Limited Partner Status for SECA Tax Exemption Requires Functional Analysis, Tax Court Holds

The U.S. Tax Court on November 28 held that nominally being a “limited partner” in a state law limited partnership is insufficient to qualify for the statutory exemption from self-employment (SECA) tax for limited partners (Soroban Capital Partners v. Commissioner, 161 T.C. No. 12). Rather, the court agreed with the government that the statutory exemption requires a functional analysis of whether a partner was, in fact, active in the business of the partnership and a “limited partner” in name only. 

SECA Tax Exemption for Limited Partners

Under Internal Revenue Code Section 1402(a)(13), the distributive share of partnership income allocable to a limited partner is generally not subject to SECA tax, other than for guaranteed payments for services rendered. However, the statute does not define “limited partner,” and proposed regulations issued in 1997 that attempted to clarify the rules around the limited partner exclusion have never been finalized. 

In recent years, courts have held – in favor of the IRS – that members in limited liability companies (LLCs) and partners in limited liability partnerships (LLPs) that are active in the entity’s trade or business are ineligible for the SECA tax exemption. 

Despite these IRS successes, some – including the taxpayer in the current case – continued to claim that state law controls in defining “limited partner” in the case of a state law limited partnership. If the court held in favor of these taxpayers, limited partners in state law limited partnerships – even active limited partners – could be eligible for the SECA tax exemption. This specific issue – i.e., the application of the exemption in the case of a state law limited partnership – had not previously been addressed by the courts. 

Soroban Capital Partners’ Position and IRS Challenge

The Soroban Capital Partners litigation filed with the Tax Court involves a New York hedge fund management company formed as a Delaware limited partnership. The taxpayers challenged the IRS’s characterization of partnership net income as net earnings from self-employment subject to SECA tax. According to the facts presented, each of the three individual limited partners spent between 2,300 and 2,500 hours working for Soroban, its general partner and various affiliates – suggesting that the limited partners were “active participants” in the partnership’s business. For the years at issue, Soroban was subject to the TEFRA audit and litigation procedures.

In its March 2 objection to the taxpayers’ motion for summary judgment, the government contended that the term “limited partner” is a federal tax concept that is determined based on the actions of the partners – not the type of state law entity. Citing previous cases, the government asserted that the determination of limited partner status is a “facts and circumstances inquiry” that requires a “functional analysis.” The taxpayers in Soroban, on the other hand, argued that such a functional analysis does not apply in the case of a state law limited partnership and that, in the case of these partnerships, limited partner status is determined by state law. 

Under the functional analysis adopted by the Tax Court in previous cases (not involving state law limited partnerships), to determine who is a limited partner, the court looks at the relationship of the owner to the entity’s business and the factual nature of services the owner provides to the entity’s operations. 

Tax Court’s Analysis

To answer the question of whether Soroban’s net earnings from self-employment should include its limited partners’ distributive shares of ordinary business income, the court turned first to two preliminary questions:

1. What is the scope of the Section 1402(a)(13) SECA tax exemption for “a limited partner, as such”?
2. If the exemption requires looking through to the limited partner’s role in the partnership, does that inquiry concern a partnership item to be resolved in a TEFRA partnership-level proceeding? 

With respect to the scope of the exemption – noting that neither the statute nor regulations define “limited partner” – the court highlighted that the statute expressly applies the exemption to “a limited partner, as such”. In interpreting statutes, the court explained that it looks at the ordinary meaning of the terms and that it must avoid rendering any words or clauses to be meaningless. Thus, the court interpreted the addition of the words “as such” to signify that Congress intended the exemption to apply to something more specific than a “limited partner” in name only. 

Disagreeing with the taxpayers’ reading of the legislative history, the court further concluded that the legislative history supports interpreting the exemption as being intended only for passive investors. 

Having concluded that a functional analysis is necessary to determine limited partner status for purposes of the exemption, the court turned to whether this inquiry concerned a “partnership item” under the applicable TEFRA procedures. The court explained that partnership items are those that (1) are required to be taken into account for the partnership tax year under subtitle A of the Internal Revenue Code and (2) are more properly determined at the partnership level.

The court stated the first prong is easily resolved – subtitle A generally requires partnerships to state the amounts of income that would be net earnings from self-employment in the hands of the recipients. The court further determined the second prong was satisfied, stating that a functional analysis of the partners’ activities involves factual determinations that are necessary to determine Soroban’s aggregate amount of net earnings from self-employment. 

Accordingly, the court held that a functional analysis applies to determine whether a partner in a state law limited partnership is a “limited partner” for SECA tax exemption purposes, and, for a TEFRA partnership, that inquiry concerns a partnership item subject to a TEFRA proceeding.