IRS scrutinizes use of the SECA limited partner exception

Editor: Greg A. Fairbanks, J.D., LL.M.

In recent years, the IRS has conducted a “compliance campaign” focused on partnerships’ computation of their partners’ self-employment income for purposes of the self-employment tax imposed by Sec. 1401(a) under the Self-Employed Contributions Act (SECA) (see IRS webpage, “IRS Announces Rollout of Five Large Business and International Compliance Campaigns” (March 13, 2018)). While the compliance campaign appears to address the application of the limited partner exception generally, this item focuses on application of the limited partner exception to service partners in service partnerships organized as limited partnerships. As part of this campaign, the IRS has challenged the position that individuals who hold limited partnership interests, as defined under state law, are automatically exempt from SECA on their distributive share of income from a limited partnership.

Background on Sec. 1402(a)(13)

In general, an individual’s self-employment income includes the individual’s distributive share of partnership income. Sec. 1402(a)(13) excludes a limited partner’s distributive share of a partnership’s income or loss from the partner’s self-employment income; the limited partner exception does not exclude the partner’s guaranteed payments received for services from self-employment income. The IRS’s announcement of the SECA compliance campaign noted that:

Partners report income passed through from their partnerships. Unless an individual partner qualifies as a “limited partner” for self-employment tax purposes, the partner’s distributive share is subject to self-employment tax under the Self-Employment Contributions Act (SECA). Some individual partners, including service partners in service partnerships organized as state-law limited liability partnerships, limited partnerships, and limited liability companies, have inappropriately claimed to qualify as “limited partners” not subject to SECA tax. [emphasis added]

Sec. 1402(a)(13) was added to the Code as part of the Social Security Amendments of 1977, P.L. 95-216. The accompanying legislative history (H.R. Rep’t No. 95-702, 95th Cong., 1st Sess., Part 1, p. 11 (1977)) provides the following rationale for its enactment:

Under present law each partner’s share of partnership income is includable in his net earnings from self-employment for social security purposes, irrespective of the nature of his membership in the partnership. The bill would exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership. This is to exclude for coverage purposes certain earnings which are basically of an investment nature. However, the exclusion from coverage would not extend to guaranteed payments (as described in 707(c) of the Internal Revenue Code), such as salary and professional fees, received for services actually performed by the limited partner for the partnership.

The Internal Revenue Code does not define the term “limited partner” as originally enacted in Sec. 1402(a)(13), and no regulations defining the term were promulgated in the years following enactment. As noted by the Tax Court in Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011), at the time the limited partner exception was enacted, entities such as limited liability partnerships (LLPs) and limited liability companies (LLCs) were not in use. As such, the term “limited partner” in 1977 would have been limited to partners in state-law limited partnerships. As further noted by the Tax Court in Renkemeyer:

A limited partnership has two fundamental classes of partners, general and limited. General partners typically have management power and unlimited personal liability. On the other hand, limited partners lack management powers but enjoy immunity from liability for debts of the partnership. Indeed, it is generally understood that a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is generally akin to that of a passive investor. [citations omitted]

An IRS attempt to define ‘limited partner’ and the legislative response

However, as entities such as LLCs and LLPs proliferated, the IRS and Treasury saw the need to issue guidance on the definition of a “limited partner,” which came in 1997 in the form of proposed regulations (REG-209824-96, 62 Fed. Reg. 1702 (Jan. 13, 1997)). At a very high level, the proposed regulations would treat an individual as a limited partner unless (1) the individual had personal liability for the partnership’s debts, (2) the individual could contract on behalf of the partnership, or (3) the individual participated in the partnership’s business for more than 500 hours during the partnership’s tax year. Additional rules might permit a partner who failed one of the three tests above to be treated as a limited partner if the rights and obligations associated with the partnership interest were identical to those of the partnership’s other limited partners. However, a service partner in certain service partnerships could never be classified as a limited partner.

A crucial aspect of the 1997 proposed regulations was the application of a uniform test to all partners to determine whether they qualified as a limited partner under Sec. 1402(a)(13), regardless of the state-law legal form of the underlying partnership entity (i.e., the proposed regulations would have applied with equal force to limited partners in state-law limited partnerships and to members of LLCs). Under the proposed regulations, some state-law limited partners would have found that they did not qualify as a limited partner for purposes of Sec. 1402(a)(13).

In response to the 1997 proposed regulations, Congress enacted a moratorium on the finalization of regulations defining a limited partner under Sec. 1402(a)(13) until July, 1, 1998 (Taxpayer Relief Act of 1997, P.L. 105-34, §935). A Senate resolution with respect to the moratorium expressed concern that the 1997 proposed regulations might run contrary to the statutory language of Sec. 1402(a)(13) by denying the limited partner exception to individuals who were limited partners under state law (143 Cong. Rec. 13297 (1997)). In any case, the 1997 proposed regulations have never been finalized and remain outstanding in proposed form.

The Sec. 1402(a)(13) limited partner exception in the Tax Court 

The next major development in the scope of the limited partner exception was the Tax Court’s 2011 decision in Renkemeyer, in which the court considered whether a group of attorneys were subject to SECA on their distributive shares of income from their law practice that was organized as an LLP. While Renkemeyer specifically considered the potential application of the limited partner exception to an LLP, the court’s analysis raised interesting questions concerning the application of the limited partner exceptions to members of state-law limited partnerships.

It is not clear that the Renkemeyer definition of a “limited partner” takes state-law entity type into account at all. The court found that “limited partner” is a technical term that has “become obscured over time because of the increasing complexity of partnerships and other flowthrough entities as well as the history of [Sec.] 1402(a)(13).” That is, the court declined to find that the term “limited partner” simply meant (or would at least include) a limited partner in a state-law limited partnership.

Instead, the court looked to the legislative history noted above to define a limited partner for purposes of Sec. 1402(a)(13) by reference to the “investment nature” of the partnership interest of individuals “who merely invested in a partnership and who were not actively participating in the partnership’s business operations (which was the archetype of limited partners at the time).” Under this definition, it appears possible that even a state-law limited partner might fall outside Sec. 1402(a)(13) if the nature of the partner’s interest strayed from that of an archetypical 1970s passive investor. A draft version of the 2022 instructions for Form 1065, U.S. Return of Partnership Income, would have required partnerships to report partners’ amounts of self-employment income based on the Renkemeyer test for limited partner status, although this language was removed from the final instructions.

Another, more recent Tax Court memorandum decision may suggest that an individual’s status as a limited partner under state law could be relevant in considering the application of Sec. 1402(a)(13). In Castigliola, T.C. Memo. 2017-62, the Tax Court considered whether certain members of a Mississippi professional limited liability company (PLLC) qualified as Sec. 1402(a)(13) limited partners. The Castigliola opinion discussed the analysis in Renkemeyer and framed the analysis as whether the person claiming the Sec. 1402(a)(13) exemption held a position in an entity treated as a partnership for federal tax purposes that is “functionally equivalent to that of a limited partner in a limited partnership.”

The Tax Court’s opinion in Castigliola does not appear to necessarily restrict Sec. 1402(a)(13) limited partner status to partners that are functionally equivalent to the archetypical limited partner interests held by limited partners in 1977 when the limited partner exception was enacted. Castigliola examined the rights and obligations of the individual partners as members of a Mississippi PLLC (as modified, if it all, by the partnership’s operating agreement) to those of a limited partner in a limited partnership, taking into account state law in effect during the tax years at issue. Because PLLC members’ rights to participate in the partnership’s business were broader than the scope of activities permitted to be undertaken by limited partners under Mississippi’s limited partnership law as in effect during the years at issue, the taxpayers in Castigliola did not qualify as limited partners under Sec. 1402(a)(13).

Active litigation before the Tax Court regarding the status of limited partners under Sec. 1402(a)(13)

At the time of this writing, cases have been recently decided or are pending before the Tax Court in which the application of Sec. 1402(a)(13) to individuals holding interests in a state-law limited partnership is at issue. A recent opinion issued in Soroban Capital Partners LP, 161 T.C. No. 12 (2023), rejected an attempt by certain service-providing individuals to rely upon their legal status as limited partners under state law to qualify for the limited partner exception. Pending Sec. 1402(a)(13) cases involving investment managers include Denham Capital Management LP, No. 9973-23 (T.C. 6/22/23) (petition filed), and Point72 Asset Management LP, No. 12752-23 (T.C. 8/11/23) (petition filed)).

Some of the factual background in Soroban can be found in the Tax Court petition, as well as in the court’s November 2023 opinion. At a very high level, the Soroban petition suggests that the limited partnership at issue serves as an investment manager for various investment funds (the petition is available on Tax Notes at 2022 Tax Notes Today Federal 171-24 (July 21, 2022)). This limited partnership is classified as a partnership for U.S. federal income tax purposes, with three individuals holding state-law limited partnership interests. The limited partnership’s sole general partner is an LLC equally owned by the same three individuals.

The petition alleges that the partnership agreement provides the LLC general partner with the sole authority to control the limited partnership’s business. However, the individuals participate in various management roles in the limited partnership’s business and receive guaranteed payments for their services. Before the Tax Court, the limited partnership disputed the IRS’s determination that the individuals’ distributive shares received in their capacity as direct partners in the limited partnership do not qualify for the exemption under Sec. 1402(a)(13).

In its opinion issued on Nov. 28, 2023, the Tax Court granted the IRS summary judgment, rejecting Soroban’s legal position that state-law limited partner status, without more, is sufficient to qualify for the limited partner exception. Rather, the court held that even a state-law limited partnership must satisfy a functional analysis test to be entitled to the limited partner exception. The court did not describe the contours of the required functional analysis but noted that it involves a functional inquiry into the roles and activities of Soroban’s individual partners.

The resolution of Soroban and the other pending cases will, hopefully, provide guidance as to the scope of Sec. 1402(a)(13). In the meantime, taxpayers are left with limited guidance as to how the required functional analysis is applied.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com. Contributors are members of or associated with Grant Thornton LLP.