The new year will likely bring more litigation and new IRS audits of limited partners following the Tax Court’s opinion in Soroban Capital Partners LP v. Commissioner that state law limited partners aren’t automatically entitled to the statutory exclusion from self-employment tax.
Whether the Tax Court reached the correct result “is going to take years to figure out,” David H. Kirk of EY told Tax Notes. “This is just the first inning, so I’m telling clients they probably aren’t going to get definitive answers until 2026, maybe even 2028, at the earliest.”
For 2024, tax professionals are weighing how the IRS’s win in the Tax Court’s November 28 division opinion in Soroban (161 T.C. No. 12) may affect similar cases concerning the limited partner exception that are pending in Tax Court or still under review at IRS Appeals. They are also wondering whether the opinion will prompt the IRS to open new audits under the Self-Employment Contributions Act (SECA) compliance campaign it launched in 2018 to ensure that the section 1402(a)(13) limited partner exception isn’t being misused.
Enacted in 1977, section 1402(a)(13) generally excludes a limited partner’s distributive share of partnership income or loss from the SECA tax. The exclusion doesn’t apply to guaranteed payments that a limited partner receives for services rendered to the partnership. Because the statute doesn’t define limited partner, the proper scope of the exemption has become the subject of a protracted legal — and at times political — debate.
While courts have previously addressed the application of section 1402(a)(13) to owners of various types of passthrough entities, including limited liability partnerships and limited liability companies, Soroban is the first published opinion to address the provision in the context of a state law limited partnership. In its precedential opinion, the Tax Court agreed with the IRS that state law classifications aren’t controlling and that a functional analysis is required to determine whether a partner in a state law limited partnership is a limited partner for purposes of section 1402(a)(13).
Tax professionals had hoped that Soroban would provide more clarity on how section 1402(a)(13) applies to “active” limited partners of state law limited partnerships. Instead, the Tax Court’s opinion has likely complicated the legal landscape, at least for the next several years.
Whether the Tax Court’s opinion is the final word on what section 1402(a)(13) means “is something to be sorted in the future,” Armando Gomez of Skadden, Arps, Slate, Meagher & Flom LLP said during a November 29 webinar on self-employment tax hosted by the District of Columbia Bar Taxation Community.
Gomez, one of the attorneys representing Soroban Capital Partners LP in the Tax Court litigation, declined to say whether his client intends to pursue an appeal. But he thinks it’s likely that other taxpayers will continue to litigate the scope of the limited partner exception, no matter what the final outcome is in Soroban. He added that several key questions must still be answered regarding how the functional analysis approach advocated by the IRS, and endorsed by the Tax Court in its Soroban opinion, would be formulated and how it would work in practice.
During the same webinar, Jennifer Breen of Morgan Lewis & Bockius LLP said that with the Tax Court’s answers to two questions — a functional analysis is required to determine limited partner status, and the analysis applies at the partnership level — the Soroban opinion “opens the door for the next phase of litigation for all the cases that are coming behind it.”
The question of who qualifies for the limited partner exception has been a source of contention since at least the 1990s, when Treasury and the IRS unsuccessfully tried to advance regulations defining a limited partner for SECA purposes.
The government explained that regulations were necessary because the scope of the limited partner exception had become more uncertain after states introduced so-called hybrid business entities and made significant changes to their limited partnership statutes in the years following enactment of section 1402(a)(13).
But after withdrawing a 1994 proposal (EE-45-94) that was heavily criticized by the tax bar, Treasury and the IRS fared no better with their revamped 1997 proposed regulations (REG-209824-96), which would have ignored state law classifications by providing new functional tests for determining limited partner status for SECA purposes. The government shelved the project after Congress expressed concerns over the proposed regs’ approach and imposed a one-year moratorium on their finalization.
To fill the gap, the IRS turned to the courts to argue...
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