In a widely anticipated decision, the Court of Appeals for the Second Circuit today issued its opinion in Soroban Capital Partners LP v. Commissioner, addressing the definition of a “limited partner” that is exempt from self-employment tax on their allocated income from a partnership.
This issue has come before several circuit courts of appeal, including a still-undecided First Circuit case (Denham Capital Management LP v. Commissioner) and a recently re-decided Fifth Circuit case (Sirius Solutions/K Alain). Ultimately, the Second Circuit ruled against the taxpayer, holding that a “limited partner” does not depend solely on state law limited liability. Instead, the court held that a limited partner is a partner who “in addition to having limited liability, does not run, manage, or control the partnership's business.”
Background
As in the other cases, the taxpayer in Soroban argued that as long as a “limited partner”—in this case, the three principals of an investment manager—carries limited liability with respect to their partnership interests, and is in form a limited partner, then the limited partner exclusion on distributive share of partnership income from self-employment tax should apply. The government has consistently maintained that limited liability alone is not sufficient, and partners who participate in the business of the partnership cannot avail themselves of the exclusion.
The Tax Court agreed with the government, applying a “functional analysis” test to determine that the three principals in Soroban were not acting as limited partners, notwithstanding their limited liability. Among other factors, the Tax Court analyzed the amount of time the principals dedicated to the business, the various management functions they carried out, their role in generating income of the business, and the amount of income they were allocated as compared to their capital contributions, ultimately determining that they were not acting as limited partners with respect to the partnership. The taxpayer appealed this holding to the Second Circuit.
The holding
While the Second Circuit ultimately affirmed the Tax Court in result, their reasoning appears on first read to differ. The Tax Court described its “functional analysis” as a “…comprehensive inquiry into whether a [partner is] ‘generally akin’ to a passive investor.” While the Second Circuit does reference the passive investment principle in its historical analysis of the limited partner exception, it does make it clear that a partner can provide services to a partnership and still benefit from the self-employment income exclusion, as long as those services do not constitute controlling, managing or running the business. While the Second Circuit also makes significant reference to the three principals having “played an essential role in generating [Soroban]’s income,” it is not clear that this by itself would also disqualify a state-law limited partner from the exclusion.
This holding, and its supporting analysis — derived from a historical analysis of what a limited partner could or could not do when the self-employment income exclusion was enacted in 1977 — is very similar to the Fifth Circuit’s holding in K Alain. Interestingly, the Second Circuit, similar to the Fifth Circuit in K Alain, expressly acknowledged that a partner may perform some services and still qualify for the limited partner exclusion – provided “the activities in question do not constitute controlling, managing, or running the business.”
However, a potentially significant distinction is that the Second Circuit appears to require both “limited liability” and a lack of “managerial control” to qualify for the exclusion, and the Fifth Circuit only explicitly required that a partner “play no significant role in managing or running the business.”
Procedural asides
In addition to the substantive issue, the Second Circuit also addressed whether the Tax Court had jurisdiction to decide this case in the first place, under the partnership procedural regime applicable to the years in question (the TEFRA rules). While ultimately the Second Circuit did agree that the Tax Court had jurisdiction, the TEFRA rules have since been replaced by a new regime under the Bipartisan Budget Act of 2015 (the BBA), and so the continued relevance of this part of the opinion is limited.
Closing thoughts
This is a significant adverse ruling for taxpayers who may have relied on limited liability alone in determining the amounts exempt from self-employment tax under the “limited partner” exception. As discussed previously, one additional case is still pending before the First Circuit, and any of the three cases may be appealed to the U.S. Supreme Court, which may or may not agree to hear an appeal. In the meantime, taxpayers should consult with their tax advisors to understand how this latest decision will impact them.
