In depth
Legal background: SECA tax and the limited partner exception
Social Security tax, as commonly referred to, is divided into two systems. First are the Federal Contributions Act (FICA) taxes imposed on employers and employees under sections 3101-3128. Second is the SECA tax imposed on self-employed individuals under sections 1401-1403. Most Americans pay, and are familiar with, FICA tax because they work as an employee rather than being self-employed.
For those self-employed individuals, SECA tax requires them to contribute to Social Security (12.4%) and Medicare (2.9%) by taxing their net earnings from self-employment. SECA tax is imposed on an individual who earns “self-employment income,” which is defined in section 1402(b) as “net earnings from self-employment derived by an individual … during any taxable year.” The term “net earnings from self-employment” (NESE) is defined in section 1402(a) to include:
"gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member" (emphasis added).
However, a very meaningful exception under section 1402(a)(13) provides that NESE does not include “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)” (emphasis added) (“Limited Partner Exception”). This counterintuitive exception, enacted in 1977, was originally intended as an anti-abuse rule rather than a benefit. Social Security was meant to replace lost earnings from work and Congress wanted to prohibit Social Security fundings/benefits from passive investment earnings from limited partnerships.
Unfortunately, neither Congress nor the IRS has defined “limited partner” for purposes of section 1402(a)(13). The IRS attempted to do so twice: first in regulations issued in 1994 (which were withdrawn), then with proposed regulations in 1997. Under the 1997 proposed regulations, the IRS provided that a partner of any entity taxable as a partnership that afforded limited liability to its owners would qualify as a limited partner under section 1402(a)(13), provided that the member did not participate in the business of the entity for more than 500 hours per year. However, Congress enacted a law in 1997 specifically preventing the finalization of regulations defining “limited partner” under section 1402(a)(13). Although the injunction preventing publication expired in 1998, Congress nor the IRS has defined the term “limited partner” since.
Factual background: Soroban Capital Partners
During the tax years at issue, Soroban Capital Partners LP (SCP) was a hedge fund organized as a Delaware limited partnership, classified as a partnership for US federal income tax purposes. In coming to its decision, the Tax Court analyzed the roles of SCP’s one general partner and three limited partners. Per SCP’s limited partnership agreement, the general partner had authority over the business affairs of the partnership. The limited partners, taking into account both direct and indirect interests, had active roles and rights over the business, however. For example, each of Soroban’s limited partners were responsible for daily risk management oversight, served on committees that oversaw Soroban’s operations, made hiring decisions, and managed employees. Each of the limited partners also treated Soroban as their full-time job.
SCP listed its guaranteed payments and the general partner’s share of ordinary business income as subject to SECA tax. But it did not report the limited partners’ share of ordinary business income as subject to SECA tax. The IRS contended that such distributive share of ordinary business income should also be subject to SECA tax because the Limited Partner Exception did not apply.
Soroban I – Functional analysis required
The first Soroban case, Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12 (2023) (“Soroban I”), addressed a purely legal question on whether a partner’s status as a limited partner in a state law limited partnership satisfied the Limited Partner Exception. SCP argued that it did while the IRS argued that the Tax Court must apply a functional analysis test, similar to the test outlined in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011) (“Renkemeyer”), to determine whether individuals are limited partners pursuant to section 1402(a)(13).
The Tax Court in Soroban I held that a functional analysis test, as applied in Renkemeyer, is required to determine whether a partner in a state law limited partnership is a “limited partner, as such” for purposes of the Limited Partner Exception. The Tax Court, however, did not undertake the functional analysis test in Soroban I because this was a ruling on SCP’s motion for summary judgment. SCP and the IRS subsequently conducted discovery on the matter and agreed to submit the case for decision without trial.
Soroban II – Functional analysis applied
In Soroban Capital Partners LP v. Commissioner, T.C. Memo. 2025-52 (“Soroban II”), the Tax Court applied the functional analysis test as set forth in Renkemeyer and Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114 (“Denham”). The Tax Court stressed that the functional analysis test is not based on a set number of factors but instead considers all relevant facts and circumstances. To this end, the Tax Court held that the facts and circumstances regarding a limited partner must indicate that the partner’s economic relationship with the partnership is generally akin to a passive investor.
Applying the functional analysis test, the Tax Court emphasized the following factors: the limited partners’ role in generating income, their role in management, how much time they devoted to their roles, how their roles were publicly marketed, and their capital contributions. Taking all of this into consideration, the Tax Court found that the SCP limited partners were essential to generating the business’s income, oversaw day-to-day management, worked for the business full time, had authority to bind the partnership, and were held out to the public as essential to the business. The Tax Court also noted that the limited partners’ trivial capital contributions show that their shares of partnership income were not a “return of investment of capital” akin to a passive investor. For example, only one of the three SCP limited partners in question actually contributed capital to SCP (USD 4 million) and his return (USD 80 million) was, in the eyes of the Tax Court, “disproportionate to the distributions he received,” indicating that they were based on services provided and not based on an investment of capital. Ultimately, the Tax Court concluded that SCP’s limited partners were “limited partners in name only” and thus not eligible for the Limited Partner Exception. Although SCP proposed its own factors of consideration based on state law, the Tax Court did not find these persuasive, noting that “the economic arrangement of the parties controls” for federal tax law purposes.
What now?
Soroban II applied the functional analysis test to a typical fund management structure and concluded that the SCP limited partners were too active to qualify for the Limited Partner Exception. In doing so, it reinforced that a limited partner’s state law classification is not enough to meet the Limited Partner Exception and created a high bar for limited partners to meet the Limited Partner Exception under a facts-and-circumstances test.
Because of the lack of guidance under the Limited Partner Exception, fund managers, like the limited partners of SCP, have diverged in their interpretation of section 1402(a)(13). Some take a position similar to SCP, relying on its state law limited partnership classification to claim that it meets the Limited Partner Exception. Others follow the 1997 proposed regulations as if they were effective.
Although there is still judicial uncertainty regarding the ultimate outcome of the Limited Partner Exception because similar cases are pending in the Tax Court or on appeal, fund managers who rely on positions similar to SCP should take Soroban II as a warning to assess their risk exposure under section 1402(a)(13) and explore mitigation strategies under the functional analysis test.
