek to re-allocate income between the general partner and the limited partner. It also stated that the IRS did not seek to

In a decision that will come as potentially bad news to many private equity and hedge funds, on November 28, 2023, the U. S. Tax Court opined in Soroban Capital Partners LP versus Comm’r that limited partners in a limited partnership who actively participate in the limited partnership are required to treat their entire distributive share of the partnership’s ordinary income as net earnings from self-employment income subject to self-employment (“SECA”) taxes. It has been common practice for limited partnerships to only treat amounts paid to limited partners that are specifically denominated as compensation as being subject to SECA taxes.The Limited Partner ExceptionThe dispute resolved by the Tax Court centered around Section 1402(a)(13) of the Internal Revenue Code, which contains the so-called limited partner exception:“There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.”Neither the Internal Revenue Code nor any IRS regulations define “limited partner.”Notably, in 1998, Congress enacted a moratorium prohibiting the IRS from finalizing regulations which provided that an individual would not be treated as a limited partner for purposes of Section 1402(a)(13) 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 a year.The Tax Court’s DecisionThe Tax Court focused on the phrase “limited partner, as such” in

The limited partners of the Managed Fund are passive investors and have no right to participate in the control of the Managed Fund. The question at issue in the CCA is whether a GP Principal's distributive share of the management fee income earned by the Management Company is subject to the SECA tax.5 Specifically, the CCA is an interpretation of the "limited partner" exception to the SECA tax set forth in IRC Section 1402(a)(13).History of the Limited Partner Exception NESE, the net self-employment earnings subject to the SECA tax, is generally defined as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions attributable to such trade or business, and generally includes the individual's distributive share of income or loss from any trade or business carried on by a partnership of which that individual is a member.6 Thus, a GP Principal's distributive share of the Management Company's fee income would have clearly been included within the meaning of NESE, and therefore subject to the SECA tax, were it not for IRC Section 1402(a)(13) (the "limited partner exception"), which excludes from NESE the distributive share of any item of income or loss of a limited partner, other than IRC Section 707(c) guaranteed payments in the nature of remuneration for services rendered.

On September 29, 2023, Treasury released the 2023-2024 Priority Guidance Plan, which included “Guidance under section 1402(a)(13),” signaling the government’s intention to finally clarify the confusion surrounding the limited partner exception.Section 1402(a)(13) of the Internal Revenue Code was enacted in 1977 to generally exclude a limited partner’s distributive share of partnership income or loss from the Self-Employment Contributions Act (SECA) tax. Because Treasury has not defined “limited partner” for purposes of the SECA tax, the scope of the limited partnership exception has become a source of contention between the IRS and taxpayers after states began to introduce new types of passthrough entities such as S corporations and limited liability companies. In 2011, Tax Court held that attorney partners who actively participated in a Kansas limited liability partnership were not limited partners. Relying on this win, the IRS has been increasingly scrutinizing taxpayers’ SECA tax exemption claims and taxpayers have been pushing back in litigation, most recently in Point 72 Asset Management, LP v. Commissioner, which we covered here, and Denham Capital Management LP v. Commissioner.Although the priority guidance plan does not specify the scope or form of its forthcoming