Sec. 1402(a)(13) and limited partnerships

The Sec. 1402(a)(13) exception from net earnings from self-employment of limited partners’ distributive shares of income does not apply to a partner in a state-law limited partnership (LP) if a functional inquiry into the functions and roles of the partner shows that the partner is limited in name only.

Background

Soroban Capital Partners LP (Soroban) is an investment firm that is organized as a limited partnership. It was originally formed as a limited liability company (LLC) but converted to a limited partnership on Jan. 1, 2015. Soroban is classified as a partnership for federal income tax purposes.

Under Soroban’s limited partnership agreement, the LP has one general partner and five limited partners. Soroban Capital Partners GP (SCP GP) is the general partner and tax matters partner. The limited partners are Eric Mandelblatt, Gaurav Kapadia, Scott Friedman, EWM1 LLC (owned by Mandelblatt), and GKK LLC (owned by Kapadia). EWM1 and GKK, being single-member LLCs, are treated as disregarded entities of Mandleblatt and Kapadia, so for federal income tax purposes, Mandelblatt, Kapadia, and Friedman are the only three limited partners of Soroban.

For 2016 and 2017, the three limited partners received guaranteed payments in exchange for providing services to Soroban. They also received their share of Soroban’s ordinary income. Soroban filed Forms 1065, U.S. Return of Partnership Income, for both years. It reported the guaranteed payments to the three limited partners and SCP GP’s share of ordinary income from Soroban on the returns as net earnings from self-employment. However, Soroban excluded the three limited partners’ share of its ordinary business income from net earnings from self-employment.

The IRS, after examining Soroban, issued Notices of Final Partnership Administrative Adjustment to the LP for the years in issue, increasing its net earnings from self-employment and gross nonfarm income by the amount of its three limited partners’ shares of ordinary income from Soroban. Soroban, through its tax matters partner, SCP GP, challenged the IRS’s determination in Tax Court.

Soroban filed a motion for summary judgment, asking the Tax Court to hold that Sec. 1402(a)(13) excluded the three limited partners’ shares of Soroban’s ordinary business income from net earnings from self-employment and thus excluded those earnings from selfemployment tax. Soroban argued that the three Soroban limited partners are state-law limited partners because Soroban is a state-law limited partnership and its limited partnership agreement identified them as such. As limited partners, Soroban contended, their distributive shares of income are excluded from net earnings from self-employment under Sec. 1402(a)(13). The IRS countered that the distributive shares of income of limited partners in state-law limited partnerships are not automatically exempt from self-employment income.

It argued that the Tax Court must apply a functional analysis test, as it had in earlier cases addressing the applicability of the limited partner exception to partners or members of other types of entities, to determine whether the three limited partners are limited partners for self-employment tax purposes.

In the alternative, Soroban asked in its motion that the court hold that any inquiry into a limited partner’s role at Soroban did not concern a partnership item and could not be resolved in a TEFRA partnership-level proceeding (i. e., subject to the audit and litigation procedures under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248). The IRS filed a motion for partial summary judgment arguing that, as a matter of law, an inquiry into the limited partners’ roles at Soroban concerned a partnership item that could be resolved in a TEFRA partnership-level proceeding.

The Tax Court’s decision

The Tax Court denied Soroban’s motion for summary judgment and granted the IRS’s motion for partial summary judgment. It held the Sec. 1402(a)(13) limited partner exception does not apply to a partner who is limited in name only and that determining whether a partner is a limited partner in name only requires an inquiry into the functions and roles of the limited partner. It also held that because net earnings from self-employment is a partnership item, an inquiry into the functions and roles of a limited partner is a factual determination that underlies a partnership item that is properly undertaken in a TEFRA partnershiplevel proceeding.

Self-employment tax on partnership income and limited partner exception: Taken together, Secs. 1402(a) and 702(a)(8) generally require partners to include their distributive share of partnership income in net earnings from self-employment. However, Sec. 1402(a)(13) contains an exception for “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Sec. 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.”

Although Sec. 1402(a)(13) does not define “limited partner, as such,” the Tax Court stated that insight into its meaning was found in the provision’s legislative and regulatory history, as well as case law. The legislative history indicated that the exception in Sec. 1402(a) (13) was intended to 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. In essence, it was enacted to exclude earnings that are of an investment nature.

1997 proposed regulations: In 1997, the IRS issued proposed regulations defining the scope of the limited partner exception (Prop. Regs. Sec. 1. 1402(a)-2; 62 Fed. Reg. 1702 (Jan. 13, 1997) ). The proposed regulations provided that an individual would not be treated as a limited partner if the individual had personal liability for partnership debts, had authority to contract on behalf of the partnership, or participated in the partnership’s trade or business for more than 500 hours during the partnership’s tax year.

However, these proposed regulations met with much criticism, leading Congress to enact a moratorium on the IRS from issuing temporary or final regulations on the subject until July 1, 1998 (Taxpayer Relief Act of 1997, P.L. 105-34, Section 935). Since that time, Congress has only briefly addressed the issue in a committee report, noting that limited partner status is determined under state law and that issues have arisen as to how limited partners that participate in management should be treated for self-employment tax purposes. The IRS has not issued any final or temporary regulations defining “limited partner.”

Tax Court decisions on limited partner exception: In 2011, the Tax Court addressed the scope of the exception in the context of a law firm set up as a limited liability partnership in Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011). The court held that lawyers who were partners in a firm were not limited partners for purposes of Sec. 1402(a)(13) because their “distributive shares arose from legal services … performed on behalf of the law firm” and not “as a return on the partners’ investments.”

In Renkemeyer, the Tax Court specifically applied a functional analysis test to determine whether the limited partner exception applied. Later, it applied the same test to an LLC and held that the professional members of the LLC were not limited partners for purposes of Sec. 1402(a)(13) (Castigliola, T.C. Memo. 2017-62). However, in those cases and other Tax Court cases dealing with the limited partner exception, the court did not address whether a limited partner in a state-law limited partnership like Soroban must satisfy a functional analysis test to be entitled to the limited partner exception.

Limited partner exception in the context of a limited partnership: The Tax Court found that Soroban’s case presented the question of whether an LP’s earnings from self-employment should include its limited partners’ distributive shares of ordinary business income. To resolve this question, the court reasoned it was necessary to address two preliminary issues.

First, the Tax Court found it was required to determine the scope of the Sec. 1402(a)(13) limited partner exception. If it concluded that the limited partner exception required an inquiry into a limited partner’s role in the partnership, the court found it was required to determine a second issue, whether it had jurisdiction to make that inquiry in partnership-level proceedings.

Because Sec. 1402(a)(13) and the applicable regulations do not define the phrase “limited partner, as such,” the Tax Court used the principles of statutory construction to ascertain Congress’s intent for the phrase. Under these rules, the court begins with the statute’s text, giving the term its ordinary meaning at the time of enactment. The court incorporated the canon against surplusage in its statutory-construction analysis of the meaning of the phrase at the time of enactment. A court is required by this canon to give effect to every clause and word of a statute in its analysis to avoid rendering any part of the statute meaningless surplusage.

The Tax Court found that, in accordance with the canon, the limited partner exception does not apply to a partner who is limited in name only, because doing so would render the words “as such” meaningless. The court stated, “If Congress had intended that limited partners be automatically excluded, it could have simply said ‘limited partner.’ By adding ‘as such,’ Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner.”

Soroban pointed to a House of Representatives report (H.R. Rep’t No. 95-702, Part 1, at 11, as reprinted in 1977 U.S.C.C.A.N. at 4168), in support of its position. Soroban noted that the House report states that Sec. 1402(a)(13) was intended “to exclude for coverage purposes certain earnings which are basically of an investment nature.” In the Tax Court’s view, this did not help Soroban because “Congress’s express text makes clear that it was looking to the nature of the earnings” and that it intended Sec. 1402(a)(13) to apply to partners that are passive investors.

Soroban also pointed to the Senate’s criticism of the proposed regulation regarding the definition of “limited partner” in a Sense of the Senate Resolution (H.R. 2014, 105th Cong., 143 Cong. Rec. S6694, S6774, S6819), in which the Senate stated that the IRS had exceeded its authority in trying to define “limited partner” in its 1997 proposed regulations. The Tax Court observed, however, that the proposed regulation contained several criteria under which a limited partner’s earnings would be subject to self-employment tax even if the person was a passive investor (e.g., the limited partner’s being personally liable for partnership debts (Prop. Regs. Sec. 1.1402(a)-2(h)(2)(i)). The Senate’s concern, the Tax Court stated, was that limited partners that were passive investors meeting any one of these other criteria would be treated as a general partner. Thus, the Tax Court found that the Senate’s concern about the criteria in the proposed regulation did not override the plain text of the statute.

Lastly, Soroban cited as support a Joint Committee on Taxation report that states: “A special rule applies for limited partners of a partnership” (Staff of J. Comm. On Tax’n, Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I, at 35 (JCX-62-07) (Sept. 4, 2007)). A footnote in that sentence explains that “limited partner status is determined under State law” (id. At 35 n. 64).

The court found that the report did not support Soroban’s position because it addresses only the meaning of the words “limited partner” and not the phrase “limited partner, as such.” According to the court, the latter phrase is what narrows the scope of the limited partner exception, and the Joint Committee report does not address its meaning. Citing its own precedent in Gregory, 149 T.C. 43, 55 (2017), the Tax Court found “[to] the extent one might read the Joint Committee on Taxation Report more broadly, it does not constitute legislative history and carries no more weight than a law review article.”

Soroban also claimed the passive activity rules in Sec. 469 and regulations bolstered its interpretation of Sec. 1402(a)(13). However, the Tax Court found that Sec. 469 was not analogous and that Soroban cited dicta out of context on this point.

Finally, Soroban asserted that the 2016 and 2017 instructions for Form 1065, U.S. Return for Partnership Income, supported its position. These instructions state: “A limited partner is a partner in a partnership formed under a state limited partnership law, whose personal liability for partnership debts is limited to the amount of money or other property that the partner contributed or is required to contribute to the partnership.” The Tax Court noted that this definition cited by Soroban is provided as part of the “General Instructions” and “Definitions” in the instructions and was not and did not purport to be a definition for purposes of selfemployment tax.

Instead, the instructions’ discussion of self-employment tax stated: “Generally, a limited partner’s share of partnership income (loss) isn’t included in net earnings (loss) from self-employment.” The Tax Court found that the instructions’ use of the qualifier “generally” made it clear that it is not always true that a limited partner’s share of partnership income is excluded from net earnings from self-employment.

Having found all of Soroban’s arguments lacking, the court held that it was required to examine the functions and roles of the three limited partners to determine whether their shares of earnings from the LP were excluded from net earnings from self-employment. The court then moved to the second issue, whether that examination should occur in the partnership-level proceedings or in a later partner-level proceeding.

As the Tax Court explained, it has jurisdiction over a TEFRA partnershiplevel proceeding when the tax matters partner or another eligible partner timely petitions it for a readjustment of partnership items. Consequently, whether it had jurisdiction to examine the functions and roles at Soroban to determine if application of the Sec. 1402(a)(13) limited partner exception turned on whether this determination is a partnership item.

Before the repeal of the TEFRA provisions by the Bipartisan Budget Act of 2015, P.L. 114-74, under Sec. 6231(a)(3), a partnership item was an item (1) that is required to be taken into account for the partnership’s tax year under Subtitle A, and (2) that regulations provide is more appropriately determined at the partnership level.

With regard to the first requirement, Sec. 1402 is in Subtitle A, and the Tax Court, citing its own precedent (Olsen- Smith, Ltd., T.C. Memo. 2005-17), found that a partnership is required to separately state the amount of income that would be self-employment income if its recipients were individuals. More specifically, a partnership must determine the entity status of its direct partners and report its ordinary income as self-employment income except to the extent the income was allocated to a direct partner that was a limited partner. Thus, the first requirement was met.

The Tax Court then considered the second requirement, whether the determination of a partner’s status as a limited partner was an item more appropriately determined at the partnership level. To answer this question, the court looked to Regs. Sec. 301.6231(a)(3)-1, which identifies partnership items that meet this criterion. Regs. Sec. 301.6231(a) (3) -1(b) provides:

Factors that affect the determination of partnership items. The term “partnership item” includes the accounting practices and the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.

The Tax Court concluded that “a functional inquiry into the roles and activities of Soroban’s individual partners as required by section 1402(a)(13) involves factual determinations that are necessary to determine Soroban’s aggregate amount of net earnings from self-employment.” Therefore, the functional analysis of the roles of the three Soroban limited partners was a partnership item that was appropriately done in partnership-level proceedings.

Reflections

Interestingly, although the limited partnership exception has been used as a justification for partners in professional partnerships not being required to pay Social Security tax on income from the partnerships, the exception was enacted to prevent the use of limited partnership investments to obtain Social Security benefits. As the Tax Court stated in a footnote to its opinion, “[b]efore its enactment, business organizations could solicit investments in limited partnerships as a means for investors to become insured for Social Security benefits. In these situations, investors in the limited partnership would perform no services for the partnership and receive Social Security coverage based on investment income.”

Soroban Capital Partners, LP, 161 T. C. No. 12 (2023)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.