Social Security taxes in the U.S. are primarily governed by two legislative frameworks: the Federal Insurance Contributions Act (FICA) for employees and employers, and the Self-Employed Contributions Act (SECA) for self-employed individuals. While FICA is widely understood due to its prevalence in traditional employment, SECA tax has particular implications for self-employed individuals, including partners in certain business structures.
For those operating as self-employed individuals, SECA tax mandates contributions towards Social Security (12.4%) and Medicare (2.9%) based on their net earnings from self-employment. This tax applies to “self-employment income,” legally defined as “net earnings from self-employment” (NESE). NESE encompasses gross income from any trade or business, minus allowable deductions, and crucially includes a partner’s share of partnership income from a trade or business, as outlined in section 702(a)(8) of the tax code.
However, a significant exception exists under section 1402(a)(13), known as the “Limited Partner Exception.” This provision excludes from NESE “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments.” Introduced in 1977, this exception was initially designed to prevent the misuse of Social Security by individuals deriving passive investment income from limited partnerships, as Social Security was intended to replace earnings from active work.
The ambiguity lies in the undefined term “limited partner” within section 1402(a)(13). Despite attempts by the IRS to clarify this definition through regulations in 1994 (later withdrawn) and proposed regulations in 1997, no definitive guidance has been established. The 1997 proposed regulations suggested that partners in entities offering limited liability, who did not actively participate in the business for more than 500 hours annually, could qualify as limited partners. However, legislative action in 1997 prevented these regulations from being finalized, and the definition remains contested.
Soroban Capital Partners and the IRS Challenge
Soroban Capital Partners LP (SCP), a hedge fund structured as a Delaware limited partnership and treated as a partnership for federal income tax purposes, became central to a recent tax dispute. SCP’s structure included a general partner and several limited partners. While the general partner held operational authority, some limited partners had significant roles, including one serving as managing partner and chief investment officer.
SCP classified guaranteed payments and the general partner’s share of ordinary business income as subject to SECA tax. However, it did not apply SECA tax to the limited partners’ share of ordinary business income. The IRS challenged this treatment, arguing that the Limited Partner Exception should not apply, thus subjecting the limited partners’ income to SECA tax.
The Tax Court’s Focus on Functional Analysis
Soroban Capital Partners sought summary judgment, asserting that its partners, being limited partners in a state law limited partnership, should automatically qualify for the Limited Partner Exception. The IRS countered that merely holding limited partner status under state law was insufficient for SECA tax exemption. The IRS advocated for a “functional analysis test,” drawing from the precedent set in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, to determine if individuals truly act as limited partners for the purpose of section 1402(a)(13).
The Tax Court agreed with the IRS, focusing on whether SCP’s limited partners were “limited partners, as such” under section 1402(a)(13), which would dictate the inclusion or exclusion of their income from NESE. While the Tax Court addressed other issues, the crux of the matter revolved around the Limited Partner Exception.
Referencing the Renkemeyer case, which involved law firm partners in a limited liability partnership (LLP) claiming SECA tax exemption, the Tax Court emphasized the legislative intent behind section 1402(a)(13). In Renkemeyer, the court concluded that the exception was intended for “individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations.” The court in Renkemeyer determined that the LLP partners did not qualify as limited partners because their income was derived from legal services, not merely from capital investment. This established a functional analysis approach, examining the actual roles and activities of partners to distinguish between investors and service providers.
Applying this functional analysis in Soroban, the Tax Court denied SCP’s motion for summary judgment. It ruled that a functional analysis, as used in Renkemeyer, was necessary to ascertain whether the Limited Partner Exception applied to SCP’s limited partners. The court did not conduct this analysis in its ruling on the summary judgment motion, leaving the factual determination for further proceedings.
Implications and What Fund Managers Should Consider
The Soroban case outcome is particularly relevant for investment funds, where partnership structures are common. The fact that a limited partner also served as managing partner and chief investment officer at Soroban Capital Partners highlights the complexity of modern fund management roles. Titles held by other limited partners, such as “co-founder” and “co-managing partner,” further suggest active involvement in the fund’s operations.
Given the prevalence of management fees in the fund industry, often calculated as a percentage of investor capital commitments, the Soroban case has significant implications for structuring fund management entities and general partner arrangements. The lack of clear IRS guidance has led to diverse interpretations of section 1402(a)(13) among fund managers. Some have relied on state law limited partnership classifications to claim SECA tax exemption for limited partners, mirroring SCP’s initial position. Others have unofficially adhered to the 1997 proposed regulations.
In light of the Soroban ruling, fund managers should reassess their tax positions regarding section 1402(a)(13). This includes evaluating their risk exposure and considering mitigation strategies. Those who have been following the 1997 proposed regulations might benefit from documenting their tax positions and recording the time spent by each limited partner in the business.
The IRS had already identified SECA tax compliance as an area of focus in its 2018 compliance campaign. The preliminary victory in Soroban suggests increased IRS scrutiny on this issue during audits. However, it’s important to note that Soroban is not the final verdict. The decision could be appealed, potentially leading to differing opinions across circuit courts.
Taxpayers should closely monitor upcoming IRS guidance on section 1402(a)(13). The IRS’s 2023-2024 Priority Guidance Plan already included this topic, and the Soroban ruling might expedite the issuance of formal guidance before the 2024 presidential election. For now, the Soroban Capital Partners case serves as a critical reminder of the functional analysis approach in determining SECA tax liabilities for limited partners in investment partnerships.
