Taxes in your practice: U.S. Tax Court holds limited partners liable for self-employment tax

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.

The U.S. Tax Court recently held limited partners in an investment firm were subject to self-employment tax. In Soroban Capital Partners LP v. Commissioner,¹ the court found that the limited partners’ income did not qualify for the limited partner exclusion from self-employment earnings under Code § 1402(a)(13) because of their involvement in the business. 

Background 

Code § 1401 imposes a tax on net earnings from self-employment derived by an individual from a trade or business carried on as a sole proprietor or by a partnership they are in. 

Code § 1402(a)(13) excludes income or loss of a limited partner when calculating net earnings from self-employment. The court found that a functional analysis is required to determine the extent to which this exception applies, including a factual inquiry into how the partnership generated the income in question and the partners’ roles and responsibilities. 

Soroban Capital Partners LP (Soroban) is a Delaware limited partnership based in New York with three limited partners and a Delaware general partner, Soroban Partners GP LLC. The limited partners included an individual person and two single-member limited liability companies owned by individuals. The interests held by these single-member limited liability companies were treated as being held directly by their individual owners. The three limited partners also owned the general partner, so Soroban was effectively owned by three individuals that the court identified as the principals of Soroban. 

During the years in question, Soroban’s income came from managing investments. The principals were essential in generating the income, and Soroban acknowledged that their unique skills and experience were indispensable to the business. The principals exercised managerial control, worked full time with Soroban, and contributed minimal capital relative to their shares of income. 

Approximately 1% of Soroban’s income was reported as self-employment earnings to the general partner’s members (also the limited partners). Soroban also reported relatively small guaranteed payments as net earnings from self-employment to limited partners. The rest of Soroban’s income was reported to the limited partners as ordinary income but excluded from net earnings for self-employment tax purposes.

The IRS issued Final Partnership Administrative Adjustments to Soroban for the two tax years in question, proposing to recharacterize the ordinary income reported to Soroban’s limited partners as net earnings from self-employment. 

U.S. Tax Court analysis and decisions 

In a prior decision, Soroban Capital Partners LP v. Commissioner,² the U.S. Tax Court denied Soroban’s motion to dismiss which argued that characterization as a limited partner for state law purposes was controlling. In that opinion, the court granted the commissioner of internal revenue’s motion, holding that § 1402(a)(13) requires a functional inquiry into the roles and responsibilities of the partners, and that this inquiry concerns a partnership item for the purposes of Tax Equity and Fiscal Responsibility Act partnership procedures.

The court in the current opinion applied a functional analysis to several key roles and responsibilities of the principal limited partners in the business, including the following considerations: 

– Roles in generating income. The court found that the principals’ time, skills, and judgment were essential to the income Soroban generated from fees charged to clients for investment management. The principals were directly responsible for managing risk, trade offers, and the investment process. This work generated substantial fees during the years in issue. 

– Roles in management. All three principals were on management and operations committees, and they made decisions related to hiring, firing, promoting, and evaluating employees.

– Time devoted. The principals devoted their full-time efforts to management and the investment activities of Soroban and its business. Soroban estimated the principals worked 2,300- 2,500 hours annually. 

– Marketing the principals. Soroban advertised the unique skill and expertise of the principals in presentations for investors, and they were publicly held as essential to Soroban’s operations. The skill and experience of one principal was so critical that his incapacity was a key-man triggering event allowing investors to withdraw funds, and the funds were obligated to liquidate if no principal was available for management. 

– Capital contributions. Two of the principals made no capital contributions to Soroban, and the other principal’s capital contributions were disproportionately small relative to the distributions he received. The disproportionate income the principals received relative to their investments did not indicate a return on capital. 

– Additional factors. Soroban argued for consideration of several other factors, including treatment as a limited partner under state law. Soroban also argued that the principals only acted with authority delegated to them by the general partner, which they in turn had the authority to manage. The court stated, “This type of legal fiction is precisely why application of federal tax law to the economic arrangement of the parties controls, and not mere state law classifications.”³

In summary, the court found that Soroban relied on the principals to function. They managed investment funds generating income for the business, actively participated in management, worked full time in the business, were critical to marketing and the continuation of client investments, and were not passive investors in Soroban. 

Based on these findings, the court held the principals were not limited partners for purposes of Code § 1402(a)(13) and their earnings were subject to self-employment tax for the years in issue. 

Conclusion 

When working with clients, lawyers should remember Soroban as a key decision subjecting investment fund earnings of limited partners to self-employment tax. The court found that the limited partners in this case were actively involved in operations and management and did not have sufficient investment to justify a limited partner return. Soroban reinforces a functionality test to determine limited partner treatment for exclusion of income from self-employment tax that may have application in many limited partnerships. 

Endnotes:

1 T.C. Memo. 2025-52 (May 28, 2025). 
2 161 T.C. 310 (2023). 
3 T.C. Memo. 2025-52 (May 28, 2025).