The U.S. Tax Court recently issued a precedential opinion in Soroban Capital v. Commissioner, holding that the limited partner exception to the Self-Employed Contributions Act (SECA) in Section 1402(a)(13) of the Internal Revenue Code requires an analysis into the functions and roles of the limited partner, so a state-law limited partner does not automatically qualify for the exception to SECA. This is a significant departure from how many taxpayers and tax advisors have interpreted and applied the SECA limited partner exception. 

Legal Background

The self-employment income of individuals is generally subject to self-employment taxes. Section 1402(a)(13), however, excepts "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership." The statute and regulations do not define "limited partner." Seeking to define the scope of the limited partner exception, in 1997, the U.S. Department of the Treasury proposed regulations that would have analyzed the partner's functions and role in the business. However, Congress issued a moratorium prohibiting the Treasury Department from finalizing the proposed regulations because it viewed the proposed regulations as an unauthorized change in the law without congressional action.

In 2011, the Tax Court in Renkemeyer v. Comm'r of Internal Revenue applied a functional analysis to determine whether partners in a Kansas limited liability partnership (LLP) – a form of state-law general partnership ­­– were limited partners for purposes of the exception. However, as the Tax Court recognized in Soroban Capital, Renkemeyer did not address a state-law limited partnership, so an open issue remained regarding whether a functional test also applied to a state-law limited partner.

Factual Background

Soroban Capital is an investment firm organized as a Delaware limited partnership and classified as a partnership for federal income tax purposes. Soroban Capital took the position on its 2016 and 2017 partnership tax returns that while the guaranteed payments to the limited partners were subject to self-employment taxes, the distributive shares in their capacities as limited partners were not.

Soroban Capital Decision

Soroban Capital argued that the term "limited partner" in Section 1402(a)(13) meant a state-law limited partner and, because its limited partners were state-law limited partners, the exception applied. The IRS disagreed, arguing that state-law limited partners were not per se exempt and that a functional analysis instead applied to determine whether the partners were limited partners for purposes of the exception.

The court agreed with the IRS, holding that the limited partner exception in Section 1402(a)(13) required an inquiry into the functions and roles of the limited partners. The court's opinion states that this interpretation is supported by the principles of statutory construction because the addition of the words "as such" suggests that the limited partner exception applied only to a limited partner who is functioning as a limited partner in a passive capacity. This view, however, renders the guaranteed payment exception superfluous because any partner performing services would not qualify as a limited partner under a functional test. As a result, the court's attempt to give meaning to the words "as such" renders 22 other words in the statute meaningless. Moreover, the court also does not reconcile its interpretation of "limited partner" with the legislative history that makes clear that the distributive share of a partner who serves as a general partner and limited partner is only subject to self-employment taxes on the distributive share received as a general partner. 

Although the decision rejects an automatic exemption for state-law limited partners in favor of a functional analysis test, the opinion gives no guidelines as to how the functional test applies and what roles or functions may cause a state-law limited partner to fail to qualify for the exception. 

Looking Ahead

The Soroban Capital decision is a dramatic departure from how many taxpayers and tax advisors previously interpreted and applied the SECA limited partner exception based on the plain language of the statute. Given its precedential nature, the decision will have significant implications for cases involving state-law limited partners currently pending on the Tax Court's docket and the many cases in IRS appeals. However, Soroban Capital is hardly the final word on the matter. The decision will likely be appealed to the U.S. Court of Appeals for the Second Circuit. Other pending cases are appealable to the U.S. Court of Appeals for the First and Fifth Circuits. Therefore, it is likely that there will be multiple circuit court opinions on this issue, possibly with differing outcomes.

In light of the Soroban Capital decision, state-law limited partners should monitor the case developments to determine how the functional analysis will be applied and evaluate their roles within their partnerships to determine whether they qualify as limited partners under a functional analysis. In addition, limited partners should consider structuring alternatives, such as use of multiple tiers of partnerships, that may help distinguish their situations from the facts of Soroban Capital.  

Holland & Knight will continue to monitor developments on this issue. For additional information or questions regarding the Soroban Capital decision and its implications or structuring alternatives.