Tax Alert: Tax Court Rules Limited Partners Must Pay Self-Employment Taxes

Written by George Livanos CPA, Tax Partner, Sax Real Estate

On November 28, 2023, the U.S. Tax Court delivered a verdict in Soroban Capital Partners LP v Comm’r, marking a significant development for private equity and hedge funds. The ruling asserts that limited partners actively engaged in a limited partnership must categorize their entire distributive share of the partnership’s ordinary income as net earnings subject to self-employment (“SECA”) taxes. Traditionally, it has been customary for limited partnerships to only subject specific compensation amounts to SECA taxes.

Exception for Limited Partners

The crux of the Tax Court’s decision revolved around Section 1402(a)(13) of the Internal Revenue Code, which features the so-called limited partner exception. This exception excludes the distributive share of income or loss of a limited partner, except for guaranteed payments for services rendered to the partnership, deemed as remuneration for those services.

The term “limited partner” is not explicitly defined in the Internal Revenue Code or any IRS regulations. In 1998, Congress imposed a moratorium preventing the IRS from finalizing regulations that would have precluded individuals with personal liability for partnership debts, authority to contract on behalf of the partnership, or participation in the partnership’s business for over 500 hours a year from being treated as limited partners under Section 1402(a)(13).

Tax Court’s Rationale

The Tax Court honed in on the phrase “limited partner, as such” in Section 1402(a)(13) and sided with the IRS. It rejected the taxpayer’s argument that anyone recognized as a limited partner under state law automatically qualifies for the limited partner exception. Drawing on statutory construction, the Tax Court, echoing a prior case involving a limited liability partnership, determined that the Section 1402(a)(13) exception necessitates a functional analysis of the limited partner’s relationship with the limited partnership. This analysis includes assessing whether the limited partner is actively providing services to the partnership.

Recommended Action

As this is a precedent-setting case, it is subject to potential appeal to the United States Court of Appeals for the Second Circuit. Private equity funds with limited partners and other limited partnerships are advised to consult with their advisors. This consultation should assess the impact of the Tax Court’s functional analysis test and determine whether they prefer to await the outcome of further litigation or IRS guidance.

For questions regarding this e-blast, please contact George Livanos, Tax Partner in Sax’s Real Estate Group, at [email protected].

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