Tax Court Takes Narrow View of Limited Partner Exclusion from SECA Tax

The Tax Court, in a victory for the IRS, recently issued an opinion holding the limited partner exception to the Self-Employed Contributions Act Tax must be construed narrowly. The court held a limited partner under state law is not automatically a limited partner for purposes of the SECA exclusion.

SECA Background

SECA imposes a tax on the self-employment earnings of individuals, which mirrors the rates applicable to wages of employees under FICA—a 12.4% rate applicable to a capped portion of earnings, plus a 2.9% rate on all earnings (with an additional 0.9% charge above certain levels). There are numerous exceptions to SECA taxes, including “the distributive share of any item of income or loss of a limited partner, as such…” As discussed below, the Tax Court leaned heavily on the words “as such” is divining Congress’ intent.

Tax Court Decision

In Soroban Capital Partners LP v. Commissioner, the taxpayer was a hedge fund organized as a limited partnership. It argued that three of its state law limited partners should qualify for the limited partner exclusion by virtue of their state law status. While the taxpayer conceded any guaranteed payments are subject to SECA, the limited partners excluded all distributive shares of ordinary business income from that calculation. The IRS pushed for a functional analysis of each limited partner that examines participation in management, exposure to liability and other facts bearing on how active each limited partner is in the business. The court sided with the IRS, focusing on “as such” in the statute to conclude Congress intended the limited partner exception to apply to more passive investors rather than a “partner who is limited in name only.”

Procedural Posture and IRS Campaign

The opinion is in response to cross-motions for summary judgment. The court did not hold the three limited partners do not qualify for the SECA limited partner exception but rather rejected the taxpayer’s broad construction of the exception. Additionally, the IRS is litigating several other SECA cases as part of its self-employment compliance initiative, including Point72 Asset Management LP v. Commissioner, Sirius Solutions LLLP v. Commissioner and Denham Capital Management LP v. Commissioner.

Next Steps

Fund managers relying on the limited partner exception should consider the IRS’ functional analysis test and potentially explore alternative structures that could mitigate the SECA tax. To learn more about how our Fund Formation & Investment Management team can assist you with the foregoing or other private fund-related matters, please reach out to one of our attorneys.