In Denham Capital Management LP et al. v. Commissioner, T.C. Memo 2024-114 (December 23, 2024), the Tax Court has held that the distributive shares of five limited partners in a private equity firm did not qualify for the limited partner exception to self-employment tax in IRC Section 1402(a)(13) and were includable in the firm's net earnings from self-employment (NESE). The court applied the functional inquiry test from its holding in Soroban Capital Partners LP et al. v. Commissioner, 161 T.C. 12 (November 28, 2023) to deny the limited partner exception because the partners were "limited in name only."

Background

Denham Capital Management (Denham) had a traditional GP/LP structure. Denham GP is the tax matters partner and general partner of Denham LP (Denham), a Delaware limited liability company that elected to be treated as a partnership and is organized as a limited partnership under Delaware law to provide investment and advisory management services to affiliated private equity funds that invest in the energy sector. During the years at issue, Denham had five limited partners who functioned in a manner similar to Denham's employees and were subject to the same general policies and procedures.

While Denham's limited partnership agreement (LPA) vested all management authority in Denham GP, all partners were voting members during the years in question. Denham's limited partners had authority to the extent delegated to them, which allowed them in 2013 to execute any agreement or document on Denham's behalf. With the exception of $8 million contributed by the founding partner, no other capital contributions were made in exchange for limited partnership interests and the LPA required each limited partner to devote substantially "all of [their] business time and attention to the affairs of "Denham" and its affiliates."

In 2016 and 2017, Denham made guaranteed payments and capital distributions to the partners and Denham GP. The modest guaranteed payments were intended to represent the partners' salaries and included the value of a package of typical employment benefits. The distributions to the partners varied from year to year because they were tied to their distributive shares of Denham's income and calculated on the basis of their profits interests, with no guaranteed minimums.

When computing the partners' NESE, Denham included their guaranteed payments (Schedule K-1, Line 4) but excluded the distributive shares of Denham's ordinary business income (Schedule K-1, Line 1). Denham reported total NESE of $1,778,532 and $1,395,001 for 2016 and 2017, respectively. On March 27, 2023, the IRS issued Final Partnership Administrative Adjustments for 2016 and 2017, increasing Denham's NESE to $29,253,718 and $24,314,415, respectively.

Law and analysis

IRC Section 1402(a) defines net earnings from self-employment to include:

the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by [subtitle A] which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in IRC Section 702(a)(8) from any trade or business carried on by a partnership of which he is a member … .

IRC Section 1402(a)(13), commonly referred to as the limited partner exception, excludes from NESE:

[the] distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in IRC 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 of those services …

In Soroban Capital Partners LP v. Commissioner, the court held that it had jurisdiction to determine a state law limited partner's status for the purpose of applying the limited partner exception in partnership-level proceedings, and that the determinations require a functional analysis inquiry to determine the roles and responsibilities of partners to determine their tax status. Before Soroban, the court applied the functional analysis test from Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), in which the court held that limited partner status was akin to passive investment status and simply maintaining limited liability status was not enough to satisfy the requirement of IRC Section 1402(a)(13).

The court in Renkemeyer looked to how partnership income was derived and found that it was received in exchange for legal services performed by the partners and that each of the partners participated in management of the firm and contributed only a nominal amount of capital for their respective shares. In that situation, the court held, the partners' distributive shares were not a return on investment, but rather earned from the provision of legal services performed on behalf of the partnership. The holding in Renkemeyer was not affected by the fact that the partners failed to comply with state partnership law formalities.

According to the court, the time, skill and judgment of the partners were essential for Denham to generate approximately $130 million of fees in exchange for services during the two years in question, a large portion of which was distributed to the partners as profits. The court disagreed with Denham's assertion that the distributions were returns on investments, given that only one of the partners had made a capital contribution to acquire their interest. Furthermore, the court noted, the distributive shares were multiple times larger than the guaranteed payments in both years.

A partner's small investment relative to income earned from services provided is not sufficient to classify a partner's distributive share as a return on investment, the court said. While the founding partner made a capital contribution to the partnership, the court held that even he could not be considered a passive investor given the size of his investment compared to the substantial fees he earned and the central role he played in generating them.

The court further noted that the LPA's requirement that partners devote substantially all of their business time and attention to the affairs of the partnership, and that they did, was evidence they each treated their work for Denham as their full-time employment and not merely a passive investment. Marketing materials further made clear that the partners had a significant role in Denham's operation, and it was the partners who solicited capital commitments.

The court also observed that each partner maintained significant control over personnel decisions, which was further evidence that they were active and fundamental contributors to Denham's operation. In addition, a sizable number of Denham employees were scheduled to receive total compensation exceeding the partners' guaranteed payments, which indicated that the guaranteed payments were not designed to adequately compensate the partners for the value of their services, the court said.

The court finally noted Denham would not exist without the partners. In addition, the court found the partners' directional and strategic guidance drew investors to Denham and is the reason Denham has maintained its success. While employees provided support to carry out the partners' guidance, none were authorized to make investment decisions for the funds. According to the court, individuals serving in roles as integral to their partnerships as those the partners served for Denham cannot be said to be merely passive investors.

Because the court ultimately determined that the partners were operating Denham's business as self-employed persons, rather than acting as limited partners as envisioned under IRC Section

1402(a)(13), Denham was prohibited from excluding the partners' distributive shares from its NESE.

Implications

In applying the judicially created "passive investor" test, the Tax Court effectively looked to the substance of the economic arrangement among the partners, rather than the form. As this test is not explicitly written into the statute, controversy is likely to continue over the extent to which the IRS and courts can apply it.

The Tax Court's decision to follow Soroban indicates that its position on this issue is fully developed. As such, it will be interesting to see the outcome in the Sirius Solutions,¹ for which the Fifth Circuit heard oral arguments on February 6, 2025.