Tax Court applies ‘functional’ analysis to limited partner exception

The Tax Court has issued an opinion in Soroban Capital Partners LP, et al v. Commissioner (161 T.C. No. 12) providing that the court will apply a functional analysis test to determine whether a partner in a state law limited partnership is a “limited partner” for purposes of the exception from self-employment tax under Section 1402(a)(13). The Soroban case, along with several other pending cases dealing with the same issue, have been closely followed because of their potential to provide significant guidance on the scope of the limited partner exception for the Self-Employed Contributions Act (SECA) tax.

The ruling comes as a blow to taxpayers and practitioners who have sought to apply a position that limited partner status under state law, standing alone, was enough to exempt a partner’s distributive share of partnership income from SECA under the Section 1402(a)(13) limited partner exception. While the Nov. 28 opinion does not fully resolve the Soroban case, taxpayers should nevertheless take action to consider the impact of the opinion on their historic tax positions, applying the limited partner exception.

Section 1402 generally requires partners to include any distributive share of partnership income when determining their self-employment taxes, but Section 1402(a)(13) provides an exception for the distributive shares of limited partners (the “limited partner exception”). In recent years, that has created a flurry of controversy around the meaning of the term limited partner for purposes of the limited partner exception, which has gone undefined by statute or final regulation since its enactment in 1977.

In a 2011 case, Renkemeyer, Campbell & Weaver, LLP v. Commissioner (136 T.C. 137), the Tax Court considered whether a partner in an entity other than a state-law limited partnership might still qualify for the limited partner exception. Examining the legislative history for the limited partner exception, which indicated that Congress intended to exclude investment-type earnings from SECA, the court suggested that partners in an entity other than a state-law limited partnership might qualify for the limited partner exception if their interest was functionally equivalent to that of a limited partner. The Renkemeyer opinion framed this functional analysis against the archetype of a state law limited partner at the time the limited partner exception was enacted. Defining features of this archetype were limited liability for partnership debts and a lack of participation in the partnership’s management.

Following Renkemeyer, the IRS has asserted, including as part of an ongoing compliance campaign, that a functional test must be applied to determine whether a partner qualifies for the limited partner exception, even for those taxpayers who are limited partners under state law. The Soroban case, along with several others, is a result of that compliance campaign.

Soroban involves a limited partnership that serves as an investment manager for various investment funds. Three individuals hold a state-law limited partner interest, while the business is classified as a partnership for U.S. federal income tax purposes. The limited partnership’s sole general partner is a limited liability company equally owned by the same three individuals. For legal purposes, the LLC general partner is solely responsible for controlling the limited partnership’s business. However, the three individuals participate in the limited partnership’s business in various officer-type roles and receive guaranteed payments for their services. The partnership is disputing the IRS’s determination that the three individuals’ distributive shares of partnership income received in their capacity as direct partners in the limited partnership do not qualify for the limited partner exception.

The recent Tax Court opinion resolves cross-motions for summary judgment as to:

• Whether a taxpayer’s status as a limited partner under state law, standing alone, is sufficient to qualify for the limited partner exception, or whether a functional analysis is required, and
  
• Whether the determination of limited partner status must be made in a partnership-level proceeding for partnerships examined pursuant to the centralized audit procedures of the Tax Equity and Fiscal Responsibility Act (TEFRA)

The court’s opinion holds for the IRS on both issues: that a functional test for limited partner status is required regardless of the type of state-law entity in which the taxpayer holds an interest and that such determination is made in a partnership-level proceeding under TEFRA.
 

The Tax Court’s holding that a functional test for limited partner status under Section 1402(a)(13) is required does not necessarily mark the end of controversy in Soroban. If litigation in the case continues, future Tax Court opinions might provide additional guidance as to how to apply the required functional analysis. Also, it is possible that the court’s opinion may be appealed. The case could continue to provide additional guidance on the functional analysis required to determine limited partner status under Section 1402(a)(13).

In the meantime, the court’s opinion rejects the notion that limited partner status under state law is alone sufficient to qualify for the limited partner exception. With that in mind, taxpayers that have historically applied the limited partner exception to shield their distributive share of partnership income from SECA should consider the potential impact of the Soroban opinion in preparing for the tax return filing season for 2023 (and future) partnership taxable years.