Co-author Caleb O’Donnell*

A recent U.S. Tax Court decision provides clarity to what the Internal Revenue Service (“IRS”) considers a limited partner for purposes of the ‘limited partner exception’ to the Self-Employment Contributions Act (“SECA”) tax under Code Sections[1] 1402(a)(3) and 1402(a)(13) (the “Limited Partner Exception”). The Tax Court held in Soroban Capital Partners LP v. Commissioner[2] that “a functional analysis test” is required to determine whether limited partners qualify for the Limited Partner Exception.

SECA ensures that self-employed individuals contribute to Social Security and Medicare by imposing a tax on net earnings from self-employment at an aggregate rate of 15.3%, consisting of two parts: 12.4% for Social Security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance) plus an additional 0.9% Medicare tax for taxpayers making over certain amounts. The Social Security portion of the SECA tax is limited to the first $160,200 of self-employment earnings for 2023 (and the first $168,600 in 2024). The Medicare portion applies to all combined wages, tips, and net earnings in the current year. The Medicare tax rate increases by 0.9% for taxpayers whose compensation, or self-employment income (together with their spouse if filing jointly) exceeds certain threshold amounts[3]

Section 1402(a) defines net earnings from self-employment to include a partner’s distributive share of ordinary business income of the partnership. Thus, a partner is subject to SECA tax unless an exception applies.

The Limited Partner Exception is one of two methods[4] used by taxpayers to avoid SECA tax. Under this exception, partners or members of partnerships and limited liability companies taxed as partnerships often assert that they qualify for the Limited Partner Exception. The Code and Treasury Regulations (“Regulations”) do not supply a clear definition for the term limited partner.[5]

The Treasury Department and the IRS proposed Regulations[6] in 1997 which adopted a three-prong test to determine whether an individual qualifies as a ‘limited partner’ for purposes of the Limited Partner Exception:

            “An individual is treated as a limited partner unless the individual:

  1. Has partial or total personal liability under state law for the entity’s debts; OR
  2. Has statutory or contractual authority to contract on behalf of the LLC; OR
  3. Participates in the entity’s business for more than five hundred hours per tax year.”

If the partner falls into any of the above situations, the partner is NOT a limited partner for purposes of the Limited Partner Exception unless:

  1. In partnerships with multiple classes of ownership, one class is the functional equivalent to a limited partner interest and at least 20% of partners qualify under the three-prong test, the distributive share from the functional limited partner interest is not subject to SECA tax.
  2. A partner working more than 500 hours may be a limited partner if other partners who satisfy the three-prong test immediately after acquisition owned at least 20% of interests.
  3. If all the partnership’s activities involve the performance of services, any individual providing services as part of that trade or business is not a limited partner, regardless of what the other rules may provide.

The IRS never finalized the Regulations because Congress enacted a one-year moratorium due to a concern that the proposed changes would exceed the Treasury Department’s authority. The IRS never withdrew the Regulations but has informally said that taxpayers may rely on them if they choose to do so.[7]

Several cases have addressed the Limited Partner Exception in the context of limited liability partnerships and limited liability companies taxed as partnerships. Soroban is the first case to apply the Limited Partner Exception to a limited partnership.

Soroban Capital Partners (“Soroban”) is an investment firm organized as a Delaware limited partnership and treated as a partnership for US federal income tax purposes. Under the limited partnership agreement, the general partner would execute the business and affairs and had ultimate decision-making authority. Individual limited partners also served as the Managing Partner, Co-Managing Partner, Chief Investment Officer, and the Head of Trading and Risk Management. Each of these limited partners devoted their full-time efforts to the business of Soroban.

Soroban made guaranteed payments in 2016 and 2017 in exchange for services and distributed ordinary business income to its limited partners who excluded them from their computation of net earnings from self-employment. Upon an audit by the IRS, the Commissioner increased Soroban’s limited partners’ net earnings by including the distributions of ordinary business income allocated to them, taking the position that they were limited partners in name only.

Soroban challenged the IRS’ finding in the Tax Court and argued that because they are a state law limited partnership and its limited partnership agreement identified their limited partners as such, Code Section 1402(a)(13) is satisfied. The IRS argued that the distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from SECA, and that the court must apply a functional analysis test, like the one used in Renkemeyer[8](in the limited liability partnership context).

Looking to the legislative history and Renkemeyer, the Tax Court reiterated that Congress intended the Limited Partner Exception to prevent passive investors from qualifying for Social Security and that it did not apply to ‘active’ limited partners. Furthermore, the Tax Court found that that the Limited Partner Exception does not apply to a partner who is limited in name only. Had Congress intended to automatically include any limited partner they would not have included the phrase ‘as such.’ By adding ‘as such,’ Congress made clear that the Limited Partner Exception should only apply to limited partner’s that are passive investors, “excluding for coverage purposes certain earnings which are basically of an investment nature.” The Court concluded that a functional inquiry into the roles and activities of Soroban’s individual partners is required to determine whether a partner in a state law limited partnership is a “limited partner, as such” for purposes of Section 1402(a)(13).

The decision did not address what the functional analysis includes or how the Tax Court might apply it. For now, the Tax Court has indicated that limited partners in name only will not qualify as ‘limited partners as such’ for the Limited Partner Exception under Code Section 1402(a)(13). Limited partnerships and their limited partners may want to engage in a functional analysis to determine its limited partner’s roles and responsibilities, potentially using the 1997 Proposed Regulations as a starting point.

Soroban was a limited partnership. More recently, the Tax Court also addressed a similar issue related to a limited liability limited partnership in Sirius Solutions LLLP v. Commissioner. [9]  In Sirius, the parties agreed that Soroban was precedential and applicable to the issues in the case.  In its status report, Sirius requested an entry of decision in favor of the Commissioner so that it could contest the Soroban decision as it applies to limited liability limited partnerships in the U.S. Court of Appeals for the Fifth Circuit.[10] Because the parties filed a stipulation of settled issues effectively conceding the matter at trial but preserving Sirius’s right to appeal, the Tax Court entered an order to that effect.  Significantly, Sirius’s decision to concede and preserve the issue for appeal avoids lengthy motion practice and unnecessary legal fees on a precedential issue already resolved by the Tax Court.  However, taxpayers should be careful when making these types of strategic moves as certain concessions made at trial cannot be raised later in the appellate courts.   

*Caleb O’Donnell was a Gray Reed Summer Associate in 2023 and will be joining us as a full-time Associate in Fall 2024.


[1] As used herein “Section” means a section of the Internal Revenue Code of 1986, as amended (the “Code”).

[2] Soroban Capital Partners LP v. Comm’r of Internal Revenue, No. 16217-22 (U.S.T.C. Nov. 28, 2023).

[3] IRS, Self-Employment Tax (Social Security and Medicare Taxes), https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes#1; Current threshold amounts: $200,000 for Single filing, Head of household (with qualifying person), Qualifying surviving spouse with dependent child. $250,000 for Married filing jointly, and $125,000 for Married filing separate.

[4] The other method is treating partners or members as employees, providing them a W-2, and flowing the balance of profits through as income that is not subject to SECA Tax. However, the Court held in Riether v. United States, 919 F. Supp. 2d 1140 (D.N.M. 2012), that taxpayers should have treated the LLC’s income as self-employment income. The IRS has long held the position that partners are not employees for purposes of the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), or withholding, and that partners cannot have dual status as a partner and an employee.

[5] Adopted in 1977, the Limited Partner Exception found in Section 1402(a)(13), creates an exception from net earnings from self-employment for limited partners excluding “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 to the extent that those payments are established to be in the nature of remuneration for those services.”

[6] Prop. Reg. § 1.402(a)-2(h).

[7] See, e.g., Miosi Says Court Losses Drove Addition of Material Participation in Guidance Plan, 09 DTR G-2 (Jan. 15, 2010) (quoting Diana Miosi, Special Counsel, IRS Office of Associate Chief Counsel (Passthroughs and Special Industries)

“[i]f you structure a transaction so that you’re within the four corners of the proposed regulations, that’s a reasonable position and we’re not going to challenge it…”

See also, IRS, LB&I Concept Unit – Self-Employment and Net Investment Income Tax, at 19 (2019):

“The 1997 Proposed Regulations are not final. They may not be enforced on taxpayers. Instead, the applicable analysis is the statutory language, legislative history, and case law. Taxpayers, however, may rely on the 1997 proposed regulations. In other words, the IRS will respect a partner’s status as a limited partner if the partner qualifies as a limited partner under the 1997 proposed regulations.

[8] In Renkemeyer v. Comm’r of Internal Revenue, 136 T.C. 137 (U.S.T.C. 2011), the Court analyzed the legislative history of Section 1402(a)(13) and found that Congress intended the Limited Partner Exception, “to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations…. would not receive credits towards Social Security coverage. They held the partners from this case were not limited partners because they were providing legal services.

[9] Sirius Sols., L.L.L.P. v. Comm’r of Internal Revenue, No. 11587-20 (U.S.T.C. Feb. 20, 2024).

[10] “Sirius Solutions requested entry of decision under Rule 251 in favor of the Commissioner so that it might contest our holding in Soroban Capital in the U.S. Court of Appeals for the Fifth Circuit.” Sirius Sols., L.L.L.P. v. Comm’r of Internal Revenue.