Over the past several years, many taxpayers, including investment fund managers, have carefully scrutinized developments in several cases exploring the application of the self-employment tax (SE tax) to limited partners. The statutory text, found in Section 1402(a)(13) of the Internal Revenue Code, provides an exception to the SE tax for certain limited partners (the LP exception). In late 2023, the Tax Court established a functional analysis for evaluating the eligibility of a partner for the LP exception in Soroban Capital Partners LP v. Commissioner (161 T.C. No. 12), but the court hadn’t yet decided on the proper status of Soroban’s LPs. More recently, that court applied the functional analysis to the limited partners of Denham Capital Management LP (T.C. Memo. 2024-114) and found that the partners in question weren’t eligible for the LP exception. The Denham case provides additional insight for investment fund managers and other service partnerships to consider when evaluating their own eligibility for the LP exception.
Background: The limited partner exception
Self-employment income includes a partners’ share of net income from a trade or business of which they are a partner. However, Section 1402(a)(13) of the Code states “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments”. This provision was enacted in 1977 with the goal of exempting income that was more akin to investment income. While the provision exempted limited partner income from SE tax, it also prevented it from being included in Social Security determinations. However, the term “limited partner” wasn’t defined in either statute or regulations. As a result, many have suggested the state law definition of limited partner is the appropriate benchmark for determining whether the LP exception applied, regardless of the rights and actions of the limited partner.
Denham Capital and the application of the functional analysis
In late December 2024, in a memorandum opinion, the Tax Court reemphasized its conclusion in Soroban that a functional analysis should apply to a determine whether a partner should qualify for the LP exception. The court then applied the functional analysis to the limited partners of Denham Capital Management LP determining five partners were “active and fundamental contributors” to the partnership rather than mere passive investors. This made them ineligible for the LP exception so all of their income from Denham was subject to SE tax.
In the court’s discussion of the functional analysis, it detailed a number of important observations about the partners’ activities before concluding that “individuals that serve roles as integral to their partnerships as those the Partners served for Denham cannot be said to be merely passive investors.” Key facts included:
- Denham’s sole source of income was service-based fees for advising and operating private investments funds.
- The partners’ “time, skills, and judgment” were essential to soliciting fund investors and generating related fees.
- Only one partner made a capital contribution in exchange for his interest.
- Guaranteed payments were small relative to “returns on investment” and related distributions.
- Four of five partners treated Denham as their full-time employment, and all served in management, participated in the firm’s investment and valuation committees, and exercised control over personnel decisions.
- Many of Denham’s employees were entitled to receive total compensation greater than the guaranteed payments made to each of the partners.
The opinion is noteworthy because it represents the first time the court has applied a functional analysis to the partners of a limited partnership or to an investment fund manager. While memorandum opinions are generally not considered precedential, Soroban was a full opinion that was precedential. In Denham, the court continually emphasized the fact that it views Soroban and other earlier SE tax cases as “settled precedent” and that “[w]e see no special justification to revisit Soroban's reasoning.”
Other legal developments with the LP exception
Despite the Tax Court’s cool reception to Denham’s positions, other taxpayers continue to litigate these issues. Another case, Sirius Solutions LLLP v. Commissioner, is currently on appeal to the Fifth Circuit. Sirius’ strategy was to sidestep the Tax Court by simply conceding that it failed the functional analysis in Soroban so that it could challenge the functional analysis itself in front of the Fifth Circuit. Sirius is asserting that the SE tax statute is unambiguous and that every limited partner should be excepted from SE tax so the creation of a functional analysis is inappropriate. Oral arguments in the case occurred in February 2025, and the pending decision will likely provide additional clarity about the application of the LP exception since the Fifth Circuit is not bound by any precedent in the Tax Court. It also seems likely that Denham will be appealed to the First Circuit.
There are a number of other cases on the LP exception pending in the Tax Court. While it seems unlikely that the Tax Court will move away from its view in those cases, they will still be helpful to other taxpayers by providing insights into how the Court applies the functional analysis to other facts.
The IRS and Treasury have also continued their work on proposed regulations on the LP exception. While the project is still on the priority guidance plan of the IRS, the Treasury Department under the Trump administration have not indicated how they feel about the project, so it’s still unclear if or when any regulations will be issued. However, one data point is that the Trump administration’s Department of Justice handled the oral arguments in Sirius and didn’t change its previous view on that issue in those arguments.
Looking ahead: How should taxpayers respond to LP exception uncertainty?
Taxpayers now have additional data points to consider when evaluating the application of the LP exception. While Denham might not have been a precedential opinion, it’s certainly not a favorable development.
Partnerships relying on the LP exception ought to carefully consider their facts and circumstances in concluding on their tax position. Taxpayers with fact patterns similar to Denham should discuss appropriate reporting of self-employment income with their tax advisors. At a minimum, it seems that where limited partners provide substantial services to partnerships, adequacy of guaranteed payments paid for services ought to be reevaluated. These partnerships might also consider whether any other changes to their operations could be warranted to improve their facts if a functional analysis was performed. They should also understand how they would manage the cashflow implications and costs associated with any changes in tax positions or disputes with the IRS to ensure that there is adequate preparation for whatever the next development in this area may be.
