On December 23, 2024, the Tax Court held, in Denham Capital Management LP v. Commissioner, that active limited partners in an investment management company formed as a limited partnership were subject to self-employment (SECA) tax and not entitled to the statutory exemption for limited partners.
The Tax Court previously decided in Soroban Capital Partners LP v. Commissioner, consistent with the IRS’s position, that the determination of limited partner status is a “facts and circumstances inquiry” that requires a “functional analysis.” However, the Denham case is the first in which the Tax Court has applied the functional analysis of whether a state law limited partner was, in fact, active in the business of the partnership and a “limited partner” in name only. The key issue in the Denham Case, as in Soroban, was whether limited partners in state law limited partnerships may claim exemption from SECA taxes – despite being more than passive investors.
Application of Functional Analysis in Denham
Denham Capital Management was organized as a limited partnership under Delaware law and offered investment advisory and management services to private equity funds. As the court addressed the functional analysis, it reaffirmed that determinations of eligibility for the exemption under Section 1402(a)(13) require a factual inquiry into how the partnership generated the income in question and the partners’ roles and responsibilities in doing so.
The court noted that, in the years at issue, Denham’s income consisted solely of fees received in exchange for services provided to investors, including advising and operating private investment funds. The court found the partners’ time, skills, and judgment to be essential to the provision of these services. It found unconvincing claims that Denham’s income – largely distributed to the partners as profits – were returns on investments, when only one of the partners had made a capital contribution to obtain their interest.
Moreover, the court stated that all the partners, except for one that had made a capital contribution, were required to “devote substantially all of [their] business time and attention to the affairs of the [p]artnership and its affiliates.” The court determined that the partners treated their roles in Denham as their full-time employment, with each participating in management and playing crucial roles in the business.
Other relevant facts cited by the court included:
- Fund marketing materials made clear that the partners had a significant role in Denham’s operation.
- The partners’ expertise and judgment were a significant draw for fund investors, who could withdraw their investments if certain partners no longer participated.
- Investment decisions for the funds were made by that fund’s investment and valuation committees, which included the partners.
- The partners each exercised significant control over personnel decisions.
- A sizable number of Denham employees received total compensation exceeding the partners’ guaranteed payments, suggesting such payments were not designed to adequately compensate the partners for their services.
Concluding that “[i]ndividuals that serve roles as integral to their partnerships as those the [p]artners served for Denham cannot be said to be merely passive investors,” the court held that the partners were not “limited partners, as such” under Section 1402(a)(13) and the partners’ distributive shares were ineligible for the SECA tax exemption for limited partners.
Takeaways for Fund Managers
This is another big win for the government. Similar to the Tax Court’s ruling in Soroban Capital Partners LP v. Commissioner, the Tax Court in Denham required a functional analysis centered around the roles and activities of the individual partners. In Denham, the Tax Court detailed the various activities of the partners to show that they were active participants in the business of Denham and were not merely passive investors receiving a return on their capital.
Primarily, it is important to note that, as in Soroban, the Tax Court denied the argument that the partners were eligible for the SECA tax exemption under Section 1402(a)(13) merely because they were limited partners in a state law limited partnership, making it clear that federal law and not state law prescribes the classification of individuals and organizations for federal tax purposes.
In accordance with the Tax Court’s decisions in Soroban, Denham, and previous cases, fund managers and their tax advisers should be determining whether a partner, including a limited partner in a state law limited partnership, is subject to SECA tax by evaluating the activities of the partner using a functional analysis similar to the Tax Court’s analysis in Denham. Fund managers should also consider the guidance provided for in 1997 Proposed Reg. §1.1402(a)-2(h), which is instructive despite never being finalized. Pursuant to this guidance, an individual is considered a limited partner unless the individual:
- Has personal liability for the debts of or claims against the partnership by reason of being a partner;
- Has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership; or
- Participates in the partnership's trade or business for more than 500 hours during the partnership's taxable year.
It is still possible that the taxpayer in Denham will file an appeal. BDO will continue to monitor developments in this and similar cases.
Please visit BDO’s Federal Tax Services page for more information on how BDO can help.