A judicial resolution may be near for the unanswered question of whether limited partners in state law limited partnerships may claim exemption from self-employment (SECA) taxes — despite being more than passive investors. Depending on the outcome in the pending Soroban Capital Partners litigation, limited partners in state law limited partnerships who actively participate in the partnership’s business may lose the opportunity to claim this exemption. If this happens, these limited partners would likely become subject to SECA tax on their partnership income.
SECA taxes can be substantial for active partners in profitable partnerships. The SECA tax rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). While the 12.4% social security tax is currently limited to the first $160,200 of self-employment earnings, partners who are subject to SECA tax must pay the 2.9% Medicare part of the tax on their entire net earnings from the partnership. There is also an additional 0.9% Medicare tax on all earnings from the partnership over a certain base amount (currently $125,000; $200,000; or $250,000 depending on the partner’s tax filing status).
Why are some limited partners in jeopardy of losing their SECA tax exemption?
Under Internal Revenue Code Section 1402(a)(13), the distributive share of partnership income allocable to a “limited partner” is generally not subject to SECA tax, other than for guaranteed payments for services rendered. However, the statute does not define “limited partner,” and proposed regulations issued in 1997 that attempted to clarify the rules around the limited partner exclusion have never been finalized.
More recently, courts have held — in favor of the IRS — that members in limited liability companies (LLCs) and partners in limited liability partnerships (LLPs) that are active in the entity’s trade or business are ineligible for the SECA tax exemption. Despite these IRS successes, some continue to claim that state law controls in defining “limited partner” in the case of a state law limited partnership and, therefore, limited partners in state law limited partnerships — even active limited partners — may be eligible for the SECA tax exemption. This issue has yet to be specifically addressed by the courts, but Soroban Capital Partners may be the first case to squarely resolve it.
What is the issue in the Soroban Capital Partners litigation?
The Soroban Capital Partners litigation filed with the Tax Court involves a New York hedge fund management company formed as a Delaware limited partnership. The taxpayers challenge the IRS’s characterization of partnership net income as net earnings from self-employment subject to SECA tax. According to the facts presented, each of the three individual limited partners spent between 2,300 and 2,500 hours working for Soroban, its general partner and various affiliates – suggesting that the limited partners were “active participants” in the partnership’s business.
In its March 2 objection to the taxpayers’ motion for summary judgment, the government contends that the term “limited partner” is a federal tax concept that is determined based on the actions of the partners – not the type of state law entity. Citing previous cases, the government asserts that the determination of limited partner status is a “facts and circumstances inquiry” that requires a “functional analysis.” The taxpayers in Soroban, on the other hand, argue that such a functional analysis does not apply in the case of a state law limited partnership and that, in the case of these partnerships, limited partner status is determined by state law.
Under the functional analysis adopted by the Tax Court in previous cases, to determine who is a limited partner, the court looks at the relationship of the owner to the entity’s business and the factual nature of services the owner provides to the entity’s operations. For the SECA tax exemption to apply, the government states (citing case law), “an owner must not participate actively in the entity’s business operations and must have protection from the entity’s obligations.”
What should limited partners do pending the outcome of the Soroban case?
Limited partners who actively participate in the partnership’s business should review their facts and circumstances and potential exposure to SECA tax. Although there is currently no clear authority precluding active limited partners of a state law limited partnership from claiming exemption from SECA tax, such a position should be taken with caution and a clear understanding of the risks—including being subject to IRS challenge if audited. The IRS continues to focus on scrutinizing such claims through its SECA Tax compliance campaign. Moreover, the opportunity to claim the exemption could be significantly narrowed depending on the outcome of Soroban Capital Partners.
An S corporation could presumably allow shareholders to avoid SECA tax on their share of earnings.
Additionally, since the S corporation would operate a trade or business, any actively participating shareholder should not be subject to the Section 1411 net investment income tax. However, since fund managers would be considered service providers, each shareholder would presumably be required to receive “reasonable compensation.” A requirement to pay reasonable compensation to the shareholders in all years (including years in which the fund does not dispose of an asset) could create cash flow burdens on the S corporation. Additionally, an S corporation can have only a single class of stock, which means all allocations and distributions must be proportionate based on share ownership. This inability to structure more flexible special allocations of income and gain may limit the effectiveness of an S corporation structure. Finally, application of existing clawback provisions would need to considered and managed.
Written by Jeff Bilsky and Neal Weber. Copyright © 2023 BDO USA, LLP. All rights reserved. www.bdo.com