By John T. Murray, CPA, Partner
Recent SECA tax court case decision clarifies meaning of “limited partner”
Since 2018, the Internal Revenue Service (IRS) has focused its attention on activities related to its Self-Employment Contributions Act (SECA) tax campaign. The IRS’s stated goal of the initiative is to improve tax return and issue selection while making the greatest use of limited IRS resources. The SECA tax campaign focuses on law firms, investment funds, and medical practices operating as limited partnerships.
Soroban Capital Partners LP v. Commissioner of Internal Revenue
Soroban Capital Partners, LP (Soroban) is an investment firm operating as a state law limited partnership and subject to the Tax Equity and Fiscal Responsibility Act (TEFRA). The Soroban Capital Partners LP v. Commissioner of Internal Revenue case arose when the IRS challenged the exclusion of three of the firm’s limited partners’ income from self-employment tax, arguing that they were not passive investors but active participants in the business.
The case centered around Section 1402(a)(13) of the Tax Code that states, “limited partners” are not subject to self-employment taxes on their distributive share of the partnership’s income. Specifically, “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.” Focusing on the phrase “limited partner, as such”, the Tax Court determined, “If Congress had intended that limited partners be automatically excluded, it could have simply said ‘limited partner.’ By adding ‘as such,’ Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner.”
On November 28, 2023, the Tax Court ruled in favor of the IRS agreeing that the three Soroban limited partners were not entitled to the self-employment tax exclusion because they were actively involved in the management, operations, and investment decisions of the partnership.
What are the tax implications for limited partnerships?
Pending a potential appeal or other court decision, the Soroban ruling will significantly impact state law limited partnerships, specifically fund managers. Limited partners that are actively involved in the state law limited partnership should analyze their participation in the partnership while considering the functional analysis of their activities, roles, and position in the partnership.
With the Tax Court ruling in favor of the IRS, it is also likely the IRS will expand its focus on tax audits of similarly situated state law limited partnerships.
SECA tax planning for fund managers
The Soban Capital Partners LP case victory in favor of the IRS may result in an expanded compliance initiative by the IRS. Fund managers will want to evaluate their current position on a limited partner’s distributive share and consider alternative structures to address net earnings from self-employment. Restructuring the ownership of Limited Partnership interests for fund managers who are active in the Partnership may provide enough separation between the partner’s investment and the partner’s payments for services that are considered subject to self-employment taxes.
New businesses considering a limited partnership entity selection will want to carefully consider tax implications based on the recent court decision.
More to come…
There are several other similar limited partnership cases pending in Tax Court. We will continue to keep you updated on tax implications or changes as these cases are decided.
Questions on SECA tax compliance for your firm? Contact your Keiter Opportunity Advisor | Email | Call: 804-747-0000.
Sources:
- “Tax Court: Limited Partner Exception to Self-Employment Taxes Is…Limited” | Cozen O’Connor
- “SECA tax audits underway as part of IRS compliance campaigns” | KPMG
- “US Tax Court Decision Opens Limited Partners to Self-Employment Tax Exposure” | Morgan Lewis
- “Tax Court Rules That Limited Partners May Be Subject to Self-Employment Tax” | Troutman Pepper
About the Author
John T. Murray, CPA, Partner
John is a member of the Firm’s Financial Services and Mergers & Acquisitions and Technology industry teams with over 20 years of experience in both the private and public accounting practice areas. He applies his experience to provide insights and identify opportunities for closely-held businesses in the real estate, healthcare, private equity, and government contracting industries. He provides ongoing budgeting, forecasting, cash management, and compensation planning for many of his clients. John also applies his expertise and knowledge in structuring transactions and reviewing proposed acquisitions in order to minimize the tax consequences for his clients that are located throughout the US as well as internationally.
More Insights from John T. MurrayThe information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.
