[co-author: Vaughn Collopy]
In Soroban Capital Partners v. Commissioner,[1] the United States Tax Court determined that entities formed as state law limited partnerships did not necessarily mean that the limited partnerships’ limited partners were limited partners for federal income tax purposes and therefore exempt from self-employment taxes.[2]
Self-Employment Taxes
Under Section 1402 of the Internal Revenue Code (“IRC”), individuals must pay a tax on net earnings from self-employment. IRC section 1402 defines “net earnings from self-employment” as the “gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus their distributive share (whether or not distributed) of income or loss described in IRC section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.”[3]
Under IRC section 1402(a)(13), a limited partner may exclude from their “net earnings from self-employment” their “distributive share of any item of income or loss,”[4] thereby avoiding self-employment taxes.
Discussion of Soroban
In Soroban, the IRS adjusted Soroban Capital Partners’ (“SCP”) net earnings from self‑employment, increasing the net earnings from self-employment to include distributive shares[5] of ordinary business income allocated to SCP’s limited partners.[6] The IRS reasoned that the limited partners were limited partners “in name only.”[7] SCP excluded the distributive shares from self-employment tax because it believed that they were limited partners for state law purposes and federal income tax purposes; therefore, they were entitled for their distributive share to be excluded[8] from self-employment taxes under IRC section 1402(a)(13).
The lack of a statutory definition of “limited partners, as such,” required the Tax Court to determine Congress’ intent, looking to both legislative history and caselaw. Courts have held that “limited partner status is determined under state law” and acknowledged that “issues have arisen under present law as to the proper self-employment tax treatment of individuals who may be limited partners under State law but who participate in the management and operation of the partnership.”[9] Until Renkemeyer, Campbell & Weaver, LLP v. Commissioner,[10] the Tax Court had not considered whether distributive shares of income allocated to (a) limited partners or (b) limited partners with management authority should be excluded from income.
In Renkemeyer, the Tax Court held that Congress intended, by using the phrase “limited partners, as such,” to distinguish between (i) limited partners who merely invest in a partnership but do not actively participate in the partnership’s business operations or perform services for the partnership in their capacity as partners and (ii) limited partners who actively participate in the partnership’s business operations or perform services for the partnership in their capacity as partners.[11] The Tax Court analyzed the function and role of limited partners to determine whether the limited partners in that case were “limited partners, as such,” and therefore entitled to have their distributive shares excluded from self-employment tax.[12]
Renkemeyer involved an LLP, while an LP was at issue in Soroban.[13] However, the Tax Court held that a functional analysis test, as originally used in Renkemeyer, should also be used in the context of the exclusion’s application with respect to limited partners in state law limited partnerships.[14] The Tax Court in Soroban found that “the limited partner [exclusion][15] does not apply to a partner who is limited in name only…Congress enacted section 1402(a)(13) to exclude earnings from a mere investment. It intended for the phrase ‘limited partners, as such’ used in section 1402(a)(13) to refer to passive investors.”[16]
IRS/Treasury Proposed Regulations
In light of the Soroban decision, the IRS and the Treasury Department have recognized a need to clarify the use of a functional analysis test with respect to the 1402(a)(13) limited partner exclusion.
To achieve this clarification, the Treasury Department and the IRS are drafting proposed regulations to clarify the limited partner exclusion, including it in the 2023-2024 priority guidance plan. The regulations will outline the scope of a functional analysis test that will be used to determine the applicability of the exclusion.[17]
The proposed regulations will emphasize and clarify the difference between limited partners who are merely passive investors and thus covered by the exclusion and limited partners who are actively involved in the partnership’s management or operation, and therefore their income is subject to self-employment tax. Although a clear line needs to be drawn, Holly Porter, Associate Chief Counsel (Passthroughs & Special Industries), acknowledges that drawing a clear line is difficult because each case is very fact-dependent.[18]
Yet another concern is whether LLCs, which are treated as partnerships for income tax purposes[19] but in which every owner has limited liability, would be able to avail themselves of the exclusion. Porter advised that until the IRS has issued the proposed regulations, taxpayers should “look at the facts of their situation and say ‘Am I more of a service partner? Am I … providing services so that I’m not really limited? Am I involved in the nature of the management of the partnership? What am I doing? Is this my full-time job?’.”[20]
Conclusion
Limited partners in state-law limited partnerships should not assume that because of their title or entity type, they may exclude their net earnings from self-employment taxes, as it could lead to an audit and the imposition of self-employment tax. Instead, the limited partners should consider the factors used in the Tax Court’s analyses Renkemeyer and Soroban, potential upcoming guidance, and the applicability of such factors to each limited partner’s role and function within the limited partnership.
[1] 161 T.C. No. 12 (2023).
[2] IRS, Self-employed individuals tax center, IRS, https://www.irs.gov/businesses/small-businesses-self-employed/self-employed-individuals-tax-center (last visited Mar. 4, 2024) (Self-employment tax is a solely Social Security and Medicare tax for self-employed individuals, comparable to the Social Security and Medicare taxes for conventional employees).
[3] I.R.C. § 1402(a).
[4] I.R.C. § 1402(a)(13).
[5] The term “distributive shares” is tax law parlance, and has nothing to do with actual an actual distribution, rather it refers to the allocated amount of the partnership’s income.
[6] Supra note 1.
[7] Id.
[8] I.R.C. § 1402(a)(13) excludes the income from self-employment tax, which is distinct from, and can have a different tax effect from, income that is exempted or deducted. This distinction is outside the scope of this article and will not be discussed further.
[9] Supra note 1.
[10] 136 T.C. 137 (2011).
[11] See id. at 150.
[12] Supra note 1 at 6 (“in Renkemeyer we specifically applied a functional analysis test to determine whether the limited partners [exclusion] applied.”)
[13] See id.
[14] Id. (“we agree with the Commissioner. A functional analysis test should be applied when determining whether the limited partnership [exclusion] under Section 1402(a)(13) applies to limited partners in state law limited partnerships.”)
[15] In the Soroban decision, the Tax Court uses “exception” and “exclusion” interchangeably. While they are very similar, they can, and in this situation do, have different tax consequences, and this article will use exclusion, which is the word used in Section 1402(a)(13).
[16] See id. at 7.
[17] Kristen A. Parillo, Government Exploring Functional Analysis Options for SECA Regs, TaxNotes (Jan. 22, 2024), https://www.taxnotes.com/tax-notes-federal/employment-taxes/aba-section-taxation-meeting-government-exploring-functional-analysis-options-seca-regs/2024/01/29/7j3m0.
[18] See id.
[19] The default for a LLC with multiple owners is to be treated as a partnership for income tax purposes, but an election can be made to be treated otherwise. This is beyond the scope of this article and will not be discussed further.
[20] Id.
