Investment Firm's Limited Partners Are Liable for Self-Employment Tax

(Parker Tax Publishing June 2025)

The Tax Court held that the IRS correctly recharacterized ordinary income allocated to an investment firm's limited partners as net earnings from self-employment subject to self-employment tax because, functionally, the partners were not acting as limited partners and thus the limited partner exclusion from self-employment taxes in Code Sec. 1402(a)(13) did not apply. Using the functional analysis test, the court concluded that the partners were not akin to passive investors because, among other things, they (1) oversaw and substantially participated in the investment process; (2) were publicly held out as essential to the operation of the business; (3) made decisions relating to the hiring, firing, promoting, and evaluating employees; and (4) their expertise was a selling point for potential investors. Soroban Capital Partners LP v. Comm'r, T.C. Memo. 2025-52.

Background

Soroban Capital Partners LP (Soroban) is a limited partnership with a general partner and three limited partners. Soroban's general partner is Soroban Capital Partners GP LLC, a Delaware limited liability company (LLC). For the years at issue, 2016 and 2017, Soroban's limited partners were EWM1 LLC, GKK LLC, and Scott Friedman. EWM1 LLC and GKK LLC were single-member LLCs wholly owned by Eric Mandelblatt and Guarav Kapadia, respectively. Neither EWM1 LLC nor GKK LLC elected to be treated as an entity separate from its owner. Thus, under Reg. Sec. 301.7701-1(a)(4) and Reg. Sec. 301.7701-3(b)(1)(ii), they were disregarded as separate entities for federal income tax purposes and the interests held by EWM1 LLC and GKK LLC were treated as being held directly by Mandelblatt and Kapadia, respectively. Considering both direct and indirect interests, Soroban was wholly owned by three individuals, Mandelblatt, Kapadia, and Friedman (Principals).

In calculating a partner's net earnings from self-employment, Code Sec. 1402(a)(13) excludes "income or loss of a limited partner, as such." Previously, in Soroban Capital Partners LP v. Comm'r, 161 T.C. 310 (2023), the Tax Court held that in determining the extent to which the limited partner exclusion of Code Sec. 1402(a)(13) applies, a functional analysis is necessary to determine the extent to which limited partners are acting as such. In Denham Capital Management LP v. Comm'r, T.C. Memo. 2024-114, the Tax Court noted that caselaw has continuously reinforced its 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 2016 and 2017, Soroban earned its income from fees it charged its clients for managing 11 investment funds. Soroban's Principals (i.e., its limited partners) played an essential role in generating this income and Soroban acknowledged that the Principals' unique skills and experience were indispensable to the business. The Principals exercised managerial control, worked full time with Soroban, and contributed little to no capital relative to their shares of income.

When calculating net earnings from self-employment for 2016 and 2017, Soroban included guaranteed payments it had made to the Principals but otherwise excluded their shares of partnership income. The IRS issued Notices of Final Partnership Administrative Adjustment for 2016 and 2017 in which it proposed to recharacterize the ordinary income allocated to Soroban's Principals as net earnings from self-employment.

In a motion for summary judgment, Soroban asked the Tax Court to find that Code Sec. 1402(a)(13) excludes the Principals' distributive shares of partnership income from net earnings from self-employment and thus any self-employment tax applies only to the Principals' guaranteed payments. Soroban argued that the characterization of the Principals as limited partners for state law purposes was controlling and, under state law, the Principals are considered limited partners for tax purposes and their distributive shares are excludible from self-employment tax. The IRS countered that Code Sec. 1402(a)(13) requires a functional inquiry into the roles of the partners to determine whether they are bona fide limited partners. Specifically, the IRS alleged that Mandelblatt, Kapadia, and Friedman were not limited partners for the purpose of Code Sec. 1402(a)(13).

Analysis

The Tax Court held that Soroban's Principals did not qualify as limited partners for the purposes of the exception in Code Sec. 1402(a)(13) because, functionally, they were not acting as limited partners. Citing its decision in Denham, as well as in Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), the court observed that the functional analysis test is designed to be a comprehensive inquiry into whether the Principals "were generally akin to passive investors." Under this test, the court said, to exclude a partner's distributive share of partnership income from net earnings from self-employment, the surrounding circumstances of the partner's economic relationship with the partnership must sufficiently indicate that it is generally one of passive investment.

In analyzing the Principals' roles and responsibilities, the court reviewed the sources of Soroban's income, the Principals' roles in generating that income, and the relationship between the Principals' distributive shares and any capital contributions they made to the partnership. Specifically, the court evaluated what roles they played in the business, the time they devoted to the business, how the partnership advertised itself to the public, whether it advertised any specific skills or expertise of the partners, and the capital contributed by the partners.

In concluding that the Principals were not akin to passive investors, the court found that (1) all three Principals oversaw and participated in the investment process which contributed to the generation of Soroban's income of approximately $247 million across the years at issue; (2) each of the Principals participated in the management of Soroban, devoted significant time to the business, and were publicly held out as essential to the operation of Soroban; (3) all three Principals made decisions related to hiring, firing, promoting, and evaluating employees; (4) the Principals devoted significant time to the business; (5) the expertise of the Principals was a selling point for potential investors; and (6) if no Principal were available to manage the funds, the funds would liquidate. While observing that Soroban employed other people to carry out the operations of the business, the Tax Court concluded that the Principals maintained control over the operations of the business and exercised authority over the core functions of Soroban's business. The court also found that the Principals' insignificant capital contributions showed that their distributive shares of income were not returns on investment.

While the Principals proposed their own list of factors, the court rejected those factors, saying they were of varying degrees of relevance. The test of whether a partner functions as a general partner or a limited partner for federal tax purposes, the court stated, is not dictated by any set number of factors. Rather, it is a facts and circumstances test that considers all relevant facts and circumstances.

Finally, the court found that the Principals were relying on the fiction that they did not serve Soroban in their individual capacities as limited partners but instead acted with authority delegated to them by the general partner, which they in turn had the authority to manage. According to the court, this type of legal fiction is precisely why applying federal tax law to the economic arrangement of the parties is controlling rather than mere state law classifications.

For a discussion of self-employment taxes as they apply to partnership income, see Parker Tax ¶20,590. For a general discussion of net-earnings from self-employment, see Parker Tax ¶13,120.

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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