Ever since LLCs were created in 1977, there has been much debate and uncertainty regarding whether and when owners of such entities are subject to self-employment tax under IRC Sect. 1402.

At the heart of this uncertainty is IRC Sect. 1402(a)(13)—the “limited partner exception”—which provides that “there shall be excluded [from net earnings from self-employment] the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments …” [Emphasis added.] 

The phrase “limited partner, as such” for purposes of the limited partner exception is not defined, and with respect to LLCs in particular, whereby all owners have limited liability under state law, there has been little guidance as to when a member would be considered a “limited partner” for such purposes.

IRC Sect. 1402 was written before LLCs existed, and although the IRS had set out in 1994 to address this question by issuing proposed regulations and re-proposed them in 1997, they were never finalized due to public outcry that the proposed change was not within Treasury’s regulatory authority. The proposed regulations would have excluded from the definition of “limited partner” individuals who bore personal liability for partnership debts, had authority to contract on behalf of the partnership, or participated in the partnership’s trade or business for over 500 hours during the tax year. 

Service partners in a service partnership were precluded from qualifying as a limited partner exempt from self-employment tax.

California’s Uniform Limited Partnership Act of 2008 addresses when a limited partner is deemed to sufficiently participate in the control of a business such that they would be held liable for the partnership’s liabilities and exempts certain activities, but it is not helpful with tax matters. 

Since then, a few court cases have provided some insight into when the limited partner exception applies in the context of LLCs and LLPs. In Renkemeyer v. Commissioner, 136 TC 137 (2011), for example, the Tax Court determined that if a limited partner in a limited liability partnership provides services to an LLP in his capacity as a partner, his distributive share of income allocated to him from the LLP would all be subject to self-employment tax.

Until recently, it was generally assumed that a limited partner in a limited partnership clearly qualified for the limited partner exception. However, on Nov. 28, 2023, the U.S. Tax Court shattered that understanding when it issued its opinion in Soroban Capital Partners LP v. Commissioner, 161 TC 12 (2023) holding that a “functional analysis test” (as opposed to state law) is to be applied in determining whether the limited partner exception applies to a limited partner of a limited partnership.

The general conclusion was that, because the statute exempts a “limited partner, as such” rather than a “limited partner,” it is not enough to be called a limited partner; one must look at what the individual actually does for the partnership and his or her level of involvement in the partnership’s business to determine whether they truly act like a passive investor and therefore meet the exception.

Soroban Capital Partners LP is a hedge fund management business organized as a Delaware limited partnership and located in New York.
It has three individual limited partners, and its general partner (GP) is an LLC owned by the same three individual limited partners.

The GP was to carry on the business and affairs of the limited partnership and had ultimate authority to make decisions on behalf of the partnership. One of the limited partners served as the managing partner and chief investment officer, another served as co-managing partner and the third served as the head of trading and risk management.

In 2016 and 2017 (the tax years under audit), guaranteed payments to all the limited partners and the GP’s share of ordinary income were reported as self-employment income on the partnership tax returns. The limited partners’ distributive share of ordinary income was excluded from self-employment income. Upon audit, the IRS determined that Soroban’s limited partners were limited partners in name only and thus not exempt under the limited partner exception.

The IRS proposed adjustments to also include the limited partners’ distributive share of ordinary income as income subject to self-employment tax. Soroban filed a Motion of Summary Judgment asking the Tax Court to hold: (1) that a limited partner’s distribute share of partnership income is excluded from self-employment income because the partners were labeled as “limited partners” under applicable state law in a state law limited partnership, or (2) alternatively, that an inquiry into the functional roles of limited partners is not a partnership item and thus cannot be determined in a partnership-level proceeding (that is, it would need to be assessed at the partner level).

The IRS filed a cross-motion, asking that Tax Court to conclude that an inquiry into the functional roles
of limited partners is a partnership item that can be determined in partnership-level proceedings.

The Tax Court concluded that:

• Limited partners in a state law limited partnership do not automatically qualify under the limited partner exception.

• The statute—in particular the phrase “as such”—applies to a limited partner only if the partner is actually functioning in the capacity of a passive investor. The exception does not apply to a partner who is a limited partner in name only.

• A “functional analysis” test would be necessary to determine whether limited partners qualify. Furthermore, this is a partnership item that is appropriate to determine in partnership-level proceedings. 

Note that the Tax Court only addressed the legal question on summary judgement of whether a partner in a limited partnership is per se excluded from self-employment tax. It did not actually address whether the limited partners in Soroban satisfied the “functional analysis test.” Further proceedings are required to resolve this case, so practitioners and owners of limited partnerships should continue to keep an eye out for further developments on how the functional analysis test is to be applied.

In the meantime, those preparing partnership tax returns and returns of limited partners in these partnerships should inquire and consider a partner’s involvement in the entity when determining whether his or her distributive share of ordinary income is subject to self-employment tax.

Owners of limited partnerships other than service partnerships whose distributive share of income is generated from both contributed capital and services provided should consult with their corporate attorneys and tax advisers to assess whether these are viable solutions. The following are a couple of potential solutions to consider:

• Restructure a limited partnership so that its general partner is an S corporation, and the limited partners are employees of the S corporation. S corporations have been used for decades to minimize FICA taxes on pass-through income to shareholders. If the limited partners are providing services to the partnership in their capacity as employees of the S corporation GP and are paid reasonable salaries, only those wages, and not the distributive share of limited partnership income allocated to either the general partner or the limited partners should be subject to payroll taxes. Keep in mind, however, that S corporations are much less flexible entities than partnerships and those taxable in California would be subject to an additional 1.5 percent income tax on its net income compared to operating as a partnership. Also consider that as of Jan. 1, 2024, California wages are subject to a 1.1 percent SDI withholding rate on an unlimited amount of wages. Lastly, beware that introducing an S corporation into the structure poses the risk that employer FICA taxes may be overpaid with respect to a high-salaried individual who receives compensation from other sources in addition to wages from the S corporation general partner. In situations where a partner receives compensation from multiple related entities, using a Professional Employer Organization (PEO) to pay and allocate salaries to the entities could possibly remedy this.

• Reorganize and segregate operations into different entities to minimize the amount of flow-through income subject to self-employment tax. The functional analysis test would generally be applied on an entity-by-entity basis, so splitting activities into different entities delineated by limited partners’ level of involvement could prevent income in entities with less limited partner participation from being tainted. However, weigh any tax savings on self-employment taxes against the additional costs to set up new entities, file additional tax returns and pay additional annual entity-level taxes.

While the decision in Soroban is significant, it is still unclear how much of the pass-through income allocated to the limited partners would be subject to self-employment tax when applying the functional analysis test. Before spending time and money to consider restructuring, also consider whether the effect of subjecting such income to self-employment tax is significant enough to matter.

In cases where the pass-through income has been treated as passive income or nonpassive income from a trader fund and not subject to self-employment tax, the partners may already be paying a 3.8 percent net investment income tax. Treating such income as subject to self-employment tax would mean replacing the 3.8 percent net investment income tax with the self-employment tax, plus 0.9 percent hospitality insurance tax.

If a partner has already hit the maximum amount of income subject to the Social Security portion of FICA taxes ($168,600 for 2024), the self-employment tax is the 2.9 percent Medicare tax plus 0.9 percent hospitality insurance tax, or 3.8 percent, the same amount previously paid in net investment income tax. The impact may be more significant when the pass-through income from a limited partnership is being treated as nonpassive (other than from a trader fund) and not subject to SE tax.

The ruling in Soroban Capital Partners LP v. Commissioner underscores the need for careful consideration of individual involvement within partnership structures. Moving forward, it is crucial for practitioners and stakeholders to stay abreast of further developments and to assess the implications for their specific circumstances.

While potential solutions such as restructuring or reorganizing entities may offer avenues for mitigating tax liabilities, the decision-making process should be informed by a comprehensive understanding of
both the legal considerations and the practical implications for owners of limited partnerships.

Ultimately, the complexities surrounding self-employment tax for LLCs, LLPs and now even limited partnership owners highlight the ongoing need for clarity and guidance in this area of tax law.