Self-employment tax and limited partnership exception: Tax Court rules again

In recent years, the IRS has won two key cases related to the Limited Partner Exception for self-employment taxes, with fund managers losing out. In December 2024, the Tax Court issued its decision in Denham Capital Management LP v. Commissioner, reaffirming its 2023 decision in Soroban Capital Partners LP v. Commissioner. Both cases stress the need for a “functional analysis” to determine whether a state law limited partner should be exempt from self-employment tax. The court ruled that partners who are actively involved in the management of a fund are not eligible for the Limited Partner Exception, which was intended for passive investors.

The Self-Employment Contributions Act (SECA) requires self-employed individuals, including partners, to pay self-employment taxes. A special exception for limited partners under Section 1402(a)(13) of the Internal Revenue Code allows their income to be excluded from self-employment tax, but this exception is often complicated b

Limited partners must be strictly passive investors.

y changes in law and business structures. Previously, the IRS had taken action against fund managers who attempted to claim this exemption for active roles in partnerships.

The Denham case involved a group of partners claiming the exception, despite their active roles in generating income for their investment manager, Denham Capital Management. The court found that the partners were not passive investors, noting that they were deeply involved in management and received substantial income for their work. Key points included their extensive time commitment, essential expertise, control over personnel decisions, and large compensation compared to their capital contributions.

The ruling emphasized that, even though these partners were legally limited partners under state law, their roles aligned more closely with active participants than passive investors. The case highlights that fund managers must carefully evaluate their partners' roles to understand the potential self-employment tax risks associated with such income classifications.

The issue isn’t settled, as appeals and other cases are still ongoing. Fund managers are advised to assess their legal structures and be cautious about how they categorize partners’ income to avoid unexpected tax consequences.