The Second Circuit has affirmed the Tax Court’s rulings against Soroban Capital Partners LP, holding that the firm’s three principals were not “limited partners” for purposes of the self-employment tax exclusion found in I.R.C. § 1402(a)(13), despite formally holding limited partner status under Delaware law. Under the Internal Revenue Code, a partner’s distributive share of partnership income is generally treated as self-employment income subject to the 15.3 percent self-employment tax on income up to $184,500 in 2026 (2.9 percent rate above that threshold), which funds Social Security and Medicare. Section 1402(a)(13), however, excludes from that tax the distributive share of a “limited partner, as such,” other than guaranteed payments for services rendered. This rule also applies to LLCs taxed as partnerships.
Soroban’s three founding principals received roughly $141.5 million in distributive shares over the 2016 and 2017 tax years, which the firm excluded from self-employment income on the theory that the principals were limited partners. The IRS disagreed, reasoning that the principals exercised full managerial control over the firm and could not be treated as limited partners for tax purposes, and issued adjustments increasing Soroban’s taxable income accordingly.
The Second Circuit first rejected Soroban’s argument that the Tax Court lacked jurisdiction to decide the adjustments, holding that net earnings from self-employment qualifies as a partnership item properly determined at the partnership level under the now repealed TEFRA audit procedures. On the merits, the court conducted an extensive review of the term “limited partner” as understood in 1977, when Congress enacted Section 1402(a)(13). The court examined contemporaneous dictionaries, treatises, state limited partnership statutes, and the legislative history of the Social Security Amendments of 1977. The court concluded that a limited partner, for purposes of the statute, must have both limited liability and a lack of managerial control over the partnership’s business. Because Soroban’s principals ran the firm’s day-to-day operations, sat on its governing committees, and made hiring and firing decisions, the court held they did not qualify for the exclusion, regardless of their formal state law title.
Notably, the Second Circuit’s opinion directly acknowledges a split with the Fifth Circuit. In K Alain L.L.L.P. v. Commissioner, the Fifth Circuit held that a limited partner is one who plays no “significant role” in managing or running the business. The Second Circuit suggested the Fifth Circuit approach may not differ dramatically in substance from the Tax Court’s “passive investor” framework, though the two circuits arrived at their tests through different reasoning and with a notable dissent in the Fifth Circuit questioning whether any functional test is appropriate at all. The Second Circuit also noted that a similar case, Denham Capital Management LP v. Commissioner, is currently pending before the First Circuit following oral argument earlier this year.
Given the growing number of circuits weighing in with varying tests and reasoning, this issue appears likely to require resolution by the United States Supreme Court. Partnerships with similarly structured limited partner arrangements should closely monitor developments in the First Circuit and consider reassessing self-employment tax positions for principals who exercise operational control, regardless of their formal partnership designation. For more information about this update, contact Liskow attorneys Leon Rittenberg III, Caroline Lafourcade, and Kevin Naccari, and visit Liskow’s Tax Practice page.