2nd Circ Narrows Self-Employment Tax Exception for Partners
The Second Circuit held that the limited partner exception to self-employment tax does not apply to partners who actively participate in the partnership's business, affirming a key Tax Court decision.
The U.S. Court of Appeals for the Second Circuit has unanimously affirmed the Tax Court’s decision in Soroban Capital Partners v. Commissioner, holding that the limited partner exception to self-employment tax is determined by a partner's functional role, not their formal title. The panel ruled that the exception in Internal Revenue Code section 1402(a)(13) applies only to passive investors, not to partners who actively run, manage, or control the partnership’s business. This decision is significant for investment funds, such as hedge funds and private equity firms, many of which are structured as limited partnerships. The ruling solidifies the IRS's position that income allocated to active principals, even if designated as limited partners, is subject to self-employment taxes. Law firms should advise fund clients, particularly those within the Second Circuit, to review their partners' roles and income allocations to ensure compliance and assess potential tax liabilities. The decision may deepen a divide among courts on how to apply the statutory language to modern partnerships.