Second Circuit Narrows LP Exception for Self-Employment Tax

The U.S. Court of Appeals for the Second Circuit, in Soroban Capital Partners LP v. Commissioner, affirmed a Tax Court holding that partners must lack managerial control to qualify for the "limited partner" exception from self-employment (SECA) taxes. The court rejected the argument that limited liability under state law was sufficient, instead endorsing the IRS's "functional analysis" test of a partner's actual role in the business.

This decision is a major setback for the investment funds industry, particularly for managers in New York, Connecticut, and Vermont. It aligns with a recently revised Fifth Circuit opinion, making a circuit split—and thus Supreme Court review—less likely. The ruling significantly strengthens the IRS's hand in its ongoing audit campaign targeting the use of the exception, which can represent a tax saving of up to 3.8% for high-income partners.

Fund managers within the Second and Fifth Circuits should immediately reassess their tax reporting positions. While the issue is now largely settled in those jurisdictions, the determination of managerial control remains a fact-specific inquiry, meaning truly passive partners should still be able to claim the exemption.