Understanding the Tax Court's Recent Ruling
The U.S. Tax Court’s recent ruling in the case of Soroban Capital Partners LP has significant implications for hedge fund management firms and their partners, determining that income distributions to its limited partners are subject to self-employment taxes because those partners were actively involved in the company’s operations.
This decision came after the Internal Revenue Service (IRS) increased Soroban's net earnings from self-employment by more than $141 million, which significantly raised the partnership’s liability for Social Security and Medicare contributions. This case follows an earlier 2023 case in which the Tax Court determined that a functional analysis is required to determine the extent to which limited partners are acting as such.
Soroban's Argument and the Court's Response
Soroban had excluded certain distributions of income to its limited partners from self-employment earnings, arguing that the limited partners qualified for an exclusion reserved for passive investors. However, Judge Ronald L. Buch, applying a functional analysis, ruled that Soroban’s limited partners were limited partners in name only; they were essential to generating the business’s income, oversaw day-to-day management, worked full time for the business, and were held out to the public as essential to the business.
The Impact on Hedge Fund Managers and Investment Advisers
This ruling has put fund managers and other investment advisers on high alert, as it signals a risk that a greater share of their earnings could be subject to self-employment taxes. The ambiguity between limited and general partners, and the IRS's historical failure to define it, adds to the complexity. According to IRC section 1402(a)(13), the distributive income share of “a limited partner, as such” is excluded from earnings subject to withholding under the Self-Employment Contributions Act (SECA).
Criteria for SECA Exemption and Industry Reactions
The Tax Court's 2023 ruling against Soroban established that limited partners must actually function as passive investors to qualify for the SECA exemption. This has led other investment firms, such as Houston consulting firm Sirius Solutions and Denham Capital Management LP, to challenge the Tax Court’s and IRS’s application of a functional test to the activities of their limited partners.
All three organizations are structured as limited partnerships, and the Tax Court also ruled against Denham in December 2024, applying the same functional analysis in the Soroban case, declaring that Denham’s LPs acted more like employees than traditional limited partners. Sirius Solutions has not yet received a final ruling, as their case is currently pending before the Fifth Circuit of Appeals, though it may face a similar outcome.
Judge Buch's Key Observations
In the recent decision, Judge Buch applied the functional test to the activities of Soroban’s limited partners. He noted in the ruling that Soroban's limited partners exercised managerial control, worked full time, and contributed little to no capital relative to their shares of income. The Judge concluded that Soroban’s limited partners were limited partners in name only. They do not qualify as limited partners under section 1402(a)(13), and their earnings constitute net earnings from self-employment for the years in question.
Your Guide Forward
Our Asset Management Industry and Tax Services teams are here to provide support and industry-specific guidance to help you navigate these complex tax issues. Please do not hesitate to reach out to us if you have any questions or concerns regarding this tax ruling and its potential impact on your hedge fund.
