Tax Court Agrees with IRS (Again) on Self-Employment Tax for Limited Partners, What Lies Ahead for the Court of Appeals

     Last month, the Tax Court issued another decision addressing the meaning of limited partner for private equity and hedge fund managers, once again subjecting the managers to Self-Employment Contributions Act (SECA) tax on their distributive shares of partnership income. In Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114, the Tax Court affirmed its earlier ruling in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310, that limited partners who actively participate in their partnership are subject to SECA tax on their share of ordinary business income, not just guaranteed payments. The Tax Court held that only “passive investors” qualify for the limited-partner exception to SECA tax. While the Tax Court has previously addressed this issue in the context of law firms, consulting firms, and doctors,[1] Soroban was the first case addressing SECA in the context of hedge funds and private equity.

     The primary issue in Soroban and Denham was whether state law or partner activities determine limited-partner status. In Soroban, the Tax Court took the IRS’s view, holding that a functional test, rather than state law, determines who is a limited partner for purposes of the SECA tax exception. The functional test assesses the partners’ roles and activities to determine if the partners are generally akin to passive investors.  The partnership in Soroban spent little time licking its wounds after the Tax Court sided with the IRS about the functional test. Meeting the IRS on its own ground, the partnership submitted briefs to the Tax Court last fall arguing that its partners passed the functional test and thus qualified for the limited-partner exception to SECA tax. Now the partnership awaits the Tax Court’s decision.

     In the time between Soroban and Denham, the Tax Court issued a similar decision in Sirius Solutions LLLP, Docket No. 30118-21. However, unlike the partnership in Soroban, who is now arguing about the application of the functional test, the partnership in Sirius conceded that its partners would fail the Tax Court’s functional test; then the partnership immediately appealed the Court’s February 2024 decision to the Fifth Circuit. The partnership’s appeal to the Fifth Circuit has been fully briefed and is scheduled for oral argument next Thursday, February 6, 2025.

     The Sirius partnership is arguing to the Fifth Circuit when the statute was enacted, the “ordinary meaning” of “limited partner” was a “state law limited partner,” not a passive investor. In other words, the partnership is arguing that the functional test conflicts with the statute and that state-law limited partners qualify for the limited-partner exception to SECA tax. That brings us back to the Denham Capital case where the Court applied the functional test and rejected limited-partner status for five state law limited partners thus subjecting them to SECA tax. Denham’s principal place of business was Massachusetts at the time the petition was filed, so it is appealable to the First Circuit. Soroban would likely be appealable to the Second Circuit creating an opportunity for several different appellate courts to weigh in on this important statutory interpretation issue.

     Even though the IRS announced a pause in its campaign examining taxpayers claiming exclusion from the SECA tax, there are several taxpayers disputing the IRS’s position both administratively and in litigation. If the early cases are any indication, taxpayers should expect a revival of the SECA tax battles across other industries.

[1] Renkemeyer v. Commissioner, 136 T.C. 137 (2011); Castigliola v. Commissioner, T.C. Memo. 2017-62; Joseph v. Commissioner, T.C. Memo. 2020-65; Hardy v. Commissioner, T.C. Memo. 2017-16 and Sirius Solutions LLLP v. Commissioner, Docket No. 30118-21.

Author

Shareholder

Brian Gardner, J.D., LL.M.

A partner at Asbury Law Firm, Tax Counsel. Brian focuses his practice on tax controversy and litigation matters.

Associate

Chris Bishop, ESQ.

Associate at Asbury Law Firm.