Court Ruling Sets Precedent on Self-Employment Tax Exclusion for Limited Partners in Hedge Fund

Court Ruling Sets Precedent on Self-Employment Tax Exclusion for Limited Partners in Hedge Fund

On Nov. 28, 2023, the U.S. Tax Court issued an opinion in Soroban Capital Partners LP v. Commissioner, ruling in favor of the IRS with its determination that partners actively participating in state law limited partnerships are not “limited partners, as such” for purposes of the self-employment tax exemption. For the full details of the Tax Court's ruling, you can access the court's opinion here. This case revolved around the crucial matter of whether the income attributed to limited partners of a hedge fund, who simultaneously receive guaranteed payments for their service contributions, qualifies for the exclusion from self-employment tax as outlined in §1402(a)(13).

In its ruling, the Tax Court articulated two significant determinations. Firstly, it emphasized that the mere classification of an individual as a limited partner under state law does not inherently confer eligibility for the self-employment tax exclusion on the individual's share of income. The Tax Court concurred with the position advocated by the IRS, asserting that a "functional analysis test" should guide the determination of whether the exclusion under section 1402(a)(13) applies to limited partners in state law limited partnerships. The Tax Court noted that a functional analysis test was appropriate because Congress referenced a limited partner “as such” in §1402(a)(13).

Secondly, the Tax Court affirmed its jurisdiction to make this pivotal determination concerning limited partners within the framework of a partnership-level proceeding, diverging from the taxpayer's contention for a partner-level proceeding. The Tax Court’s conclusion that the partnership must make this determination (bringing it within the Tax Court’s jurisdiction) was based on its reading of Reg. §301.6231(a)(3)-1(b), which defines the scope of partnership items for purposes of the “TEFRA” partnership audit rules that applied during the years at issue.

Within the aftermath of the Tax Court's recent ruling, ambiguities persist. One key area of uncertainty concerns the extent to which the same partner can maintain a dual capacity as both a limited partner entitled to an investment-type return that is exempt from self-employment tax while also functioning as a general partner whose allocations are subject to self-employment tax because of their participation in the partnership’s trade or business. The Tax Court has yet to address the application of this functional analysis test to finally conclude what portion of the income is subject to self-employment tax; discovery is ongoing in the case.  

Funds should carefully weigh their options in light of this initial ruling. An appeal by the petitioner is possible, and rulings in three similar cases are still outstanding. The IRS added the limited partner exception topic to its 2023-2024 priority guidance plan. In the meantime, funds may want to reconsider their basis for claiming the limited partner exception, or whether an alternative organizational structure may better support the limited partner exception.

We will continue to monitor these developments and will provide updates as decisions are made.  If you have any questions, please connect with one of our professionals today.


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Court Ruling Sets Precedent on Self-Employment Tax Exclusion for Limited Partners in Hedge Fundhttps://www.cbiz.com/Portals/0/Images/Hero-Court-Ruling-Sets-Precedent.jpg?ver=vQ3n4QUYrSEjmqn_2GAiYw%3d%3dhttps://www.cbiz.com/Portals/0/Images/Thumb-Court-Ruling-Sets-Precedent.jpg?ver=KbvSlKts64B4Kn5PkfBmJQ%3d%3dOn Nov. 28, 2023, the U.S. Tax Court issued an opinion in Soroban Capital Partners LP v. Commissioner, ruling in favor of the IRS with its determination that partners actively participating in state law limited partnerships are not “limited partners, as such” for purposes of the self-employment tax exemption. 2023-12-11T18:00:00-05:00On Nov. 28, 2023, the U.S. Tax Court issued an opinion in Soroban Capital Partners LP v. Commissioner, ruling in favor of the IRS with its determination that partners actively participating in state law limited partnerships are not “limited partners, as such” for purposes of the self-employment tax exemption. Regulatory, Compliance, & LegislativeIndividualsFederal TaxTax ReformYes