Partners fail to qualify for exception in Soroban case

The U.S. Tax Court ruled in Soroban Capital Partners LP et al. v. Commissioner, T.C. Memo. 2025-52, that partners who were active and fundamental contributors failed to qualify for an exception from self-employment tax on their distributive share of partnership income under Section 1402(a)(13).

The May 28 ruling follows the November 2023 precedential opinion (Soroban Capital Partners LP et al. v. Commissioner, 161 T.C. 310) in which the Tax Court held that a functional analysis must be applied to determine whether a state law limited partner’s distributive share of partnership income is exempt from self-employment taxes under Section 1402(a)(13). In this case, the court ruled in favor of the IRS by applying the functional analysis test established in Denham Capital Management LP et al. v. Commissioner, T.C. Memo. 2024-114.

Taxpayers should consider the potential implications of the Soroban and Denham opinions on the prospective viability of relying on a limited partner’s state law status when applying the limited partner exception to self-employment taxes.

Background

Enacted in 1977, Section 1402 generally requires a partner to include their distributive share of partnership income in earnings from self-employment when determining their self-employment taxes. However, Section 1402(a)(13) provides an exception for the distributive share of limited partners (the “limited partner exception”).

The statute does not define “limited partner” for purposes of the exception and no regulations have been promulgated defining the term. Historically, certain taxpayers and practitioners may have sought to apply a position that limited partner status under state law was enough to satisfy the limited partner exception, but this position has been of focus for the IRS in a recent compliance campaign on the computation of partners’ self-employment income.

Soroban, a New York-based hedge fund management entity organized as a Delaware limited partnership, filed a Tax Court petition in July 2022 challenging the IRS’s position. The Service claimed that the partnership improperly applied the limited partner exception to its three founders for tax years 2016 and 2017, based solely on their classification as limited partners under Delaware law.

On Nov. 28, 2023, the Tax Court issued its first opinion in Soroban Capital Partners LP et al. v. Commissioner, 161 T.C. No. 12. (See our prior December 2023 article on this topic) The Tax Court’s Nov. 28 opinion held that the court must apply a functional analysis test to determine whether a partner in a state law limited partnership is a “limited partner, as such” for purposes of Section 1402(a)(13).

However, the opinion did not include a functional analysis for the parties to apply. After the opinion was issued, the parties conducted discovery on whether the partners in question were deemed limited partners under a functional analysis. Ultimately, the IRS and Soroban agreed to submit the case for decision without trial in August 2024.

After the Tax Court’s initial ruling in Soroban, the Tax Court issued an opinion in Denham that interpreted and applied a functional analysis test for state law limited partners. Denham was the first Tax Court opinion to apply a functional analysis for determining whether a state law limited partner meets the Section 1402(a)(13) self-employment tax exception.

Soroban findings

In its most recent ruling, the court applied the functional analysis set out by the court in Denham, emphasizing the following factors in determining whether the partners’ participation was that of a passive investor:

• The partner’s role in generating income
• The partner’s role in management
• The partner’s time devoted to the business
• Marketing the partner’s role in the business
• The partner’s capital contributions

In its analysis of these factors, the court found the partners worked full time and were essential to Soroban’s investment strategy and operations, exercised managerial control, served on key committees, had authority to bind the partnership, their income was not a return on capital investment but compensation for services rendered. Soroban marketed the partners’ expertise as a key selling point to investors, and the amount of capital contributed compared to their distributive income was far greater than one would expect for a return on investment. As a result, the court held that the partners’ distributive shares were subject to self-employment tax, regardless of their “limited partner” title under state law. The Tax Court noted in the opinion that “federal tax law, and only federal tax law, controls the classification of ‘partners’ and ‘partnerships’ for federal tax purposes.”

As part of the proceedings, Soroban proposed its own list of factors for a functional analysis test. However, the court found that many of the factors relied on the state law classification of the partners and did not appropriately explore the economic reality of the partners’ active involvement in the partnership. 

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