In Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12 (Nov. 28, 2023), the Tax Court has ruled on whether a limited partner’s share of a partnership’s business income constitutes self-employment income where that limited partner performs services for the partnership. A detailed discussion of the Soroban decision is included in the Appendix, but some key takeaways include:
- The Tax Court held that for purposes of determining whether a state law limited partner’s share of a partnership’s ordinary business income is eligible for the Internal Revenue Code Section 1402(a)(13) exclusion from self-employment income for purposes of Self-Employed Contributions Act (SECA) taxes, the partner’s status as a limited partner under state law is insufficient on its own to qualify the partner’s distributive share for the exclusion.
- Rather, a functional analysis of the limited partner’s functions and roles with respect to the partnership is required to make that determination.
- The Tax Court determined that the exclusion was not intended to apply to a partner who is “limited in name only.”
- In the view of the Tax Court, the statutory language of the exclusion and its legislative history establish that Congress enacted Section 1402(a)(13) to exclude earnings from a mere investment from constituting self-employment income, and thus, the exclusion only applies to passive investors.
- Furthermore, the determination of a limited partner’s self-employment income is a partnership item that can be made in a Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) proceeding.
- Though consistent with Tax Court precedents that have applied the same functional analysis to partners of limited liability entities that are not limited partnerships, this is the first time the court has ruled on Section 1402(a)(13)’s applicability to a limited partner in a state law limited partnership.
- While the Tax Court’s decision ruled on pretrial summary judgment motions and is appealable, it constitutes precedent until overturned or modified by a subsequent judicial decision or legislative action.
- Although it is believed that a consensus will develop among practitioners in the near future, discussions have indicated that there is a preference to follow the Soroban holding in connection with filing 2023 tax returns.
- Therefore, it is recommended that affected taxpayers consider applying the functional analysis to the activities, functions, and roles of limited partners to determine their eligibility for the exception and calculate their remaining 2023 estimated tax payments based on the results of that functional analysis.
While the Tax Court decision ruled on summary judgment motions, the decision confirms the Tax Court’s view that as a substantive matter, mere status as a limited partner in a state law limited partnership is insufficient on its own to establish entitlement to the Section 1402(a)(13) exclusion from self-employment income for distributive share of partnership income. Rather, a functional analysis of the limited partner’s functions, roles, and activities with respect to the partnership is necessary to establish whether that partner is entitled to the exemption. Although the case considered a partnership conducting an investment business, the holding would be equally applicable to any limited partnership whose partners provide services to or on behalf of the partnership.
Procedurally, the Soroban case has not yet gone to trial and may be appealed. Nevertheless, the decision constitutes precedential authority unless and until it is overturned or modified by a court or through legislative actions. Additionally, there are several other pending cases involving substantially identical issues around partner eligibility for the Section 1402(a)(13) exclusion at various stages of litigation before the courts that could reasonably be expected to apply the “functional analysis” holding of Soroban and Renkemeyer to determine whether the taxpayers at issue in those proceedings are eligible for the Section 1402(a)(3) exclusion. Citrin Cooperman’s Commercial Tax Services Practice will monitor developments as these cases proceed and provide updates on any significant developments.
In light of the holding in Soroban, any limited partnership whose limited partners perform services for or on behalf of the partnership (as well as those limited partners) should be cognizant that the IRS would be expected to raise this issue on examination and seek to apply the functional analysis of the limited partners’ activities to determine whether their share of partnership ordinary trade or business income is subject to the self-employment tax. Furthermore, given the breadth of the definition of “partnership-related item” under the Bipartisan Budget Act of 2015 (BBA) audit provisions, the IRS would also be expected to assert that determination of self-employment income of a partner is a partnership-related item subject to determination at the partnership level in a proceeding under the BBA.
While consensus on how to respond to Soroban is still developing among practitioners, given the precedential effect of the decision, early indications are that a conservative approach to 2023 filings may be warranted. Accordingly, it is recommended that limited partners consider making any remaining 2023 estimated tax payments based on the outcome of a functional analysis of their activities, functions, and roles as limited partners with respect to their partnerships.
Background: Internal Revenue Code Section 1401(a) imposes a tax on the self-employment income of individuals. Section 1401(a) includes in self-employment income an individual’s distributive share of bottom-line partnership income or loss derived from a partnership trade or business. However, Section 1402(a)(13) excludes from self-employment income the individual’s “distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments” for services rendered to the partnership. While courts have previously ruled that this exclusion is inapplicable to partners in other legal entities taxed as partnerships (e.g., limited liability partnerships, limited liability companies) where the purported limited partners’ shares of partnership income arose from services they performed for the legal entity, the Tax Court had not previously considered the application of the Section 1402(a)(13) exclusion to a limited partner in a state law limited partnership that provides services to the partnership.
The Soroban case: Soroban Capital Partners LP (LP) is an investment firm organized as a state law limited partnership that was comprised of a single general partner and several limited partners and was subject to the TEFRA audit procedures. The limited partners performed various services for and on behalf of LP’s investment business and received both guaranteed payments and a distributive share of partnership income. On its returns for 2016 and 2017, LP reported the guaranteed payments as self-employment income but excluded the limited partners’ shares of ordinary business income from self-employment income. On examination, the IRS increased LP’s self-employment income by the shares of ordinary business income allocated to the limited partners, concluding that the partners were limited partners in name only.
In Soroban, the Tax Court denied LP’s motion for summary judgment that a limited partner’s distributive share of partnership income is excluded from net earnings from self-employment under Section 1402(a)(13), ruling that a partner’s status as a limited partner under applicable state law is not itself sufficient to establish entitlement to the exclusion. The court said that making such a determination requires a functional analysis of the limited partner’s activities with respect to the partnership.
In support of its summary judgment motion, LP argued that because it was a state law limited partnership and its partnership agreement identified the limited partners, as such, Section 1402(a)(13) was satisfied. LP’s motion points to, among other things, the ordinary meaning of the term “limited partner” as previously construed by the Tax Court and subsequent legislative and regulatory developments affirming that limited partners in state law partnerships only pay self-employment tax on their guaranteed payments. However, the IRS argued to the contrary that based on the legislative history to the exception, distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from self-employment income, and therefore, a functional analysis of the limited partner’s activities with respect to the partnership is required to determine a limited partner’s eligibility. The court agreed with the IRS and held that a state law limited partnership must apply a functional analysis to determine whether its partners are “limited partners, as such” within the meaning of the Section 1402(a)(13) exclusion. In this regard, the court pointed to the functional analysis test previously set forth in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), a case determining whether limited partners who were lawyers in a limited liability partnership qualified for the Section 1402(a)(13) exclusion.
The court determined that the exception in Section 1402(a)(13) does not apply to a partner who is “limited in name only.” The court, looking to legislative history, explained that by referring to a “limited partner, as such” in the text of the Section 1402(a)(13) exclusion, Congress enacted Section 1402(a)(13) to exclude earnings from a mere investment. Congress, therefore, intended that the exclusion apply to a limited partner who is functioning as a limited partner, that is, as a mere passive investor. Thus, the court held, it must examine the functions and roles of the limited partners to make the determination of whether the exception applies.
Addressing a TEFRA procedural question raised by the taxpayer’s summary judgment motion, the court concluded that the inquiry into the substance of the limited partners’ roles and activities is a “partnership item” that is appropriately determined in a TEFRA proceeding at the partnership level. In this regard, the court pointed to Treasury Regulations that provide that partnership items include, among other things, “legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.” The court reasoned from the regulatory definition of “partnership item” that, because functional inquiry into the roles of LP’s limited partners involves factual determinations that are necessary to determine LP’s aggregate self-employment income, such a functional inquiry is a partnership item.
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