US Tax Court Will Weigh In on Self-Employment Tax for Limited Partners

Private equity, hedge fund, and other investment fund sponsors should be aware that there continue to be significant developments in the Internal Revenue Service's (IRS’s) audit campaign with respect to the potential liability for Self-Employment Contributions Act (SECA) tax of investment professionals through their limited partnership interests in fund management vehicles. In addition to numerous ongoing IRS tax audits, there are two pending cases docketed in the US Tax Court that may provide long-awaited clarity to partnerships and their limited partners currently facing or anticipating an IRS examination related to the application of the SECA tax to limited partners’ distributive shares from a partnership.

LP Exception

In 2018, the IRS launched its SECA tax “compliance campaign,” and began opening issue-based examinations focusing its audit attention on limited partnerships—e.g., state law limited partnerships (LPs), limited liability companies (LLCs), limited liability partnerships (LLPs), and limited liability limited partnership (LLLPs)—operating in the asset management, financial services, private equity, and hedge fund industries.

The IRS asserts that the limited partners in these partnerships provide services to the partnership and thus should be subject to SECA taxes on their annual allocations of partnership earnings at the current self-employment tax rate of 15.3%. The IRS's position is in direct opposition to a reporting position that limited partnerships and their partners have taken for decades: that limited partner interests are explicitly exempted from SECA taxes under Internal Revenue Code Section 1402(a)(13) (the LP Exception).

The LP Exception provides that a limited partner’s distributive share of partnership income or loss generally isn’t subject to SECA taxes. This exclusion does not apply to guaranteed payments that a limited partner receives for services rendered to the partnership. Because the statute does not define the term “limited partner,” the question of whom it covers has become more complicated with the introduction of new types of state law entities, such as LLCs and LLPs. The IRS continues to audit limited partnerships, opening new examinations with regularity and proposing the imposition of SECA taxes on limited partners’ annual allocations.

While the LP Exception was enacted more than four decades ago, there is no specific authority that provides that a partner who is a limited partner for state law purposes somehow would not qualify for the LP Exception. However, two cases that are currently docketed will apparently force the US Tax Court to address this issue.

Pending Tax Court Cases

In Soroban Capital Partners LP v. Commissioner, a New York hedge fund manager filed a motion for summary judgment on February 7 asking the Tax Court to rule that limited partners in a state law limited partnership are exempt from SECA taxes on their annual distributive share of allocations under the LP Exception.

In opposition, the IRS argues that the proliferation of new pass-through entity types, including state law LLCs, LLPs, and LLLPs, complicates enforcement. The IRS calls for the application of a “functional test,” which would determine whether limited partners in a partnership or entity treated as a partnership for US federal income tax purposes should be subject to SECA taxes by looking at the nature of their activities in the partnership, rather than only the nature of their partnership interest. In other words, the IRS argues in essence that only silent or passive investors qualify for the LP Exception. Ironically, the IRS has historically argued that qualification under state law as a limited partner was key to the application of the LP Exception.

The Soroban filings follow closely on the heels of a summary judgment briefing in another case, Sirius Solutions, LLLP v. Commissioner, which involves the application of the LP Exception to an LLLP. Notably, an LLLP is generally formed under a state’s limited partnership statute, and so an LLLP would appear to fall within the LP Exception.

In cases such as Sirius Solutions that involve a pass-through entity other than an LP, such as an LLC, LLP, or LLLP, the IRS has argued that because there is not a general partner as a matter of state law, the members cannot truly be “limited partners” and, accordingly, they should not be considered limited partners for SECA purposes either.

The Tax Court denied summary judgment in Sirius Solutions and scheduled the case for trial in June 2024.

SECA Campaign Audits

Although the SECA campaign has been underway for nearly five years, the IRS does not appear to have developed a plan to address issues or problems that have arisen during that time. As recently as February 1, 2023, an IRS executive noted that while no additional guidance on the LP Exception to the SECA tax was forthcoming at this time, the IRS will continue to conduct SECA tax examinations and will base its next steps on audit outcomes.

Over the last five years of audit activity under the SECA campaign, the IRS has focused on several themes, such as the activities of certain limited partners and the presence and amount of capital contributions. This focus often ignores the partnership’s specific facts, business operations, and other regulatory or contractual realities that guide decision-making and partnership structuring. Whether faced with an IRS audit or simply seeking to manage audit risk, partnerships and their limited partners should familiarize themselves with the IRS’s principal areas of focus and ongoing litigation in this area. Additionally, they should know how to best present their specific facts, the nature of their business operations, and their regulatory and contractual limitations to most successfully argue that they are exempt from the application of SECA tax—not only as a statutory matter though the LP Exception, but functionally as well.

Looking Forward

Keeping abreast of these cases is critical to strategically handling ongoing or anticipated IRS SECA tax audits. The IRS’s commitment to continuing the SECA campaign and the recent emphasis by both the IRS and the Biden administration on increased examinations of partnerships and high-net-worth individuals—as well as the recent allocation of additional IRS enforcement funding through the Inflation Reduction Act (IRA) totaling $47.6 billion and the administration’s 2024 revenue proposals seeking an additional $29.1 billion to continue IRA-funded enforcement and compliance initiatives—mean these examinations are not likely to let up in the near term.