Functional Analysis Determines Limited Partner Status for Self-Employment Tax Purposes

(Parker Tax Publishing December 2023)

The Tax Court held that the limited partner exception of Code Sec. 1402(a)(13), which excludes from net earnings from self-employment the distributive share of any item of income or loss of a "limited partner, as such," does not apply to a partner who is limited in name only. The court further held that determining whether a partner is limited in name only is a factual determination that requires a functional analysis rather than a determination under state law. Soroban Capital Partners LP v. Comm'r, 161 T.C. No. 12 (2023).

Background

Soroban Capital Partners LP (Soroban) is an investment firm that is organized as a Delaware limited partnership. Soroban is composed of one general partner and five limited partners. However, two of its limited partners are single-member limited liability companies and thus are disregarded for federal income tax purposes. Therefore, for federal income tax purposes, Soroban has three limited partners: Eric Mandleblatt, Guarav Kapadia, and Scott Friedman. For 2016 and 2017, Soroban was subject to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) audit and litigation procedures.

Mandelblatt, Kapadia, and Friedman received guaranteed payments in exchange for providing services to Soroban. On its partnership returns for 2016 and 2017, Soroban reported total net earnings from self-employment representing these guaranteed payments. Soroban also reported the general partner's share of the partnership's ordinary business income. However, Soroban excluded Mandelblatt's, Kapadia's, and Friedman's shares of Soroban's ordinary business income in its computation of net earnings from self-employment. The IRS issued Notices of Final Partnership Administrative Adjustment for the years at issue, increasing Soroban's net earnings from self-employment and gross nonfarm income. Soroban filed a Tax Court petition challenging the IRS's determinations.

Soroban filed a motion for summary judgment, asking the court to find as a matter of law that (1) Code Sec. 1402(a)(13) excludes Mandelblatt's, Kapadia's, and Friedman's shares of Soroban's ordinary business income from net earnings from self-employment and thus excludes those earnings from self-employment tax; or, in the alternative, (2) that any inquiry into a limited partner's role at Soroban does not concern a partnership item and cannot be resolved in a TEFRA partnership-level proceeding. The IRS filed a motion for partial summary judgment asking the court to find as a matter of law that an inquiry into a limited partner's role at Soroban does concern a partnership item and could be resolved in this proceeding.

Code Sec. 1401(a) imposes a tax on the self-employment income of individuals. Self-employment income is defined in Code Sec. 1402(b) as the net earnings from self-employment derived by an individual during any tax year. Under Code Sec. 6031, partnerships are required to determine and report their partners' distributive shares of income, gains, deductions, and credits. Under Code Sec. 702(a)(8), each partner is required to separately take into account their distributive share of the partnership's taxable income or loss, exclusive of items requiring separate computation. Taken together, these Code sections require partners to include their distributive shares of partnership income in net earnings from self-employment.

But there are exceptions to this rule. Specifically, Code Sec. 1402(a)(13) contains a limited partner exception that excludes from net earnings from self-employment "the distributive share of any item of income or loss of a limited partner, as such," other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are in the nature of remuneration for those services. Code Sec. 1402(a)(13) does not define the phrase "limited partner, as such."

In Renkemeyer, Campbell, & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), the Tax Court was called upon to determine the scope of the limited partner exception. The court applied statutory construction principles to determine whether partners in a limited liability partnership (LLP) should be considered limited partners under Code Sec. 1402(a)(13). The court concluded that the statute's intent "was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations ... would not receive credits towards Social Security coverage." In addition, the court found that Congress did not contemplate excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes. Lastly, the court held that the partners in that case were not limited partners for purposes of Code Sec. 1402(a)(13) because their distributive shares arose from legal services performed on behalf of the law firm and not as a return on the partners' investments.

Soroban contended that Mandelblatt, Kapadia, and Friedman were state law limited partners and therefore their distributive shares of income were excluded from net earnings from self-employment under Code Sec. 1402(a)(13). Soroban relied on legislative history to support its argument that the phrase "limited partner, as such" means a limited partner under state law. For example, Soroban cited a footnote from a Joint Committee on Taxation report stating that "limited partner status is determined under State law." Soroban also pointed to the instructions for the Form 1065, which state: "A limited partner is a partner in a partnership formed under a state limited partnership law, whose personal liability for partnership debts is limited to the amount of money or other property that the partner contributed or is required to contribute to the partnership." In discussion of self-employment tax, the instructions state: "Generally, a limited partner's share of partnership income (loss) isn't included in net earnings (loss) from self-employment."

Analysis

The Tax Court held that a functional analysis test must be applied to determine whether a partner in a state law limited partnership is a "limited partner, as such" for purposes of Code Sec. 1402(a)(13).

The court noted that in Renkemeyer it specifically applied a functional analysis test to determine whether the limited partner exception applied. But that case specifically dealt with an LLP and not a limited partnership as present here. The court observed that, while subsequent opinions have applied Renkemeyer to determine whether taxpayers in passthrough entities are limited partners under Code Sec. 1402(a)(13), the Tax Court has not addressed whether a limited partner in a state law limited partnership must satisfy a functional analysis test to be entitled to the limited partner exception. The court agreed with the IRS that the distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from self-employment income and that a functional analysis test should be applied when determining whether Code Sec. 1402(a)(13) applies to limited partners in state law limited partnerships.

The court found, based on its interpretation of the language of Code Sec. 1402(a)(13), that the limited partner exception does not apply to a partner who is limited in name only. The court reasoned that if Congress had intended that limited partners be automatically excluded, it could have simply used the term "limited partner." By adding "as such," Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner. In the court's view, Soroban's reliance on legislative history to overcome the plain meaning of the statute was unavailing. The court said that to the extent legislative history might be used to shed light on the meaning of the phrase "limited partner, as such," it confirmed the court's conclusion. Congress enacted Code Sec. 1402(a)(13), the court found, to exclude earnings from a mere investment. It intended for the phrase "limited partners, as such" used in Code Sec. 1402(a)(13) to refer to passive investors.

The court noted that the Joint Committee Report relied on by Soroban addressed only the meaning of the words "limited partner" and not the phrase "limited partner, as such." The court reasoned that those latter words narrow the scope of the limited partner exception, which the Joint Committee Report did not address. The court also disagreed with Soroban's argument that the Form 1065 instructions supported its definition. The court found that the word "generally" in the discussion of self-employment tax in the instructions made clear that it is not always true that a limited partner's share of partnership income is excluded from net earnings from self-employment.

Next, the court found that the examination of the functions and roles of a limited partner to determine whether their shares of earnings are excluded from net earnings from self-employment must happen in the present partnership-level proceedings rather than a later partner-level proceeding. The court found that a functional inquiry into the roles and activities of Soroban's individual partners as required by Code Sec. 1402(a)(13) involves factual determinations that are necessary to determine Soroban's aggregate amount of net earnings from self-employment. Accordingly, the court found that the functional inquiry into their roles is a partnership item and appropriate for these proceedings. The court therefore denied Soroban's motion for summary judgment and granted the IRS's motion for partial summary judgment.

For a discussion of the limited partner exception, see Parker Tax ¶20,590.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com