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Limited Partners May Pay Self-employment Tax if New Tax Court Ruling Stands

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The US Tax Court has made a potentially far-reaching decision in a recent case involving the self-employment tax liability of limited partners in a New York investment firm. The Court determined that limited partners should be subject to an analysis of their “function and roles” to determine if they are true limited partners. If they are not, the limited partners will be subject to self-employment tax not only on their guaranteed payments for services but also on distributions of ordinary income.

Facts in the Case

In Soroban Capital Partners LP, v. Commr., a limited partnership that was subject to the TEFRA audit and litigation procedures made guaranteed payments and distributed ordinary income to its limited partners. It excluded the distributions of ordinary income to the limited partners from its computation of net earnings from self-employment. The IRS determined that the distributions should have been included in partnership’s computation of net earnings from self-employment because of the roles the limited partners played in managing the business. The limited partners all provided services to the partnership and received both guaranteed payments and ordinary income from the partnership. The partnership argued that the designation of the partners as limited partners must be respected.

The Tax Court granted summary judgment to the IRS finding that, as a matter of law, the role of limited partners must be analyzed using a “functional test” to determine whether limited partners are taking an active role in the business that subjects their share of partnership ordinary income to self-employment taxes. The Court did not actually apply the test to the partners in the case. That step will have to take place in further litigation. The Court only set forth the controlling law on the issue with its new “functional analysis” mandate.

In short, unless overruled on appeal, the law going forward is this:  distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from self-employment income and the extra 15.3% tax that comes along with it.

Outlook and Implications

Partnerships in the financial services business, including private equity firms and hedge funds, will now need to perform their own functional analysis to determine whether their limited partners will be subject to self-employment tax. The IRS is focused on this issue. The agency included the self-employment liability of limited partners as a compliance area of its LB&I audit campaigns in 2018, and it still is an active IRS campaign.

The problem is that there is a new test for limited partners, but the Court has not shown taxpayers how it will be applied. For this reason, it is important for firms to be proactive and consult their tax advisors to pre-screen limited partners’ roles to determine if they are vulnerable to a self-employment tax challenge. Meanwhile, tax advisors will be watching how the Soroban case develops. It is expected that the Second Circuit Court of Appeals will be called upon to review the Tax Court’s bold action, but final resolution of the matter may take a while.

Lucia Smeal, Frazier & Deeter

Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, an adjunct tax professor with Georgia State University’s J. Mack Robinson College of Business and with Franklin University, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker and writer on current tax developments.

Contributors

Lucia Nasuti Smeal, Adjunct tax professor at Georgia State University

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