United States: Tax Court Raises Questions About SECA Exemption Claimed By Fund Managers

In Soroban Capital Partners LP v. Commissioner,¹ the Tax Court addressed the scope of the so-called “limited partner exception” from U.S. federal self-employment tax (“SECA”).

Background

The tax base on which SECA applies excludes “the distributive share of any item of income or loss of a limited partner, as such.” The statute does not define the phrase “limited partner, as such” for these purposes. Treasury issued proposed regulations² in 1997 that would have adopted a functional analysis (based on liability, management and participation) for determining whether a taxpayer qualified for the limited partner exemption under SECA. Congress, however, subsequently issued a moratorium on any temporary or final regulations regarding the definition of “limited partner, as such,” and the regulations were never finalized. In 2018, the IRS launched a compliance campaign specifically focused on the limited partner SECA exemption and in September 2023, included a similarly targeted project in its 2023-2024 priority guidance plan. Courts have generally agreed with the IRS that a functional analysis applies to interpret the phrase “limited partner, as such” in prior cases involving LLCs and LLPs, but the Soroban case is the first to address the scope of the exemption in the context of a state law limited partnership.

Discussion

Soroban Capital Partners LP (“Soroban”), a New York hedge fund organized as a Delaware limited partnership, was beneficially owned by three individuals for U.S. federal income tax purposes. On its federal income tax return for the years at issue, Soroban included guaranteed payments made to the three individuals for their services but excluded the three individuals' shares of Soroban's ordinary business income in its computation of net earnings from self-employment. The IRS contended that Soroban instead should have treated the three individuals' distributive shares of Soroban's income as self-employment earnings subject to SECA. In response, Soroban asked the Tax Court to issue a summary judgment that limited partners in a state law limited partnership are exempt from SECA on their distributive shares of partnership income.

The Tax Court rejected Soroban's motion for summary judgment, holding that the limited partner SECA 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 role of the limited partner. Referencing prior case law and the legislation history of the SECA statute, the Tax Court indicated that such a functional analysis should focus on whether a limited partner is “merely invested in a partnership” or “actively participating in the partnership's business operations.”

Key Takeaways

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 a functional analysis. Accordingly, it is unclear to what extent the Soroban decision will impact those taxpayers claiming the “limited partner” SECA exemption, particularly limited partners in state-law limited partnerships. For instance, it is possible the Tax Court could decide a limited partner that does not satisfy the functional test will be subject to SECA with respect to its entire distributive share of partnership earnings or, alternatively, a partnership must apportion a limited partner's distributive share of income among earnings subject to SECA and those exempt from SECA based on the limited partner's functional role with respect to the partnership.

In light of the Tax Court's ruling and the IRS focus on this issue in the context of asset managers and private funds, private fund managers may wish to consult with their tax advisors regarding the implications of the decision on their circumstances. Certain private fund managers may also consider alternative approaches for minimizing earnings subject to SECA.

Footnotes

1. 161 T.C. No. 12.

2. REG-209824-96.

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