Self-Employment Tax Applies to Investment Firm's Limited Partners

(Parker Tax Publishing January 2025)

The Tax Court held that partners in an investment firm partnership were not "limited partners" as defined in Code Sec. 1402(a)(13) and thus the partnership may not exclude the partners' distributive shares from the partnership's net earnings from self-employment. The court also concluded that determining the applicability of the limited partner exception is a partnership item over which the Tax Court has jurisdiction. Denham Capital Management LP v. Comm'r, T.C. Memo. 2024-114.

Background

Denham Capital Management GP LLC (Denham GP) is the tax matters partner and state law general partner of Denham Capital Management LP (Denham), a Delaware limited liability company that elected to be treated as a partnership for federal income tax purposes. Denham offers investment advisory and management services to affiliated private equity funds. In addition to Denham GP, Denham had the following five limited partners during 2016 and 2017 (the years in issue): Stuart Porter, Scott Mackin, Carl Tricoli, Riaz Siddiqi, and Jordan Marye (collectively, Partners). Except for Porter, none of the Partners made capital contributions to Denham to acquire their interests.

Denham's Limited Partnership Agreement (LPA) governed the obligations and authority of Denham's partners for the years in issue. Under the LPA, Denham GP had "unlimited liability" for Denham's debts. Partners enjoyed limited liability and could be held personally liable for the debts and obligations of Denham only to the extent, if any, of capital contributions they made to Denham. Each of the Partners served on some or all of Denham's management, valuation, and/or investment committees. The Partners' role with Denham was so fundamental to the firm's operation that investors had the right to withdraw their investments early if one or more of the Partners died, became disabled, or could no longer devote substantially all business time to the funds.

With the exception of Siddiqi, who had begun to phase out, each of the Partners was scheduled to receive a salary of $325,000 and no bonus. In 2016 and 2017, Denham made guaranteed payments and capital distributions to each of the Partners. The distributions were multiple times larger than the guaranteed payments in both years. Denham generated approximately $70 million and $61.3 million in total revenue for 2016 and 2017, respectively, all of which was derived from fees collected in exchange for its investment management services.

No guaranteed payments or distributions were made by Denham GP to the Partners in 2016 or 2017. However, in each of those years Denham, the limited liability partnership, made guaranteed payments and capital distributions to the Partners and Denham GP. The guaranteed payments were intended to represent the Partners' salaries and included the value of a package of typical employment benefits.

When computing the Partners' net earnings from self-employment (NESE) for the years in issue, Denham included their guaranteed payments but excluded their distributive shares of Denham's ordinary business income. Denham reported total NESE of approximately $1.8 million and $1.4 million for 2016 and 2017, respectively. In March of 2023, the IRS issued final partnership administrative adjustments (FPAAs) for the years in issue, increasing Denham's NESE to approximately $29.3 million and $24.3 million for 2016 and 2017, respectively. Denham disagreed with the IRS's assessment and the case landed in the Tax Court.

Under Code Sec. 1402(a), NESE includes the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions attributable to such trade or business, plus the individual's distributive share (whether or not distributed) of income or loss described in Code Sec. 702(a)(8) from any trade or business carried on by a partnership of which the partner is a member.

Generally, under Code Sec. 1402(b), self-employment income is equivalent to the NESE derived by an individual during the tax year. Code Sec. 1402(a) also provides a list of exclusions from NESE, including "the limited partner" exception in Code Sec. 1402(a)(13). That exception excludes from NESE an individual's distributive share of any item of income or loss of a limited partner, other than guaranteed payments described in Code Sec. 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 of those services.

In Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), the Tax Court applied a functional analysis test to determine if lawyer-partners of a Kansas limited liability partnership were limited partners under Code Sec. 1402(a)(13). As part of its analysis in Renkemeyer, the Tax Court found that a partner's having limited liability was not enough for the partner to qualify as a limited partner. Instead, the court focused on how the partnership income was derived and determined that, in that case, it was received in exchange for legal services performed by the partners. Thus, the Tax Court held that the partners' distributive shares of income were not a return on the partners' investments, but were earned by providing legal services on behalf of the law firm.

In Soroban Capital Partners LP v. Comm'r, 161 T.C. 310 (2023), the Tax Court held that it has jurisdiction to determine a state law limited partner's status for the purpose of determining applicability of the limited partner exception and that such determinations require a functional analysis inquiry to ascertain the roles and responsibilities of partners to determine their status for tax purposes. The Tax Court concluded that the limited partner exception only applies to passive investors and not to a partner who is limited in name only.

The IRS, relying on the decisions in Soroban and Renkemeyer, argued that the Partners were not passive investors and thus could not exclude their distributive shares of Denham's ordinary business income from the NESE calculation. Denham and the Partners countered that the Partners are eligible for the limited partnership exception because the Partners complied with formalities prescribed by state partnership law. The Tax Court was asked if (1) an adjustment to a partnership's NESE is an adjustment to a partnership item subject to determination at the partnership level, and (2) the income attributable to the five limited partners is excludable from Denham's NESE under the limited partner exception pursuant to Code Sec. 1402(a)(13).

Analysis

The Tax Court, citing its decisions in Renkemeyer and Soroban and the doctrine of stare decisis, held that (1) the applicability of the limited partner exception in Code Sec. 1402(a)(13) is a partnership item over which the court has jurisdiction, and (2) the Partners were not limited partners under Code Sec. 1402(a)(13) and thus Denham cannot exclude the Partners' distributive shares from its NESE. The Tax Court rejected Denham's position that the Partners were eligible for the limited partnership exception merely because they complied with formalities prescribed by state partnership law.

In reaching its decision, the court found Denham's reliance on two 2020 tax cases unpersuasive as neither case addressed the issue of the applicability of the Renkemeyer functional analysis test to a state law limited partner. The court also found that the Partners were operating Denham's business as self-employed persons, rather than acting as limited partners as that term would have been understood when Congress enacted Code Sec. 1402(a)(13). The court said that Denham's position did not comport with caselaw, which has continuously reinforced the position that determinations under Code Sec. 1402(a)(13) require a factual inquiry into how the partnership generated the income in question and the partners' roles and responsibilities in doing so.

In determining Denham's NESE, the court analyzed the Partners' roles and responsibilities to ascertain whether their relationships with Denham were more akin to those of passive investors or employees. The court reviewed the sources of Denham's income for the years in issue, the Partners' role in generating it, and the relationship between the Partners' distributive shares and any capital contributions they made to the partnership.

Denham's income for 2016 and 2017, the court observed, consisted solely of fees it received in exchange for services provided to investors such as advising and operating the private investment funds. The Partners' time, skills, and judgment, the court noted, were essential to the provision of these services and the fees generated from those services were substantial. The court thus rejected Denham's claims that these amounts, which were largely distributed to the Partners as profits, were returns on their investments, especially in light of the fact that only one of the Partners' made a capital contribution to acquire his interest. The court concluded that individuals that serve roles as integral to their partnerships as those the Partners served for Denham cannot be said to be merely passive investors.

Finally, the court observed, the legislative history of Code Sec. 1402(a)(13) does not support the conclusion that Congress intended to exclude 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.

For a discussion of self-employment taxes on partnership income, see Parker Tax ¶20,590. For a discussion of individuals who are subject to self-employment tax, see Parker Tax ¶13,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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