When we think of taxes, we often think of income taxes. But for business owners, they also have to contend with payroll and/or self-employment taxes. These other taxes can be substantial for businesses and their owners.
This is why Congres and taxpayers have devised several ways to avoid these taxes. The rules are nuanced enough to create opportunities to do just that. For example, this is one of the primary reasons why taxpayers who qualify for S corporations use Subchapter S corporations.
One of the running disputes between taxpayers and the IRS involves self-employment tax and an exception to tax for limited partners. We have previously covered other disputes involving this issue that have not fully resolved these issues.
The question is whether partners can call themselves limited partners, even though they are active in the partnership, and take advantage of this exception to tax.
The U.S. Tax Court recently addressed this question in Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12, which addresses whether limited partners in a partnership are exempt from self-employment tax on partnership income.
Facts & Procedural History
The partnership was a Delaware limited partnership. It provided investment management services.
On its tax returns, the partnership had excluded the distributive shares of ordinary business income allocated to its limited partners from its calculation of net earnings from self-employment. Put another way, when it issued the Schedule K-1s to the partners, it did not report the income on the schedules as being subject to self-employment tax.
The partnership is a TEFRA partnership, so the IRS audit was conducted at the partnership level. The IRS determined that the limited partners were subject to self-employment tax. According to the IRS, the limited partners were limited partners in name only.
The partnership brought suit in the U.S. Tax Court seeking a ruling that as limited partners, the partners were automatically exempt from self-employment tax on their distributive income.
About Self-Employment Tax
Self-employment tax is imposed on an individual’s net earnings from self-employment. This can include net earnings as a sole proprietor. It can also include a partner’s distributive share of income from any trade or business carried on by the partnership, with some exceptions.
The purpose of the self-employment tax is to fund Social Security and Medicare benefits for self-employed individuals. The self-employment tax rate is 15.3% on 92.35% of net earnings. This consists of a 12.4% Social Security portion and a 2.9% Medicare portion. Up to an annual threshold amount of net earnings ($147,000 for 2023) is subject to the full 15.3% rate. Above that amount, only the 2.9% Medicare portion applies.
While the partnership does not pay self-employment taxes, the partnership has to decide whether income is to be reported as being subject to self-employment tax by the partners. The partnership then calculates net earnings from self-employment at the partnership level and reports those amounts to partners on the Schedules K-1 that are issued to partners. Partners then report this pass-through amount on their tax returns. The partners do so by filling out the Schedule SE on their Forms 1040.
The Limited Partner Exception
One exception to the self-employment tax rules is for limited partners. This exception is found in Section 1402(a)(13).
This provision excludes limited partners’ distributive shares from net earnings subject to self-employment tax, except for guaranteed payments. This means that for all but guaranteed payments, limited partners are not subject to self-employment tax.
The policy rationale behind this limited partner exception was to exclude earnings that are passive investment income in nature rather than active business income. Investors should not be subject to this tax. Investors are generally those who just enjoy the limited liability of the business entity but do not participate in the control or management of the partnership.
The nuance can be understood by examining the application of self-employment tax to those who own short-term rental investment properties. If substantial services are provided, then self-employment taxes apply. If not, then they do not. You can read about the self-employment tax on short-term rentals here.
The question of whether self-employment tax applies to royalties earned by an author is also instructive.
Who is a Limited Partner for SE Tax
That brings us back to the issue in this case. The question is whether the limited partners qualify for the limited partner exception to self-employment tax.
The U.S. Tax Court held that the limited partner exception does not apply automatically solely based on a partner’s formal classification under state law: “the limited partner exception does not apply to a partner who is limited in name only.” The court said that it must examine the actual roles and functions served by the partner. Thus, to determine whether earnings are passive investment income exempt from self-employment tax or active business income subject to tax requires a case-by-case functional analysis.
Because of the procedural aspects of this case, the court did not go on to explain what factors it would consider in making this determination. This will likely come later in the proceeding or from other court cases. And the IRS is likely to issue guidance on this topic. Given the language in the court opinion, it is likely that the courts would adopt a factor analysis that considers factors such as these:
- Level of participation in managing or controlling partnership operations and business decision-making
- Authority to sign contracts or make commitments binding the partnership
- Involvement in day-to-day partnership business activities
- Performance of services for the partnership or involvement in partnership revenue-generating operations
- Receipt of fees, compensation, or shared profits of the partnership for services rendered (beyond just investment returns)
- Limitations on liability for partnership debts and claims under state law
- Investment in the partnership and exposure to risk of loss
- Compliance with state law requirements for classification as a limited partner
- Holding out as a general partner to creditors, clients, or the public
Until further guidance is issued, partnerships and limited partners should review their tax positions to determine whether to start reporting and paying self-employment taxes on distributive shares of partnership income.
This case shows that merely holding the title “limited partner” does not automatically exempt partnership income from self-employment tax. Courts will look to substance over form, examining the levels of authority, management, direction, and control exercised by partners. Partners should carefully weigh if their actual roles match those expected of passive limited partner investors if seeking exemption from self-employment taxes.