Tax Court Holds that 1402(a)(13) Exclusion Does Not Automatically Apply to Limited Partners in State Limited Partnerships

On November 28, 2023, the United States Tax Court released a decision in a case that has been closely followed by many in the asset management industry. In Soroban Capital Partners, L.P. v. Commissioner, the Tax Court ruled that the IRC Sec. 1402(a)(13) exclusion from net earnings from self-employment does not extend to partners who are limited “in name only.”  

While the court has previously ruled that partners in limited liability partnerships (LLPs) and members of limited liability companies (LLCs) who are actively participating in the business are not entitled to the exclusion, this is the first case to address a state law limited partnership.  

Case Background

Soroban Capital is an investment management firm organized as a Delaware limited partnership. For tax years 2016 and 2017, Soroban Capital had one general partner and three limited partners. The general partner handled all the partnership’s business affairs and had ultimate authority to act on behalf of the partnership. The limited partners performed some services for the partnership but were not permitted to take part in management, operation, or control. In exchange for those services, the limited partners received guaranteed payments that were subject to self-employment (SECA) tax.

Relying on IRC Sec. 1402(a)(13), the limited partners excluded their distributive shares of partnership income from SECA tax. The IRS challenged Soroban Capital’s position that the limited partners qualified for the IRC Sec. 1402(a)(13) exclusion, and proposed adjustments to include the limited partners’ full distributives shares in the partnership’s net earnings from self-employment. Soroban Capital filed a Motion for Summary Judgement requesting that the Tax Court hold:

• That a limited partner’s distributive share of partnership income is excluded from net earnings from self-employment under IRC Sec. 1402(a)(13), solely due to their status as limited partners, and
• That the inquiry into the role of the limited partners was a partner-level item that should not be determined in a TEFRA partnership-level proceedings.

The IRS filed a Cross-Motion for Summary Judgement, requesting the Tax Court hold that the inquiry into the role of the limited partners is a partnership item that can be determined in partnership-level proceedings under TEFRA.

Analysis and Holdings

Generally, partners must report their net earnings from self-employment income for purposes of the self-employment tax. IRC Sec. 1402(a)(13), however, provides an exclusion for the distributive share of income of a “limited partner, as such,” other than guaranteed payments received by a limited partner for services actually provided to the partnership. The term “limited partner” is not defined in the IRC and the courts have had to interpret the meaning.

The Tax Court looked to the plain language, focusing in particular on the “as such” proviso in the statute, and determined that the SECA tax exclusion does not apply to a partner who was “limited in name only.” The Tax Court also relied on its 2011 decision in Renkemeyer v. Commissioner, which dealt with whether limited partners in a law firm LLP were qualified for the IRC Sec. 1402(a)(13) exclusion. The Renkemeyer Court concluded that for purposes of IRC Sec. 1402(a)(13), “the interest of a limited partner in a limited partnership is generally akin to that of a passive investor.” The Tax Court then compared the limited partners’ distributive shares to their initial capital investment in the law firm and concluded the distributive shares were all income received for services, and not merely a return on investment.

Ultimately, the Tax Court in Soroban concluded that:

• Limited partners of a state limited partnership are not qualified for the IRC Sec. 1402(a)(13) exclusion simply because they are called limited partners,
• A “functional analysis test,” like the one in Renkemeyer, should be applied to determine whether the limited partners qualify for the IRC Sec. 1402(a)(13) exclusion, and
• The calculation of net earnings from self-employment is a partnership item and adjustments may properly be made in a TEFRA partnership-level proceeding.

What Comes Next for Soroban?

Soroban Capital may appeal the Tax Court’s decision. The Court did not issue an opinion on whether the limited partners in Soroban were qualified to use the IRC Sec. 1402(a)(13) exclusion. The actual determination as to whether these limited partners are qualified for the limited partner exclusion under IRC Sec. 1402(a)(13) will presumably depend on the application of the “functional analysis test” in further proceedings.

There are currently two other cases involving the application of IRC Sec. 1402(a)(13) to limited partners in state limited partnerships before the Tax Court which may be appealable to different circuits than Soroban. Additionally, the IRS indicated in its FY 2023-2024 Priority Guidance Plan that it intends to release guidance on IRC Sec. 1402(a)(13) early next year.

Previous Guidance on 1402(a)(13)

In 1997, Treasury and the IRS proposed regulations addressing when a limited partner might fall within the IRC Sec. 1402(a)(13) exclusion, though these regulations were never finalized. Under the 1997 proposed regulations, a partner would not be treated as a limited partner if they:

• Had personal liability for partnership debts,
• Had authority to contract on behalf of the partnership, or
• Participated in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year.

Chief Counsel Advice 201436049 (CCA), released on September 5, 2014, could also give taxpayers a glimpse of the IRS’s potential approach. That CCA dealt with an LLC that was in the business of investment management and was treated as a partnership for tax purposes. The partners worked full time for the business and received wages. The LLC claimed the partners were limited and qualified for the IRC Sec. 1402(a)(13) exclusion. The IRS advised that the partners were not qualified, as the income they earned through the LLC was from investment and management services they performed and was not income “which is basically of an investment nature.”

Practical Implications of Soroban

The Tax Court’s decision introduces uncertainty for partners in state law limited partnerships that perform services for the partnerships, both because it is not clear how any appeal may be resolved, and because the Court did not provide guidance on how the functional analysis test should be applied to the Soroban facts.  Nevertheless, taxpayers with facts similar to Soroban might attempt to apply the functional analysis facts based on other authorities that have applied it, while waiting for the IRS or the courts to provide additional guidance. Taxpayers could also revisit the 1997 proposed regulations and analyze if they would be considered a limited partner under the previously proposed test.

Ultimately, it is important to consider all relevant facts in analyzing Soroban’s impact on a particular taxpayer. Taxpayers who believe they may be impacted by Soroban or another pending case should reach out to a trusted tax advisor for further guidance.