The IRS Continues Winning Self-Employment Contributions Act (SECA) Tax Against Limited Partners in Private Equity and Hedge Funds

Recently, the Internal Revenue Service ("IRS") has successfully asserted that limited partners in private equity and hedge funds that are organized as limited partnerships were subject to tax under the Self-Employment Contributions Act ("SECA"), the self-employment equivalent to the FICA payroll taxes. The recent court wins continue an earlier line of precedent that challenged the same exclusions claimed by owners of limited liability companies ("LLCs") and similar "hybrid" entities.

Internal Revenue Code ("IRC") Section 1401(a)(1) imposes self-employment tax on the "self-employment income" of every individual. An individual's self-employment income is his "net earnings from self-employment," which is broadly defined in IRC Section 1402(a) as:

• the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share . . . of income or loss . . . from any trade or business carried on by a partnership of which he is a member, [subject to numerous exceptions].

One such exception to the SECA tax is the so-called "limited partner exclusion" in IRC Section 1402(a)(13), which excludes "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" from net-earnings from self-employment. That is, pursuant to IRC Section 1402(a)(13), only a limited partner's guaranteed payments for services rendered to or for the partnership are subject to self-employment tax.

In 2011, in Renkemeyer, Campbell & Weaver, LLP v. Commissioner (available here), the US Tax Court examined the applicability of the limited partner exclusion to partners of a limited liability partnership, a group of lawyers. Employing a functional analysis, the Tax Court concluded that the partners, who actively performed services for the partnership (a law firm) in their capacity as partners, were not limited partners for purposes of IRC Section 1402 despite their designation as such under state corporate law. Focusing on the partners' active participation in the partnership's business and the partners' "nominal" capital contributions to the partnership, the court reasoned that the partners were not "generally akin" to passive investors and the partners' distributive shares of the partnership's income "did not arise as a return on the partners' investment." The court held that their distributive shares of partnership income were subject to self-employment tax. Over the years following the Renkemever decision, the Tax Court and other federal courts have engaged in a similar analysis when considering the self-employment tax liability of members in LLCs and similar state-law entities in a variety of service industries.  See, e.g., Castigliola v. Comm'r, T.C. Memo. 2017-62 (professional limited liability company); Hardy v. Comm'r, T.C. Memo. 2017-16 (LLC); Riether v. United States, 919 F. Supp. 2d 1140 (D.N.M. 2012) (LLC); Howell v. Comm'r, T.C. Memo. 2012-303 (LLC).

After these cases, many limited partners in state-law limited partnerships continued to claim the limited partner exclusion, based upon the plain language of the statute. Although the IRS was opposed to this position (indeed, the IRS Large Business & International division has maintained an enforcement campaign regarding this issue since 2018), until 2023, no court had issued an opinion considering the exclusion's applicability to state-law limited partners.

That changed with the Tax Court's opinion in Soroban Capital Partners LP v. Commissioner (available here), which held for the first time that state-law limited partners did not necessarily qualify for the limited partner exclusion and were subject to a functional analysis; the 2023 Soroban opinion did not apply the functional analysis, affording the parties the opportunity to further develop the relevant facts. After Soroban, Tax Court cases involving other state-law limited partners have been decided in favor of the IRS, with the court engaging in a "comprehensive inquiry that [sought] to determine, on account of the pertinent facts and circumstances, whether the [p]artners were 'generally akin' to passive investors." See Denham Cap. Mgmt. LP v. Comm'r, T.C. Memo. 2024-114 at 14 (quoting Renkemeyer, 136 T.C. at 147 – 48) (emphasis in original); see also Sirius Solutions, L.L.L.P. v. Comm'r, No. 30118-21 (T.C. Feb. 20, 2024) (stipulated decision). Last week, the Tax Court issued an opinion applying the functional analysis test and holding that the Soroban limited partners themselves did not qualify for the limited partner exclusion. See Soroban Cap. Partners LP v. Comm'r, T.C. Memo. 2025-52.

This issue is not settled yet. Two of the cases are already on appeal in different circuits, and we expect Soroban to be appealed too. See Denham Cap. Mgmt. LP v. Comm'r, No. 25-1349 (1st Cir.); Sirius Solutions L.L.L.P. v. Comm'r, No. 24-60240 (5th Cir.). There are also several cases involving state-law limited partners pending before the Tax Court. See, e.g., Atalaya Cap. Mgmt. LP v. Comm'r, Docket No. 03253-25; Moon Cap. Mgmt. LP v. Comm'r, Docket No. 01929-25; MKP Cap. Mgmt. LP v. Comm'r, Docket No. 00126-25; Riverstone Equity Partners LP v. Comm'r, Docket No. 17512-24; Point72 Asset Mgmt. LP v. Comm'r, Docket No. 12752-23.

Practice Point

The application of SECA tax to limited partners is not settled. We expect several decisions from appeals to various Circuit Courts of Appeal in the coming years.  In addition, if there are divided appellate decisions, perhaps a request for review by the US Supreme Court.

If you have this issue, expect the IRS to challenge and assert SECA tax if the partner materially participates in the business of the partnership. Consider asking your tax professional to analyze the level of risk you have on this issue under the functional analysis, and if you find the level of risk may be high, prepare for battle with the IRS.

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