The Second Circuit Court of Appeals (court) in Soroban Capital Partners LP v. Commissioner, affirmed a US Tax Court holding that partners who actively manage and control a partnership's business are not "limited partners" for purposes of the IRC Section 1402(a)(13) exception from self-employment tax. The court concluded that Congress intended the exception to apply only to partners functioning as passive investors and not to partners whose activities include managing, operating or controlling the partnership's business.

Facts

Soroban Capital Partners LP (Soroban) is a Delaware limited partnership that served as an investment manager to hedge funds. During the 2016 and 2017 tax years, Soroban allocated approximately $141.5 million of ordinary business income to its three founding principals, who held interests as limited partners. Soroban excluded those distributive shares from net earnings from self-employment (NESE) under IRC Section 1402(a)(13), while treating guaranteed payments made to the principals as subject to self-employment tax.

Following an audit, the IRS determined that the principals did not qualify as limited partners within the meaning of IRC Section 1402(a)(13) because they worked full time in the business and exercised substantial managerial authority. The IRS consequently recharacterized the distributive shares as NESE. The Tax Court agreed with the IRS, first holding that the determination requires a functional analysis and later concluding that the principals were not limited partners because they exercised managerial control over the business (see Tax Alert 2023-2013). The taxpayers appealed.

Law and analysis

IRC Section 1401 imposes self-employment tax on an individual's self-employment income, which generally includes the individual's NESE under IRC Section 1402. In the partnership context, net earnings from self-employment generally include a partner's distributive share of income from a trade or business carried on through a partnership.

The limited-partner exception in IRC Section 1402(a)(13), however, 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.

The principal issue before the court was whether a partner qualifies as a limited partner solely by virtue of being a limited partner entitled to limited liability under state law or whether the partner's actual role in the business must also be considered.

The court rejected the taxpayers' argument that limited liability alone determines limited partner status. Instead, it held that a "limited partner" for purposes of IRC Section 1402(a)(13) means a partner who:

1. Has limited liability for partnership obligations
   And
2. Does not run, manage or control the partnership's business

The court noted that both characteristics were fundamental attributes of limited partners when Congress enacted IRC Section 1402(a)(13) in 1977 and that limited partners historically were understood to be investors who contributed capital but generally did not participate in management of the business.

In the court's view, the statutory phrase "limited partner, as such" limits the exception to income earned in a partner's capacity as a limited partner. Income attributable to management and control of a partnership's business is not earned in that capacity and therefore falls outside the exception.

The court found further support in the overall structure of IRC Section 1402, in which various exclusions from NESE focus on income derived from passive investment rather than active business operations. The court reasoned that the limited partner exception should be interpreted consistently with that broader statutory framework.

According to the court, Congress enacted the Social Security Amendments of 1977 to address concerns that passive investors in limited partnerships could obtain Social Security coverage through minor investment interests rather than through labor-related earnings. The court noted that legislative materials repeatedly described the excluded income as investment-type income and emphasized that Social Security benefits are intended primarily to replace earnings from work.

Based on that history, the court concluded that Congress viewed limited partners as passive investors whose role was distinct from that of partners actively engaged in operating a business. The court therefore determined that extending the exception to partners who manage and control a partnership would be inconsistent with the purpose underlying the statute.

Principals were not limited partners

Applying its interpretation of IRC Section 1402(a)(13), the court agreed with the Tax Court that the three principals did not qualify as limited partners.

The record showed the principals:

• Worked full time in the partnership's business
• Managed investment activities
• Participated in generating partnership income
• Served on governing committees
• Exercised authority over hiring, firing, promotion and employee evaluations
• Oversaw significant aspects of day-to-day operations

The court concluded that the principals exercised managerial control over the partnership and played an essential role in generating its income. As a result, they were not functioning as limited partners within the meaning of IRC Section 1402(a)(13), and their distributive shares constituted NESE subject to self-employment tax.

Partnership-level jurisdiction

The taxpayers also argued that the Tax Court lacked jurisdiction because the determination of whether income constitutes NESE allegedly was not a partnership item subject to Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership-level proceedings.

The Second Circuit rejected that argument and held that NESE is a partnership item for purposes of the TEFRA procedures applicable during the years at issue. The court concluded that determining whether partnership income constitutes NESE affects the characterization and amount of partnership income and therefore is appropriately resolved at the partnership level. Accordingly, the court affirmed the Tax Court's jurisdiction to review the IRS adjustments.

Implications

The Second Circuit in Soroban joins the Tax Court and the Fifth Circuit in adopting a functional approach to the limited partner exception from self-employment tax. While the approaches applied by these courts are similar, they are not identical. The Tax Court and the Second Circuit have adopted a test focused on whether the taxpayer runs, manages or controls the partnership's business. The Fifth Circuit, in K. Alain L.L.L.P. v. Commissioner (No. 24-60240, 5th Circ.), adopted a test that looks to whether the taxpayer played a significant role in running or managing the partnership's business (see Tax Alert 2026-1740). It is unknown if the petitioners in Soroban or K Alain L.L.L.P. will petition the United States Supreme Court for certiorari. In addition, the First Circuit is considering the scope of the limited partner exception in Denham Capital Management LP v. Commissioner (No. 25-1349, 1st Circ.), in which a decision may be issued shortly.

Taxpayers should carefully consider these authorities and consult with their tax advisers in determining how to report their shares of partnership income.