The United States Tax Court’s decision in Soroban Cap. Partners LP v. Commissioner,1 marks development in the taxation of partnership income, particularly for investment funds structured as limited partnerships. The ruling clarifies the application of the “functional analysis” for determining whether a partner’s distributive share of partnership income is excluded from self-employment tax under Code Section 1402(a)(13).2 This article examines the legal and practical implications of the Soroban decision, analyzes its impact on fund management and tax treatment, and offers guidance for fund managers and their advisors navigating this evolving landscape. It also considers how the IRS may adjust its enforcement strategies in light of this precedent.
I. Section 1402(a)(13) and the Limited Partner Exception
Code Section 1402(a)(13) provides that, for purposes of the Self-Employment Contributions Act (“SECA”) tax, “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)” shall not be included in the net earnings from self-employment.3 Historically, limited partners in investment funds and professional service partnerships have relied on this provision to exclude their distributive shares from self-employment tax, often based on their status as “limited partners” under state law.
However, the Tax Court’s jurisprudence—most notably in Renkemeyer, Campbell & Weaver, LLP v. Commissioner 4 and Denham Cap. Mgmt LP v. Commissioner 5—has shifted the focus from formal state law classifications to a “functional analysis” of the partner’s actual role in the partnership. The Soroban decision cements and extends this approach, with significant consequences for fund managers and their advisors, as well as possible influence on the outcomes in similar cases on appeal in the First Circuit (Denham) and the Fifth Circuit (Sirius Solutions).6
II. The Soroban Case
Soroban Capital Partners LP (“Soroban”) is a Delaware limited partnership engaged in investment management, wholly owned by three individuals either directly or through disregarded entities (the “Principals”).7 Soroban’s general partner, Soroban Capital Partners GP LLC, was also owned by the Principals.8 For the tax years 2016 and 2017, Soroban derived all of its income from management and performance fees for services provided to affiliated investment funds.9
The Principals were responsible for all aspects of Soroban’s business: investment decisions, risk management, personnel matters, and serving on all key management committees.10 Each devoted full-time effort to the partnership, working an estimated 2,300–2,500 hours per year.11 Soroban reported only the guaranteed payments made to the Principals as net earnings from self-employment, excluding their distributive shares from SECA tax by relying on Code Section 1402(a)(13).12
The IRS issued Final Partnership Administrative Adjustments recharacterizing the Principals’ distributive shares as net earnings from self-employment, subjecting them to SECA tax.13 Soroban challenged the adjustments, arguing that state law status as a limited partner should control.14
III. Legal and Practical Implications of the Court’s Functional Analysis
The Tax Court rejected Soroban’s reliance on state law formalism, holding that the determination of “limited partner” status for Code Section 1402(a)(13) purposes requires a functional analysis of the partner’s actual role and responsibilities.15 The Court concluded that the distributive shares of income allocated to the Principals were not returns on capital investment, but rather compensation for their active services. Accordingly, the Principals’ distributive shares were found to constitute net earnings from self-employment and were subject to SECA tax.
A. The End of State Law Formalism
Soroban underscores the principle from prior case law that state law status as a “limited partner” is not determinative for federal tax purposes. The Court’s functional analysis means fund managers and their advisors must recognize that the mere designation of a partner as “limited” under state law will not shield that partner’s distributive share from SECA tax if the partner is actively engaged in the partnership’s business.16
B. Capital Contributions and Returns on Investment
The Court gave significant weight to the relationship between capital contributions and distributive shares.17 Fund managers should carefully consider the structure of capital accounts and the allocation of income to ensure that returns on investment are clearly distinguished from compensation for services.
C. Marketing and Investor Communications
The Court’s reliance on Soroban’s marketing materials and investor communications as evidence of the Principals’ essential role in the business highlights the importance of consistency between public representations and tax positions.18
IV. Best Practices and Recommendations
In light of the Soroban decision, fund managers and their advisors should consider the following best practices:
A. Draft Precise and Consistent Partnership Agreement Provisions
The partnership agreement should specify who has authority to manage the partnership, make investment decisions, and bind the entity. Partnership agreements should explicitly prohibit limited partners who are intended to be passive investors from participating in the management or control of the partnership’s business. Importantly, serving on key management committees, exercising authority over hiring and firing, and having the power to bind the partnership in contracts are all indicia of active participation.19 Accordingly, fund managers should be cautious about granting such authority to individuals who are intended to be treated as passive limited partners for tax purposes
B. Distinguish Between Service Partners and Passive Investors
Funds should consider establishing distinct classes of partnership interests—one for service partners, who are actively involved in management and operations, and another for passive investors. The rights, responsibilities, and economic entitlements of each class should be clearly delineated.
C. Ensure Consistency Across All Documentation and Communications
All offering documents, private placement memoranda, and investor presentations should accurately reflect the roles of partners as described in the partnership agreement. Avoid language that suggests passive limited partners are essential to the business or its management.
Funds should maintain records of partners’ actual involvement in the business, including time spent, committee participation, and decision-making authority. This documentation can be critical in the event of an IRS audit or litigation.
Fund managers should periodically review partnership agreements and related documents to ensure they continue to reflect the actual roles and responsibilities of all partners, especially as the business evolves or new partners are admitted.
D. Consult with Experienced Tax Counsel
Fund managers should engage tax counsel with expertise in partnership taxation and self-employment tax issues to review partnership agreements and operational practices. Tax counsel can help identify potential risks and recommend structural changes to align with the functional analysis standard.
In complex or ambiguous situations, fund managers may consider seeking a private letter ruling or other guidance from the IRS to clarify the tax treatment of partnership income.
E. Educate Partners and Staff
Fund managers should ensure that all partners and relevant staff understand the importance of adhering to the defined roles in the partnership agreement. This includes refraining from unauthorized management activities by passive limited partners.
It is also important to educate partners about the potential self-employment tax consequences of their activities and the importance of maintaining the integrity of the partnership’s structure.
V. Anticipated IRS Enforcement Approaches
The Soroban decision provides the IRS with additional firepower for challenging the exclusion of distributive shares from self-employment tax based on limited partner status. Fund managers and their advisors should anticipate the following enforcement trends:
- Increased Audits and Scrutiny: The IRS is likely to increase its scrutiny of partnership returns, particularly those of investment funds and professional service firms, to identify partners whose activities may not qualify as passive.
- Functional Analysis in Examinations: Examiners will likely request detailed information about the roles, responsibilities, and time commitments of partners, as well as copies of marketing materials and partnership agreements.
- Focus on Disproportionate Allocations: The IRS may challenge allocations of income to limited partners where the allocations are not commensurate with capital contributions or are tied to the performance of services.
- Use of Publicly Available Information: The IRS may review offering documents, websites, and other public materials to assess the actual roles of partners.
- Potential for Retroactive Adjustments: The IRS may seek to recharacterize prior years’ returns where partners have been treated as passive limited partners but have in fact been actively engaged in the partnership’s business.
Conclusion
The Tax Court’s decision in Soroban represents a significant development in the application of the limited partner exception to self-employment tax. By emphasizing a functional analysis over state law formalism, the Court has affirmed the narrow circumstances under which limited partners may exclude their distributive shares from SECA tax. Fund managers and their advisors must carefully assess the roles and responsibilities of all partners, align partnership structures with economic realities, and ensure consistency between tax positions and public representations. Proactive compliance and thoughtful structuring will be essential to mitigate risk and adapt to the evolving enforcement landscape.
[1] T.C. Memo. 2025-52 (2025).
[2] References to the Code throughout this article refers to the Internal Revenue Code of 1986, as amended.
[3] Code § 1402(a)(13).
[4] 136 T.C. 137, 148 (2011) (“[I]t is generally understood that a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership.”).
[5] T.C. Memo. 2024-114, 9 (2024), on appeal, No. 25-1349 (1st Cir.) (“Our caselaw has continuously reinforced our position that determinations under section 1402(a)(13) require a factual inquiry into how the partnership generated the income in question and the partners’ roles and responsibilities in doing so. Petitioner’s position that the Partners are eligible for the limited partnership exception merely because the Partners complied with formalities prescribed by state partnership law does not comport with our caselaw.”).
[6] Sirius Solutions L.L.L.P. v. Comm’r, No. 11587-20 (Tax Ct. Feb. 20, 2024), on appeal, No. 24-60240 (5th Cir.)
[7] Soroban, T.C. Memo. 2025-52 at 1, 3-4.
[8] Id. at 3-4.
[9] Id. at 6.
[10] Id. at 7-11.
[11] Id. at 10.
[12] Id. at 5.
[13] Id. at 13.
[14] Id. at 14; see also id. at 19-20 (proposing alternative factors to measure whether a partner is a limited partner).
[15] Id. at 16.
[16] See id. at 20.
[17] See id. at 18-19.
[18] See id. at 12, 18.
[19] See id. at 9-10.
