The limited partner exception from self-employment taxes: Soroban II

In Soroban I, the Tax Court held that a functional analysis of a state law limited partner’s roles and responsibilities with respect to the partnership is required to determine whether such individual qualifies for an exception from self-employment tax for limited partners under section 1402(a)(13) (the “Limited Partner Exception”). In the May 28th decision in Soroban II, the Tax Court completed this analysis and found the roles and responsibilities of the limited partners of Soroban Capital Partners LP (the “Management Company”) to be too significant for the limited partners to qualify for the Limited Partner Exception. This decision follows a similar finding in Denham Capital Management LP v. Commissioner³, which presented similar facts.

Self-employment tax and the limited partner exception

For a brief discussion of the Limited Partner Exception, relevant caselaw, and an analysis of the decision in Denham, see our publication “Another U.S. IRS Victory in the Self-Employment Tax Arena: Denham Capital Management”. 

Soroban II 

The Management Company was set up as a state law limited partnership. Other than amounts characterized as guaranteed payments, the limited partners in the Management Company claimed the Limited Partner Exception with respect to their income allocations from the Management Company, which earned fees from managing private investment funds (the “Business”). 

Applying a similar functional analysis as it completed in Denham, the Tax Court in Soroban II considered the partners’ roles in both management and operations of the Business, their time devoted to the Business, how their capital contributions compared to the distributions received from the Management Company, and how their role in the Business was marketed to potential investors. The court noted the functional analysis that should be applied to determine whether a state law limited partner is a limited partner for purposes of the Limited Partner Exception is a facts and circumstances test that considers all relevant facts and circumstances. In particular, the court rejected the formalistic argument that the three individual limited partners were acting in their capacity as members of the general partner, concluding that substantively the three individuals were not acting in a limited partner capacity. 

The following facts were among those emphasized by the court in concluding that the partners did not qualify for the Limited Partner Exception: 

• The partners’ time, skills, and judgment were “essential” to the Business’ generation of income given they managed the funds, risk, and trade offers and oversaw the investment process. 
• The partners participated in the management of the Business by serving on multiple committees including the committee responsible for hiring, firing, promoting, and evaluating employees. In the court’s view, the fact that other individuals were employed to help operate the business did not mitigate the fact that the partners “maintained control over the operations of the business” and “exercis[ed] authority over the core functions.” 
• The partners devoted their full-time efforts to the Business. 
• The special skill and experience of the limited partners was advertised to investors, who were given rights to withdraw funds if certain or all of the limited partners were unavailable to manage the funds. 
• Only one limited partner contributed any capital to the Management Company, and this amount (approximately $4 million) was disproportionate to the income allocated to him for the years at issue (approximately $80 million). 

Next steps 

Following the Tax Court’s decisions in Soroban I, Denham, and now Soroban II, fund managers set up as limited partnerships should carefully consider the legal structure of their manager entities and understand the potential risks of characterizing their partners’ allocated income as other than self-employment income, especially if the factors mentioned above are applicable. Litigation in other cases remains ongoing (briefs have been filed to the Fifth Circuit in Sirius Solutions LLLP v. Commissioner). 

Hogan Lovells will continue to monitor developments in this area. 

Authored by Jessica Millett and Max Feinstein.