KMK Law Corporate & Securities Blog

Hedge funds and private equity groups have long used the “limited partner exception” to minimize self-employment taxes, but on March 13, 2018, the IRS announced that it was going to increase its scrutiny on taxpayers utilizing that exception.^[1] As part of that campaign, a number of cases are currently being litigated regarding the limited partner exception.^[2] On November 28, 2023, the Tax Court issued its first ruling on one of the cases dealing with this exception, Soroban Capital Partners LP et al. v. Commissioner; 161 T.C. No. 12 (2023).

Tax Background on Self Employment Taxes
Employees and their employers are generally subject to a 15.3% tax based on wages received by/paid to employees, with the employee paying half of the tax and the employers paying the other half.^[3] Self-employed individuals are subject to self-employment taxes, also equal to 15.3%, but such individuals pay the entire amount.^[4] However, § 1402(a)(13) excludes a “limited partner’s” distributive share of partnership income or loss from self-employment taxes.

Federal tax law doesn’t provide a definition of limited partner, and proposed regulations (REG-209824-96) issued in 1997 that would have imposed functional guidelines for determining limited partner status became the subject of a one-year congressional moratorium and haven’t been finalized since. Without any specific definition, taxpayers and the IRS have battled out over who qualifies as a limited partner for years.

In 2011, the Tax Court was called upon to determine the scope of the limited partner exception. It applied statutory construction principles to determine whether partners in an LLP (a limited liability partnership)^[5] should be considered limited partners under § 1402(a)(13).^[6] In Renkemeyer, the Tax Court analyzed the legislative history of § 1402(a)(13) and concluded that its intent “was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations . . . would not receive credits towards Social Security coverage.” The Court further found that “[t]he legislative history . . . does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes.”^[7] Lastly, the Court held that the partners in that case were not limited partners for purposes of § 1402(a)(13) because their “distributive shares arose from legal services . . . performed on behalf of the law firm” and not “as a return on the partners' investments.”^[8]

Soroban Capital Partners LP v. Commissioner
In Renkemeyer, the Tax Court specifically applied a functional analysis test to determine whether the limited partner exception applied. But that case specifically dealt with an LLP. In the Soroban case, the partnership in question was a limited partnership and the Court was dealing with the applicability of the limited partner exception for income allocations to the partnership’s limited partners. While there have been subsequent opinions applying Renkemeyer to determine whether taxpayers in pass-through entities are limited partners under § 1402(a)(13), the Tax Court has not addressed whether a limited partner in a state law limited partnership must satisfy a functional analysis test to be entitled to the limited partner exception.^[9]

The limited partners contended that the limited partner exception applied per se to taxpayers who were limited partners under state law. Thus, their argument went, because Soroban is a state law limited partnership and its limited partnership agreement identified the petitioners as limited partners, § 1402(a)(13) is satisfied. The IRS disagreed, arguing that the distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from self-employment income. The IRS asserted that the Court must apply a functional analysis test, similar to the test outlined in Renkemeyer, to determine whether individuals are limited partners pursuant to § 1402(a)(13).

The Court agreed with the IRS that a functional analysis test should apply. The Court looked to § 1402(a)(13), which excludes from net earnings from self-employment “the distributive share of any item of income or loss of a limited partner, as such,” and focused on the phrase “as such.” (Emphasis added.) The Court determined that the limited partner exception does not apply to a partner who is limited in name only. If Congress had intended that limited partners be automatically excluded, it could have simply said “limited partner.” By adding “as such,” the Court reasoned that Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner. The Court also looked to legislative history and found that the exception was to apply to earnings from “mere investment.” In other words, passive investors.

Unfortunately, the case went back to the IRS to apply the functional analysis test with respect to the petitioners to determine if they qualified as limited partners, for purposes of the exception, based on their roles and activities in the partnership, so, at this time, we do not know what factors the IRS will use to determine whether a limited partner is considered a limited partner under § 1402(a)(13).

Conclusion
Taxpayers utilizing limited partnerships to take advantage of the limited partner exception for self-employment taxes should reevaluate their role in the partnership. If they are more than a silent passive investor, then they should analyze whether their activities rise to a level that negates the exception.

[1] See IRS Announces Rollout of Five Large Business and International Compliance Campaigns, available at https://www.irs.gov/businesses/irs-lbi-compliance-campaigns-mar-13-2018.

[2] See Denham Capital Management LP v. Commissioner, Dkt. No. 9973-23; Point72 Asset Management LP v. Commissioner, Dkt. No. 12752-23; Sirius Solutions LLLP v. Commissioner, Dkt. Nos. 11587-20, 30118-21.

[3] See Federal Insurance Contributions Act, §§ 3101-3125.

[4] See Self-Employment Contributions Act of 1954, §§ 1401-1403.

[5] LLPs are general partnerships in which the general partners have limited liability. There are no state-law “limited partners” in an LLP.

[6] See Renkemeyer v. Comm’r, 136 T.C. 137 (2011).

[7] Renkemeyer at 150.

[8] Id.

[9] See, e.g., Castigliola v. Commissioner, T.C. Memo. 2017-62, at *7-14 (finding professional LLC members not limited partners for purposes of section 1402(a)(13)).