Tax Court Clarifies Functional Analysis for Limited Partners and Self-Employment Tax

At a Glance

• Private fund sponsors and affiliates that are state law “limited partners” should consider whether they may be subject to self-employment tax based on a functional analysis rather than state law classifications.
• On May 28, 2025, in Soroban Capital Partners LP v. Commissioner, the U.S. Tax Court clarified the functional analysis framework that determines whether the self-employment tax exemption from the Internal Revenue Code applies to state law limited partners.¹

Background

Many investment management firms that want pass-through tax treatment are organized as limited partnerships rather than limited liability companies due to a perceived opportunity to reduce self-employment tax. Specifically, while the Internal Revenue Service (IRS) has explicitly taken the position in the past that all payments to service-provider owners of a limited liability company (LLC) that is an operating business are considered “self-employment income,” there was a gray area with respect to a similar structure where the operating company was organized as a limited partnership (LP) instead.

Specifically, if an operating company were organized as a limited partnership where service providers held small interests and provided services through a general partner (for which they were reasonably compensated) and also held interests as limited partners, limited partnerships took the position that such service providers would not be subject to self-employment tax on their distributive share of income received in their capacity as limited partners. The IRS has been challenging that analysis and was successful in the U.S. Tax Court (Tax Court) in the Soroban case.

Soroban Capital Partners LP (Soroban) is an investment firm and a Delaware limited partnership, the general partner of which was Soroban Capital Partners GP LLC (Soroban GP). Three individual owners (principals) had direct and indirect ownership of both Soroban (as limited partners) and Soroban GP. Section 1402(a)(13) of the Internal Revenue Code excludes from self-employment income “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments.” Accordingly, when calculating net earnings from self-employment with respect to its three limited partners, Soroban included guaranteed payments but excluded their distributive shares of partnership income.

The Tax Court held that the principals were not limited partners within the meaning of the exclusion from self-employment income, because their role with the partnership failed the court’s factual functional analysis. Although the principals were state law limited partners, they were too instrumental in the operation of the partnership to claim the exclusion, such that their role was more akin to that of a general partner versus a passive investor. In short, the principals were not acting as limited partners, so their distributive share of partnership income was includible as net earnings from self-employment.

The Functional Analysis

The Tax Court applied a functional analysis based on the facts and circumstances of the case, ultimately holding that the principals were not limited partners for purposes of self-employment tax. Although the functional analysis is not based on a set number of factors, in the Soroban case the Tax Court focused on the following five factors to determine whether the principals acted as limited partners:

1. Role in Generating Income

The court looked to the importance of the principals’ time, skills and judgement to the operation of the business as a role more in line with that of a general partner.

2. Role in Management

The court evaluated the extent to which the principals participated in important committees of the partnership and personnel decisions as suggesting control and authority over the partnership’s core business akin to that of a general partner.

3. Time Devoted to the Business

The court associated significant time devoted to business activities of the partnership with a more instrumental role in the business more like that of a general partner rather than an investor, especially where the hours worked resembled full-time employment.

4. Marketing the Role in the Business

The court evaluated advertising materials and the partnership’s leveraging of the principals’ expertise to garner more business as instrumental to the business, suggesting a role more like that of a general partner.

5. Capital Contributions

The court considered the principals’ disproportionately small capital contributions relative to distributive shares of income for limited partners as indicating that the distributive share of income was not a return on investment.

Implication

Distributive shares of income may constitute net earnings from self-employment for limited partners who are not passive investors. Careful consideration of the functional analysis test should be undertaken by limited partners who provide services to a partnership.

For More Information

For further information or questions you may have regarding the tax treatment of limited partners for self-employment tax purposes in light of the Soroban case, you may contact the authors, or a member of the firm’s investment management team or transactional tax team.

Summer associate Alexander Evans contributed to this update.