The Tax Court in Soroban Capital Partners LP, 161 T.C –, No. 12, Dec. 62,310, has recently addressed the issue of when limited partners may be subject to self-employment tax, or, stated another way, when they are true limited partners.
The limited partnership involved in the case and subject to TEFRA audit procedures made guaranteed payments to and also distributed ordinary income to its limited partners. The partnership excluded distributions of ordinary income to its limited partners from the computation of net earnings from self-employment, including only the guaranteed payments.
The Internal Revenue Service determined that the distributions of ordinary income to these limited partners should have been included in the computation of net earnings from self-employment. The court was ruling on summary judgment requests from each side.
The partnership filed a motion for summary judgment that a limited partner’s distributive share of partnership income is excluded from net earnings from self-employment by virtue of the partner’s status as a limited partner. Both the partnership and government filed motions for summary judgment on the issue of whether the court had jurisdiction in TEFRA partnership-level proceedings to inquire into the functional roles of the limited partners.
Who is a limited partner?
Code Sec. 1402(a)(13) provides as follows: “There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 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 for those services.”
The Tax Court focused on the “as such” language to hold that a functional analysis test should be applied to determine whether the limited partners were, in fact, limited partners for purposes of Code Sec. 1402(a)(13). The court pointed to a series of cases contrasting who is a limited partner as compared to a general partner, focusing on whether the partner was performing in an active or passive role.
The Tax Court was focused only on denying a motion for summary judgment sought by the partnership. Therefore, it only set forth the requirements for the functional analysis test and did not perform the functional analysis test on the facts in this proceeding.
Tax Court jurisdiction
The case also involved an issue as to whether the Tax Court had jurisdiction to perform the functional analysis test in a TEFRA partnership-level proceeding or whether that should occur at a partner-level proceeding. The court looked at the factors that determined whether an item is a partnership item and concluded that, since the item involved the accounting practices that underlie the determination of the amount, timing and characterization of items of income, credits, gain, loss and deductions of the partnership, the item is a partnership item.
The Tax Court determined that, since net earnings from self-employment is a partnership item, it is appropriate that a partnership item be resolved at a partnership-level proceeding. Therefore, such an inquiry was a factual determination that underlies a partnership item that is properly determined in a TEFRA partnership-level proceeding.
Summary
There could be further litigation on this issue, involving either an appeal to a higher court or a factual determination on the merits. However, this decision points to the need to not solely rely on the limited partner label to determine the appropriate calculation of net earnings from self-employment.
Partnerships and their advisors, therefore, should consider the undertaking of their own factual analysis of the roles played by those labeled as limited partners in their partnerships, rather than relying on the label alone to determine the appropriate calculation of net earnings from self-employment for tax purposes.
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