On Nov. 28, 2023, the Tax Court held that to determine whether the distributive share of partnership profits of a state-law limited partner qualifies for the exception from self-employment tax in Sec. 1402(a)(13), the limited partner’s function and role in the partnership must be examined. This ruling, coming in the case of Soroban Capital Partners, was the court’s initial decision on the nature or scope of the limited partner exclusion in the case of a limited partnership.

The precedential opinion in Soroban, made on cross-motions for summary judgment, did not perform the prescribed functional analysis. Exactly what functional analysis may be required will presumably be determined in further proceedings in the case. This article explores the two main possibilities and concludes that a test based on the limited partner’s control over the operations of the limited partnership is the more appropriate inquiry.

Background

Sec. 1401(a) imposes a tax on the self-employment income of individuals.  Self-employment income is defined as “the net earnings from self-employment derived by an individual … during any taxable year.” Sec. 1402(a) in turn defines net earnings from self-employment as:

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

Taken together, these sections require partners to include their distributive shares of partnership income profits in net earnings from self-employment. However, Sec. 1402(a)(13) contains an exception to the imposition of self-employment tax for “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in 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 for those services” (emphasis added).

Sec. 1402(a)(13) does not define the phrase “limited partner, as such.” However, the legislative history of the subsection reveals that, when this subsection was enacted, Congress intended to exclude the distributive share of partnership net income of limited partners from the Social Security system — exempting that income from self-employment taxes but also precluding it from generating any future retirement benefits, the value of which at that time was considered to exceed the incurrence of self-employment tax. For certain limited partners seeking to qualify for Social Security benefits with modest amounts of partnership income, this provision closed what Congress considered a potential loophole — by keeping limited partner income from qualifying the limited partner for Social Security benefits.

Five decades since the enactment of Sec. 1402(a)(13), however, changes have made the present costs of inclusion in the Social Security system less attractive for many taxpayers. Instead of seeking to pay self-employment tax in order to partake in the future benefits of the Social Security system, they have sought to avoid self-employment taxes. Thus, Sec. 1402(a)(13) became regarded not as a “loophole closer,” but as a provision that could protect certain income from Social Security taxes. In a sense, the provision transformed from a loophole closer into something perceived as a loophole.

If the functional analysis demanded by the Tax Court in Soroban adheres to the purpose of Sec. 1402(a)(13) as set forth in the legislative history, the provision will be construed broadly to exclude most limited partners from self-employment tax — and thus the benefits of the Social Security system.

Soroban and possible factors

Soroban involved a limited partnership subject to the TEFRA regime. The IRS adjusted the partnership’s net earnings from self-employment, taking the position that the limited partners did not qualify for the Sec. 1402(a)(13) exclusion because they were limited partners in name only. Disputing the self-employment tax adjustments, the partnership filed a petition in the Tax Court.

The Tax Court concluded that in order to determine whether a putative state-law limited partner — i.e., one designated under the documents governing the limited partnership and who purports to be a limited partner under the law — qualified as a “limited partner, as such” under Sec. 1402(a)(13), “we must examine the functions and roles of the limited partners in the partnership to determine whether their shares of earnings are excluded from net earnings from self-employment.”

The remainder of this article focuses on what Soroban’s prescribed functional analysis may or should entail. As a threshold matter, the functions and roles that might tend to disqualify a state-law limited partner from qualifying as a limited partner under Sec. 1402(a)(13) should be separated from the functions and roles that do not exclude a state-law limited partner from the protection of Sec. 1402(a)(13).

On its face, Sec. 1402(a)(13) directs that the mere provision of services to the limited partnership by a limited partner would not deny the limited partner the exclusion of his or her distributive share of partnership profits from self-employment tax. As quoted above, the exclusion applies to a limited partner’s distributive share other than any portion that is both (1) a guaranteed payment described in Sec. 707(c) and (2) remuneration for services actually rendered to the partnership. Thus, the statute contemplates that in some cases limited partners would provide services to their partnerships and that the limited partner’s remuneration for those services would not be a guaranteed payment. Otherwise, there would be no reason for the statute to require that payments excepted from the exclusion be guaranteed payments. Thus, under the terms of Sec. 1402(a)(13), the portion of the partner’s distributive share that is remuneration for services but is not a guaranteed payment must be excluded from the partner’s self-employment income. That is because that portion of the distributive share is not excepted from the general rule of exclusion.

The statute’s acknowledgment that limited partners can provide services to the limited partnership without falling outside the exclusion implies that a court must focus on more than merely the activities of the limited partner when performing the functional analysis called for in Soroban.

In seeking to understand what Soroban’s functional analysis may or should entail, the discussion below first examines the Revised Uniform Limited Partnership Act, then explores cases applying Sec. 1402(a)(13)’s limited partner exception to limited liability partnerships (LLPs) and professional limited liability companies (PLLCs), and finally looks at a regulation that Treasury proposed in 1997 to define the scope of Sec. 1402(a)(13).

Revised Uniform Limited Partnership Act

A fundamental premise of tax law is that state law creates property rights and interests, while federal law governs the tax treatment of those property rights. Since each U.S. state has its own laws, the exact meaning of “limited partner” may vary slightly from state to state. Thus, a review of the activities and roles that would exclude a partner from qualifying as a limited partner in a state-law limited partnership should be instructive. If a partner does not qualify as a limited partner under state law, it is reasonable to assume that the partner would not qualify as a “limited partner, as such” under Sec. 1402(a)(13).

When faced with the question of whether a putative limited partner should retain or be stripped of their status as a limited partner, state laws have focused on whether a limited partner has control over the business of a limited partnership. If the person exercises control, they may be denied treatment as a limited partner based on the state’s version of the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA). Most relevant to Soroban’s functional analysis is the version in effect in 1977, when Sec. 1402(a) (13) was enacted.

Prior to a revision in 2001, Section 303(a) of RULPA (1976) stated that a limited partner shall not lose limited liability and become liable as a general partner unless, “in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business.” With respect to the meaning of “control,” Section 303(b) of RULPA (1976) provided that a limited partner does not participate in the control of the business solely by doing one or more of the following:

(1) being a contractor for or an agent or employee of the limited partnership or of a general partner or being an officer, director, or shareholder of a general partner that is a corporation;

(2) consulting with and advising a general partner with respect to the business of the limited partnership; (3) acting as surety for the limited partnership or guaranteeing or assuming one or more specific obligations of the limited partnership;

(4) taking any action required or permitted by law to bring or pursue a derivative action in the right of the limited partnership;

(5) requesting or attending a meeting of partners;

(6) proposing, approving, or disapproving, by voting or otherwise, one or more of the following matters:

(i) the dissolution and winding up of the limited partnership;

(ii) the sale, exchange, lease, mortgage, pledge, or other transfer of all or substantially all of the assets of the limited partnership other than in the ordinary course of its business;

(iii) the incurrence of indebtedness by the limited partnership other than in the ordinary course of its business;

(iv) a change in the nature of the business;

(v) the admission or removal of a general partner;

(vi) the admission or removal of a limited partner;

(vii) a transaction involving an actual or potential conflict of interest between a general partner and the limited partnership or the limited partners;

(viii) an amendment to the partnership agreement or certificate of limited partnership; or

(ix) matters related to the business of the limited partnership not otherwise enumerated in this subsection (b), which the partnership agreement states in writing may be subject to the approval or disapproval of limited partners;

(7) winding up the limited partnership pursuant to Section 803; or

(8) exercising any right or power permitted to limited partners under this act and not specifically enumerated in this subsection (b).

This list of actions that do not convert a limited partner to a general partner may be relevant to the functional analysis prescribed in Soroban. These types of activities often were at issue when creditors of a limited partnership sought to make a limited partner liable for a partnership debt. There are multiple court opinions from nearly every state examining the issue of whether a limited partner should lose the cloak of limited liability due to activities they undertook on behalf of the limited partnership. The focus of the determinations in those cases was whether the limited partner’s activities amounted to control of the business of the partnership. As long as the limited partner engaged in activities such as those in the Section 303(b) list, they were not considered to have exercised control over the partnership and thus remained limited partners under state law.

For example, in the Hommel case, the nominal limited partner personally approved the majority of the contracts that were made by the limited partnership and had the final say over all projects being considered by the partnership. The Ohio Court of Appeals held that a limited partner may not have ultimate control over the decisions that are made during the ordinary course of business, which is the function of the general partner. Thus, the partner was stripped of his limited liability.

Section 303 of RULPA (1976), with its list of permissible activities, was referred to as the “control rule.” In 2001, the “control rule” was abandoned in RULPA, and the list of activities that a limited partner could undertake without being deemed in control of the business was removed. However, since it was in effect in 1977 when Congress enacted Sec. 1402(a)(13), the list should still be instructive when determining whether certain activities undertaken by a limited partner constitute control over the activities of the limited partnership, such that the limited partner would fail to qualify as a limited partner under state law and, thus, fall outside the exception to self-employment tax provided for under Sec. 1402(a)(13).

Even before the 1976 revisions, decisions under the ULPA from earlier years indicate a clear difference between “activity” and “control.” For example, in Grainger v. Antoyan, the plaintiff claimed that the limited partner’s position as a sales manager of an auto dealer partnership rendered him personally liable. The court ruled for the limited partner, however, because despite the facts that he had the authority to sell cars, had other salesmen working under him, and on several occasions cosigned checks, he had little say in the actual ongoing operations of the business. He did not have any authority as to (1) hiring or discharging personnel, (2) purchasing new cars, (3) determining the selling price of cars and the trade-in allowances for customers buying new cars, or (4) evaluating the creditworthiness of prospective customers.

Similarly, in Silvola v. Rowlett, the limited partner served as a foreman in an auto repair shop and had on several occasions purchased parts and extended credit to people he knew.  Unlimited liability was not imposed, however, as these actions did not amount to control of the business, the management of which was still vested in the general partner.

The use of the control rule in both pre- and post-RULPA (1976) cases serves as a warning against giving too much control over operations to a limited partner hoping to avoid self-employment tax under Sec. 1402(a)(13).

Case law involving LLPs and PLLCs

As of this writing, no court has undertaken the functional analysis prescribed by the Tax Court in Soroban for determining whether a limited partner in a state-law limited partnership qualifies as a “limited partner, as such.” Thus, there is no case law directly on point that outlines the factors involved in making the determination, or the weight to apply to each factor. However, the Tax Court has issued opinions evaluating the roles played by partners in a limited liability partnership (LLP) and by members of a professional limited liability company (PLLC). Although LLPs and PLLCs are legal constructs distinct from limited partnerships, these opinions may be of some utility for cases involving limited partners in limited partnerships.

In Renkemeyer, Campbell & Weaver LLP, the Tax Court focused on the activities of the putative limited partners rather than the control over the partnership exercised by those limited partners and held that the partners in a law firm that was organized as an LLP were not “limited partners, as such” for purposes of Sec. 1402(a)(13). The partners were lawyers who provided professional services to the firm’s clients in exchange for a share of the firm’s net income. Their distributive shares were not guaranteed payments. The Tax Court considered whether the partners were exempt from self-employment tax on their distributive shares of the partnership’s income and held that they were not “limited partners, as such” for purposes of Sec. 1402(a)(13) because their “distributive shares arose from legal services … performed on behalf of the law firm” and not “as a return on the partners’ investment.”

The opinion stated that the intent of Sec. 1402(a)(13) “was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations … would not receive credits towards Social Security coverage” and that “[t]he legislative history … does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes.”

The Renkemeyer opinion could be interpreted to mean that an LLP partner could not qualify as a “limited partner, as such” under Sec. 1402(a)(13) if they were active in the business and not merely a passive investor of money or property. This analysis can be referred to as an “activity test,” as opposed to the control test described above for state-law cases involving the status of putative limited partners. Under an activity test, the sheer extent of one’s participation in the operations of a limited partnership could prevent a putative limited partner from qualifying as a “limited partner, as such” under Sec. 1402(a)(13), regardless of whether those activities involved any control of such operations.

A later Tax Court case may have sought to limit the import of the Renkemeyer opinion. In Castigliola, the Tax Court applied a control test to determine whether members of a legal practice that was organized as a PLLC such” under Sec. 1402(a)(13). The petitioners were attorneys who practiced law solely through the PLLC, which was member managed. The members’ compensation agreement required guaranteed payments to each member that were commensurate with local legal salaries. Any net profits of the PLLC in excess of the guaranteed payments were distributed among the members in accordance with the members’ agreement.

All four members of the PLLC participated in controlling the PLLC. They collectively made decisions regarding their distributive shares, borrowing money, personnel, and the rate of pay for employees. They each supervised associate attorneys and signed checks for the PLLC. The Tax Court cited both the Mississippi Annotated Code and RULPA (as revised in 1985) for the proposition that a lack of control of the business was an essential component of a limited partnership interest. The court then examined the managerial powers of the petitioners, explaining:

Common to each of the [various state law] definitions of “limited partner” … are the primary characteristics of limited liability and lack of control of the business. In this case, the respective interests in the PLLC held by [the members] made each a member of the PLLC, which was member managed. Therefore, management power over the business of the PLLC was vested in each of them through the interest each held.

The court then found that the management powers vested in and exercised by the members of the PLLC prevented them from being considered limited partners under Sec. 1402(a)(13) and subjected their excess distributions to self-employment tax.

Since the Renkemeyer opinion was a regular Tax Court opinion, it should carry more weight than a memorandum decision such as was rendered in Castigliola. A regular opinion is considered a precedent, while memorandum decisions are not. Thus, even though the Castigliola case was decided more recently than Renkemeyer, the Renkemeyer opinion, and its endorsement of an activities test, may have a greater influence on the next decision to be rendered by the Tax Court. Indeed, the Soroban opinion cited Renkemeyer for its interpretation of the legislative history of Sec. 1402(a)(13).

Prop. Regs. Sec. 1.1402(a)-2

Another source that courts might consult in performing Soroban’s functional analysis is a proposed regulation that Treasury issued in 1997 to define the scope of Sec. 1402(a)(13)’s limited partner exception. The proposed regulation provided that an individual would not be treated as a limited partner if the individual (1) had personal liability for partnership debts, (2) had authority to contract on behalf of the partnership, or (3) participated in the partnership’s trade or business for more than 500 hours during the partnership’s tax year. However, the proposed regulations also expressly excluded “service partners in service partnerships” from using this exception.

The first two prongs appear to be consistent with a control test as set forth in RULPA and used in Castigliola. Under the first prong of the proposed regulations, in order for a limited partner to be subject to personal liability for partnership debts, they must have exercised control over the partnership such that state law deprives them of limited partner status. The second prong appears to designate the authority to contract on behalf of the partnership as a characteristic of control that would deny limited partner status. The third prong, however, seems more relevant to an activity test by limiting the number of hours a partner can spend on partnership activities (regardless of whether such activities amount to control of the partnership) and remain a limited partner.

This proposed regulation was widely criticized as not reflecting either the wording or intent of Sec. 1402(a)(13). In response to that criticism, Congress issued a moratorium prohibiting Treasury from issuing any temporary or final regulation with respect to the definition of a limited partner under Sec. 1402(a)(13) before July 1, 1998. The reasoning behind the moratorium was that “the Senate [was] concerned that the proposed change in the treatment of individuals who are limited partners under applicable State law exceeds the regulatory authority of the Treasury Department and would effectively change the law administratively without congressional action.” Despite the lifting of the moratorium some 25 years ago, Treasury has not issued revisions to the proposed regulations or final regulations on this topic.

While the proposed regulation is of questionable value, and though proposed regulations are not binding on taxpayers or the courts, the IRS has a general policy of not taking litigating positions that conflict with outstanding proposed regulations. Thus, if a limited partner in a state-law limited partnership met one of the disqualifying conditions in the proposed regulation, the IRS might assert a liability for self-employment tax with respect to any distributive shares of partnership profits from the limited partnership because the limited partner did not fit within the definition of a “limited partner, as such” in Sec. 1402(a)(13).

It is worth noting that the proposed regulation recognized the possibility that a single partner could simultaneously hold both a limited partnership interest and a general partnership interest. Further, general and limited partnership interests held by the same partner, even when held directly, are not to be aggregated, grouped, or viewed together. Activity in the role of general partner that is subject to self-employment tax would not subject the distributive share of partnership profits relating to the limited partnership interest to self-employment tax. Prop. Regs. Sec. 1.1402(a)-2(h)(3) provides that:

An individual holding more than one class of interest in the partnership who is not treated as a limited partner under paragraph (h)(2) of this section is treated as a limited partner under this paragraph (h)(3) with respect to a specific class of partnership interest held by such individual if, immediately after the individual acquires that class of interest —

(i) Limited partners within the meaning of paragraph (h)(2) of this section own a substantial, continuing interest in that specific class of partnership interest; and,

(ii) The individual’s rights and obligations with respect to that specific class of interest are identical to the rights and obligations of that specific class of partnership interest held by the limited partners described in paragraph (h)(3)(i) of this section. [Emphasis added.]

Arguably, the segregation of general and limited partnership interests held by the same partner explains the meaning of the words “as such” in Sec. 1402(a)(13); that is, the phrase is an admonition that the exception only applies to the share of the partner’s limited partnership interest and does not extend to any distributive shares of partnership profits received on account of a general partnership interest held by the same partner. An implication of this interpretation is that a person holding both general and limited interests could be subject to self-employment tax as to the general partnership interest — which might give the person the power to completely manage the partnership — while the distributive share of the person’s limited partnership interest is not subject to self-employment tax. In such a case, even control over the operations of the partnership — if exercised solely in the role of general partner — should not bar distributive shares of profits related to limited partnership interests (except for distributions of guaranteed payments for the performance of services) from qualifying for the exclusion from self-employment tax.

Exercising control

Determinations of whether the activities engaged in by a limited partner prevent them from being a “limited partner, as such” for purposes of the Sec. 1402(a)(13) exception to self-employment tax for distributions from a limited partnership will depend on the facts of each case. Thus, it may take years before the law is settled in this area.

The terms of Sec. 1402(a)(13), the section’s legislative history, historic state law interpretations of permissible roles of limited partners, and the Castigliola decision all argue in favor of the application of a control test to perform the functional analysis mandated by the Tax Court in the Soroban opinion in order to determine whether a putative limited partner in a state-law limited partnership is a “limited partner, as such” under Sec. 1402(a)(13). Nonetheless, the Renkemeyer decision was a regular Tax Court opinion, meaning that an activity test based solely on the extent of activity engaged in by the limited partner could apply.

Some newer business structures provide that the “limited partner” in a limited partnership has little or no control, but the same individual who owns the limited partnership interest is also the owner of a closely held general partner of the limited partnership (which may be a noneconomic or an economic general partner). If the same individual is both a limited partner and one of a small number of owners of the general partner, it is possible that the Tax Court could take into consideration the limited partner’s significant control of the limited partnership through ownership of the general partner (or possibly through another upper-tier entity).

In keeping with the legislative purpose of Sec. 1402(a)(13), the phrase “limited partner, as such” should be construed broadly to include most limited partners in state-law limited partnerships. Engaging in the activities listed in Section 303(b) of RULPA (1976) should not prevent a limited partner from qualifying as a “limited partner, as such” under Sec. 1402(a)(13). As listed above, these would include being a contractor for or an agent or employee of the limited partnership or of a general partner, consulting with and advising a general partner with respect to the business of the limited partnership and proposing or approving of a change in the nature of the business. However, exercising control beyond the activities listed in Section 303(b) of RULPA (1976), such as making the daily managerial decisions for the partnership, may be a role to avoid if a limited partner seeks to fall within the exception to self-employment tax found in Sec. 1402(a)(13).

While Prop. Regs. Sec. 1.1402(a)-2 is not likely to be finalized in its current form and is of questionable value, a limited partner hoping to avoid self-employment tax on a distributive share of partnership profits from a limited partnership may nonetheless wish to (1) ensure they retain limited liability for the partnership debts under state law and (2) avoid the authority to contract on behalf of the partnership. The proposed regulation’s third prong — the proscription against participating in the partnership’s business for more than 500 hours during the partnership’s tax year — seems less impactful, since it appears that the manner in which those hours are spent (i.e., taking control over the management of the partnership, or merely engaging in the activities specified in Section 303(b) of RULPA or in similar activities) is much more important than a mere tally of the hours. Nonetheless, restricting one’s activity to less than 500 hours annually would appear to blunt any IRS argument based upon a sheer number of hours spent on activities of the limited partnership.

Further insight into the activities and roles that would remove a nominal limited partner’s limited liability for limited partnership debts can be found in state court opinions from the partnership’s originating state. The decisions in these cases have largely hinged upon the extent to which the limited partner exercised managerial control over the operations of the partnership.

Tax planning and considerations

The roles and activities of limited partners in state-law limited partnerships should be examined to determine whether the limited partner exercises enough control over the partnership that self-employment tax should be reported on future income tax returns for the distributive shares of profits attributed to the limited partners.

Limited partners who are concerned about their ability to qualify for the exception to self-employment tax should work with their advisers to review their limited partnership agreements for provisions that grant excessive power over managerial decisions or operations to limited partners and to determine whether limitations on the control to be exerted by the limited partners should be added to the agreement. If a limited partnership is structured such that partners holding limited partnership interests would qualify as limited partners under the law of their governing state as it existed in 1977, distributive shares of partnership profits with respect to those interests should be excluded from self-employment tax under Sec. 1402(a)(13), unless the distribution is a guaranteed payment for services rendered by the limited partner to the partnership.

The appropriate application of Sec. 1402(a)(13) to limited partners in limited partnerships should be closely monitored in the coming months because the situation is fluid. Tax Court opinions could be rendered on the merits of the Soroban case or in two other limited partnership cases that are already docketed in that forum. In addition, a revised final regulation or a new proposed regulation could be issued. While Prop. Regs. Sec.1.1402(a)-2 was never finalized or withdrawn; Treasury did include guidance under Sec. 1402(a)(13) in its 2023–2024 Priority Guidance Plan.