Tax Court Again Uses Functional Test to Deem Partners Limited ‘In Name Only’

The Tax Court, following recent precedent, determined that three partnership members were not limited partners based on their day-to-day functions and thus subject to self-employment tax. (Soroban Capital Partners LP, (5/28/2025) TC Memo 2025-52)

Background.

Soroban Capital Partners LP is a limited partnership registered as a Delaware LLC, with a principal place of business in New York, New York. The IRS in April 2022 sent Soroban Notices of Final Partnership Administrative Adjustment (FPPA) for tax years 2016 and 2017. According to the IRS, Soroban mischaracterized income allocated to its limited partners: EWM1 LLC, GKK LLC, and Scott Friedman.

The adjustments treated the limited partners’ ordinary income as self-employment net earnings, resulting in increases to Soroban’s self-employment income for 2016 ($77,663,963) and 2017 ($63,866,302).

Generally, Code Section 1402(a) provides that net earnings from self-employment means the gross income derived by an individual from any trade or business carried on by such individual, less the business’ deductions and the individual’s distributive share of income or loss from a partnership.

An exception under Code Sec. 1402(a)(13), however, excludes the distributive share of any item of income or loss of a limited partner — other than guaranteed payments — from net earnings from self-employment. But the IRS’ notices informed Soroban that the exception did not apply to the limited partners for both tax years.

Prior proceedings.

The Tax Court previously ruled in Soroban v. Commissioner (161 TC 310) that a “functional analysis test” is necessary to “determine whether a partner in a state law limited partnership is a ‘limited partner'” under Section 1402(a)(13). The court also determined it had jurisdiction to determine in a TEFRA proceeding how to apply the functional analysis test. Accordingly, the court granted the IRS’ motion for partial summary judgment upholding the FPPAs.

Shortly after, the Tax Court ruled in Denham Capital, Management, LP (TC Memo 2024-114) that Congress intended the exception to apply to partners that are “passive investors” and not “actively participating” in daily business operations.

Soroban and the IRS filed a joint motion to submit their case, and then filed simultaneous briefs. Among the new files was Soroban’s motion to reopen the record, so that it would reflect its Forms 1065 for 2016-2017 and earlier.

Memorandum opinion.

The Tax Court in a May 28 memorandum opinion again sided with the IRS in Soroban, finding the limited partners were limited partners “in name only” and did not qualify for the Section 1402(a)(13) exception for federal tax purposes.

Soroban’s partners were “essential” to its business operations and were responsible for generating income, the Tax Court said. Because those earnings were not “of an investment nature,” the court upheld the IRS’ adjustments. Applying the functionality test, the court said they were also “held out to the public” as essential and participated in management and Soroban’s decision-making processes.

Moreso, they worked full-time, and “their earnings constitute net earnings from self employment for the years in issue,” the opinion read. Soroban’s arguments relied on a “legal fiction” that the individual partners served the business in a limited capacity. “Instead, petitioner argues, they acted with authority delegated to them by the general partner, which they in turn had the authority to manage.”

The court added that Soroban’s position “is precisely why application of federal tax law to the economic arrangement of the parties controls, and not mere state law classifications.”

For more on the limited partnership exception for federal self-employment tax purposes, see Checkpoint’s Federal Tax Coordinator ¶A-6157.