On January 12, 2024, the U.S. Department of the Treasury released a new fact sheet that in part reiterates, and revamps, the IRS’ commitment to their initiative of auditing limited partnerships. The release comes after five years of scrutiny in this area and an important court case, resulting in significant impact to limited partners who serve private fund managers.
IRS Focus on Self-Employment Contributions Act and the Soroban Capital Case
In 2018, the IRS began increasing its focus on Self-Employment Contributions Act (SECA) taxes being properly reported by partners who provide services to private funds, yet claim exemption from SECA because they have a limited interest in the partnership.
As part of the ongoing IRS initiative, private fund managers were dealt a tax blow in November 2023 when the United States Tax Court issued an adverse decision against Soroban Capital Partners in Soroban Capital Partners, L.P. v. Commissioner. The three limited partners of Soroban Capital took the position that besides their guaranteed payments, the remainder of their ordinary business income from the partnership was not subject to self-employment income tax. They made this claim under the long-standing provisions of Internal Revenue Code Section 1402(a)(13).
Unlike cases that preceded Soroban, this was the first one related to an asset manager. Prior to this case asset managers were widely seen to be inherently different, in that the partners providing services could serve in two capacities — as a manager and as an investor. In the judges’ decision, they point out that the statute does not define a “limited partner,” saying the legislative intent was meant to exclude income if investment in nature, and that protection under Section 1402(a)(13) will not extend to those who are limited partners in name only.
As a result, the limited partners in Soroban Capital had to perform a functional analysis test, evaluating their roles to determine if they were an active partner and therefore not required to pay self-employment tax. The analysis was composed of a three-prong test, using the 1997 IRS proposed regulations, that would reclassify limited partners for Section 1402(a)(13) purposes if any of the following applies:
- Have personal liability for debts or claims,
- Have authority to contract on behalf of the partnership, OR
- Participate for more than 500 hours during the taxable year.
If the partner failed any of the above functional tests, which all of the Soroban partners did, they would not be treated as a limited partner and must pay SECA taxes.
Importantly, and likely because it was not applicable in their particular situation, the Soroban case does not discuss the portion of the 1997 proposed regulations that allows an individual who is not a limited partner to nonetheless bifurcate and exclude a portion of their distributive share of the partnership. Under this portion of the regulations, the partnership either has to have more than one class of interest or be a truly limited partner or partners under the functional analysis test. In each case, bifurcation of interests would be permitted only if their distributive share equals the distributive share of partners who qualify as limited partners and also own a substantial, continuing interest in the partnership. This portion of the proposed guidelines, while not applicable in the Soroban case, seems to validate the position that asset managers can in fact wear two hats in certain situations.
Currently, a similar U.S. Tax Court case, Denham Capital Management LP et al. v. Commissioner, is waiting to be heard and revolves around equity interest only partners. We await to see how the Court will apply the 1997 proposed regulations in this case, hopefully examining the portion not addressed in Soroban, to provide additional direction on how to navigate this issue moving forward. The IRS has also suggested it intends to issue guidance on the functional analysis test, although that timeline is unknown. Any additional guidance via regulation or case law will affect the asset management community and how limited partnerships can be structured.
In the interim, the Soroban decision has widespread implications across the industry for all limited partners who were previously seeking an exemption of SECA under Section 1402(a)(13), but who failed the functional analysis test and likely no longer have a filing position going forward.
Contact Kristine Bly at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.