2nd Circuit Backs Tax Court’s Limited Partner Rule

On Sept. 17, the U.S. Court of Appeals for the 2nd Circuit held in Soroban Capital Partners LP v. Commissioner, that a “limited partner” under IRC Section 1402(a)(13) means a partner who has limited liability for partnership debts and who does not participate in running the business. The court held that since the taxpayer’s limited partners participated in management of the taxpayer, they do not qualify as limited partners and therefore are subject to self-employment tax on their distributive shares. This case represents another unfavorable decision for partners seeking to use the limited partner exception under Section 1402(a)(13).

Background

IRC Section 1401 imposes Social Security and Medicare taxes on net earnings from self-employment, which generally includes a partner’s distributive share of partnership trade or business income. Section 1402(a)(13) excludes from net earnings subject to self-employment tax the distributive share of income of a “limited partner, as such” other than guaranteed payments for services (the “limited partner exception”).

In recent years, litigation has focused on when partners in limited partnerships, limited liability partnerships, and limited liability companies should be treated as limited partners for Section 1402(a)(13). The Tax Court developed a functional analysis test in Renkemeyer, Campbell & Weaver LLP v. Commissioner (2011) and applied that in Soroban in 2023, holding that the phrase “limited partner, as such” limits the exception to partners functioning as passive investors.

Soroban opinion

The 2nd Circuit in Soroban held that limited partners must have limited liability and must not run, manage, or control the partnership’s business. In affirming the Tax Court’s decision, the 2nd Circuit looked to the plain meaning of the term “limited partner” at the time that the limited partner exception was enacted by Congress and determined that limited partners do not participate in running or managing the business. Applying that functional analysis test, the court held that the principals did not qualify for the exception because they worked full time and exercised managerial control over the taxpayer.

Crowe observation

Soroban’s approval of the Tax Court’s functional analysis test stands in contrast to the approach taken in the 5th Circuit’s most recent decision in Sirius Solutions LLLP v. Commissioner, which held that a limited partner for purposes of Section 1402(a)(13) is a partner who plays no significant role in managing or running the business.

Looking ahead

Partners in the 2nd Circuit who are, or are considering, relying on the Section 1402(a)(13) limited partner exception should evaluate their management and operational responsibilities rather than relying solely on state-law titles or limited liability. Taxpayers in other circuits should continue to monitor developments in this area, as litigation is ongoing in other jurisdiction with decisions expected soon. Given the uncertainty in this area, taxpayers seeking to rely on the limited partner exception under Section 1402(a)(13) should consult their tax adviser to evaluate eligibility.