Limited Partner Exception to Self-Employment Tax – What to Do in Light of the Recent Soroban Case

Background on the Limited Partner Exception 

Section 1401 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), imposes self-employment tax on an individual’s self-employment income. Self-employment income is generally defined as the net earnings from self-employment, which is “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions … attributable to such trade or business” either earned directly or allocated from a partnership of which the individual is a member. Section 1402(a) sets forth several exceptions; notably, Section 1402(a)(13) provides an exception for an individual’s “distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments…”

Self-employment tax is imposed at a rate of 3.8%. There is a somewhat complicated calculation but the effective marginal federal tax rate (not taking into account self-employment tax imposed on income below certain thresholds) is about 2.9% plus, if applicable, state and local tax savings.

 The limited partner technique is an established structure commonly used by investment fund managers to minimize self-employment tax. In connection with this planning, many investment managers are organized as limited partnerships and principals and other persons may be admitted as limited partners of the investment manager.

 Congress and the Internal Revenue Service (the “IRS”) have been aware of the limited partnership exception for many years. There have been a number of legislative proposals over the years to address the exception, none of which have been enacted.  Further, the IRS has not issued any guidance on the limited partner self-employment tax issue since 1997 when regulations were proposed, and Congress responded by issuing a one-year moratorium on their finalization. 

 The IRS has prevailed in court on the issue, but only with respect to entities that were taxed as partnerships but were not state law limited partnerships (e.g., limited liability companies). In Soroban (discussed below), the most recent case, the IRS prevailed with respect to a state law limited partnership. The taxpayer in that case may appeal the decision. However, if the taxpayer plans on appealing, it is not clear whether it would wait until the Tax Court rules on the application of the functional analysis to the facts in the case.

 There are two other cases currently before the Tax Court on this specific issue. There are a number of ongoing audits that are part of an IRS audit campaign on the issue, as well. Also, it should be noted that the IRS has added this issue to its 2023-2024 Priority Guidance Plan. And there is always the possibility of legislation on the issue (but this has been the case for many years).

 In any event, it might be several years before the issues are decided in court and any guidance or legislation would likely only be issued on a prospective basis. 

The Soroban Case 

The Tax Court recently issued an opinion on the application of the limited partner exception to an investment manager that was a state law limited partnership. In Soroban Capital Partners LP v. Commissioner (161 T.C. No. 12 (November 28, 2023)), 1% of the limited partnership’s income was allocated to the general partner (owned by the three principals), 99% of the limited partnership’s income was allocated to the principals as limited partners, and guaranteed payments were made to the principals. The K-1s issued to the limited partners did not designate the income allocated to the limited partners as self-employment income.

In responding to motions for summary judgment from both the IRS and the investment manager, the Court ruled that, as a matter of law, the determination of whether income is subject to self-employment tax is determined at the partnership level item and that a functional analysis must be used to determine whether the limited partner exception applies. The Court placed significant emphasis on the “limited partner, as such” language in Section 1402(a)(13).

The Court, however, did not address whether the principals would be considered limited partners based on a functional analysis test. And it is not clear what criteria would be relevant for determining whether the principals would be considered limited partners under a functional analysis. It is possible that the limited partners (principals) may qualify for the exception for a portion of the income allocated to them.

What Should Investment Managers Do in Light of the Soroban Case?

New Managers

 For new investment managers that are large, it may still make sense to organize the investment manager as a state law limited partnership. The incremental cost of using a limited partnership instead of a limited liability company is not material and preserves the optionality to rely on the exception in light of how case law develops and if there is any other guidance on the issue. Managers could also organize as limited liability companies taxed as partnerships and have the ability to change their structure in the future depending on developments in the law. Additionally, new managers could consider the alternatives discussed below.

Existing Managers 

It may be beneficial for existing investment managers to wait and see what develops in 2024. 

 2023. With respect to 2023, there are three options:

 (1) Status Quo. File 2023 tax returns consistently with prior returns and take the position that income allocated to limited partners is not subject to self-employment tax.

 (2) File extensions and pay tax. File extensions for 2023; pay self-employment tax on all income allocated to limited partners; and see what develops, if anything, prior to the extended due date for 2023 partnership tax returns (September 15, 2024).

 (3) Pay tax and file amended tax returns. File 2023 tax returns; pay self-employment tax on all income allocated to limited partners and file amended returns claiming refunds. 

 Option 2 would be the most conservative way to proceed until there is clarity, if any. Also, tax return preparers are still evaluating what tax positions they may be willing to take on tax returns and what, if any, disclosure may be required if relying on the limited partner exception.

 2024. Going forward there are several options to consider in addition to just paying self-employment tax on all limited partner income.

 (1) Status quo and see what develops. Estimated tax payments for 2024 could be made assuming that limited partner income is not subject to self-employment tax.

 (2) Obtain a transfer pricing study. If the investment manager is a limited partnership, a transfer-pricing study could be obtained to bolster the position that only a portion of the limited partners’ income is attributable to the performance of services and subject to self-employment tax. It is not clear that this would provide any tax benefit since the IRS’s view seems to be that income is either subject to self-employment tax or the net investment income tax (i.e., there is no “third bucket’ that is not subject to either tax).

 (3) S corporation alternative. Alternatively, the investment manager could elect to be classified as an S corporation, and the S corporation could pay a portion of its income as reasonable compensation and the remainder as distributions, that potentially could avoid self-employment tax. What is “reasonable compensation” is a question of fact, though there are certain practitioner rules of thumb that may be followed. There are also several eligibility requirements for a valid election to be an S corporation, some of which may be problematic for an investment manager (e.g., single class of stock requirement; in general only individuals and certain trusts as owners; etc.). Note, under some of the legislative proposals distributions from an S corporation would also be subject to self-employment tax.

 A better alternative, if an S corporation is to be used, may be to have each owner of the investment manager own its interest in the investment manager through its own S corporation; if the investment manager itself is not an S corporation, there would still be flexibility in how the owners of the investment manager are compensated (such as issuing profits interests). 

 State and local taxes, including pass-through entity taxes, also need to be considered if the investment manager (or its owners) are S corporation(s). For example, an S corporation is subject to tax in New York City.

 (4) Incentive fees versus incentive allocation. Some managers, including managers of funds that have made Section 475(f) mark-to-market elections, receive incentive fees. In light of the Soroban case, those managers may want to reconsider whether it is preferable to receive an incentive allocation.

 The industry is still digesting the Soroban case and considering how to proceed for 2023 and beyond with respect to the scope of the limited partner exception. This is a very important tax issue, and our Tax Department is keeping a very close eye on it.  

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If you have any questions regarding the above or any other tax issues, please contact your primary Kleinberg Kaplan attorney or a member of our Tax Department listed below.