December 1st, 2025

Denham Capital Management LP Seeks to Reverse Tax Court's Decision Upholding Government's Partnership Item Adjustment for Net-Self Employment Income Before the First Circuit Court of Appeals

The IRS issued notices of Final Partnership Administrative Adjustment ("FPAA") for 2016 and 2017 to Denham Capital Management LP in March 2023. In accordance with the (former) TEFRA partnership audit regime, the tax matters partner, Denham Capital Management GP LLC, a large private equity firm, timely filed its petition with the U.S. Tax Court for each year. In accordance with its FPAA, the government had determined that net earnings from self-employment for 2016 was to be increased by $27.475M and by $22.92M for 2017. The case was tried by Chief Judge Kathleen Kerrigan in 2024, and the Court entered its decision on January 14, 2025, in sustaining the IRS's adjustments. Denham GP LLC timely filed an appeal with the First Circuit.

The first issue before the Tax Court was whether an adjustment to a partnership's net self-employment income is an adjustment to a partnership tax item under the partnership audit rules. The second and arguably the primary issue in the case is whether individuals who render services on behalf of an unincorporated entity taxed as a partnership for federal income tax purposes, can qualify under the exception for net-income from self-employment tax with respect to income allocable to their ownership interest as a "limited partner" under Section 1401(a)(13) and therefore avoid social security tax. As discussed below, the Tax Court, following its own precedent, found that the partners were not to be treated as limited partners for purposes of Section 1402(a)(13) in instances where the partners were main actors in generating the firm's income, devoted substantially all their time to operating the business and business decisions of the company, including controlled personnel decisions, and demonstrated they were crucial and active parts of the firm's business. The taxpayer therefore failed to meet its burden of proof that such partners were not subject to self-employment tax on the basis that they were "merely passive investors". The taxpayer appealed the Tax Court's decision to the First Circuit Court of Appeal where the parties have recently filed briefs.

Background of the Section 1402(a)(3) Exception for Net Income from Self-Employment of a Limited Partner and the Tax Court's Response

Section 1401(a) imposes a tax on the self-employment income of every individual for a taxable year (the self-employment tax). Self-employment income is defined as “the net earnings from self-employment derived by an individual...during any taxable year” excluding (1) the portion in excess of the Social Security wage base limitation for the year as well as (2) all earnings from self-employment if the total amount of the individual's net earnings from self-employment for the taxable year is less than $400. Section 1402(b). Section 1402(a) defines earnings from self-employment as "gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in Section 702(a)(8) from any trade or business carried on by a partnership of which he is a member...". The social security tax rate for 2026 is 12.4% on the first $184,500 of net self-employment income and the Medicare add-on rate of 2.9% applies to all self-employment income without a ceiling amount. The Medicare tax is increased by 0.9% for single taxpayers with SE income over $200,000 and for taxpayers filing a joint return with SE over $250,000 ($125,000 for married taxpayers filing separate returns but only with respect to the amount above the threshold amount. A deduction is allowed for 7.65% of self-employment income computed without regard to the 0.9% additional Medicare self-employment tax. Section 1402(a)(12).

As one of several statutory exclusions from the definition of self-employment income, Section 1402(a)(13), enacted in 1977, excludes the distributive share of the net income or loss of a "limited partner" from SE tax. This exception does not apply, however, in certain instances. For example, the limited partners exception does not apply with respect to guaranteed payments made to a partner, including a limited partner, as remuneration for services rendered to or on behalf of the partnership. The limited partner exception to SE tax was enacted into law by Congress to thwart efforts made by certain taxpayers to end-run the SE tax such as by investing amount in small sums in limited partnerships and treating the earnings as not subject to the SE tax. In order to provide the proper balance in this area, Congress enacted as exclusion from self-employment income for "the distributive share of any item of income or loss of a limited partner, as such. The statute does not define a limited partner for this purpose and as a result the IRS and taxpayers have differed on the proper scope of Section 1402(a)(13) with taxpayers predictably arguing that limited partners, as passive investors for state law purposes, qualify for the exclusion.

In 1997, proposed regulations were issued to define the scope of the exception. 62 Fed. Reg. 1702 (1/13/1997). This pronouncement, which borrows from the active versus passive
material participation rule of 500 hours under the passive activity regulations to Section 469, announced that an individual would not be treated as a limited partner if such 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 taxable year. Shortly thereafter the proposed regulation was "shelved" based on criticisms that were lodged. Congress then announced a moratorium prohibiting the Treasury from issuing any regulation on the definition of limited partner under Section 1402(a)(13). See Taxpayer Relief Act of 1997, P.L. 105-34, Sec. 935. Congress has continued to study the issue understanding that litigation on this issue has and will continue to be resolved by the courts. Taxpayers continue to argue that the state law definition of "limited partner" should be controlling for purposes of Section 1402(a)(13) based on an "ordinary meaning" test. The argument advanced is that since Congress did not define what "limited partner" means for purposes of this exception, the Websterian definition should control for litigation purposes as the proper legal standard. The Courts, so far, have not been inclined to go along.

Litigation continued in the courts, particularly the United States Tax Court, on whether the status of simply being a "limited partner" under state law, would allow such "limited partners" to benefit from the exception. The courts, particularly the United States Tax Court, has not been receptive and in contrast to the "limited partner" status rationale, has applied a "substance over form" type approach in sorting out the "active limited partner" from a "passive limited partner". In Soroban Capital Partners, LP v. Commissioner, 161 T.C. 310 (2023), the Tax Court, in a fully reviewed decision per Judge Buch, held that the limited partner exception is inapplicable where a limited partner is "passive" in name only and otherwise actively engaged in the business of the partnership. Such "limited partner" should not be treated as a limited partner for purposes of Section 1402(a)(13). In its FPAAs for the two years in issue, the government proposed recharacterizing ordinary income allocated to Soroban's limited partners as self-employment income. The increase in SE income was $77.7M for 2016 and $63.87M for 2017. After deciding the cross motions for summary judgment in favor of the IRS, the Court applied a functional analysis into the key roles and responsibilities of the principal limited partners in the business. The Court concluded that the principals in question were not limited partners for purposes of Section 1402(a)(13) and their earnings were income from self-employment. T.C. Memo. 2025-52.

Prior to Soroban Capital Partners, LP, supra, in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), the Tax Court applied its "functional analysis test" in determining whether attorney-partners of a Kansas limited liability partnership were to be treated as limited partners for purposes of Section 1402(a)(13). The Tax Court, per Judge Jacobs, held, inter alia, that the attorney partners' distributive shares of law firm net income were subject to self-employment tax as such distributive shares of income were not derived from investments but from legal services that the attorney-partners performed on behalf of the partnership. The facts involved a special allocation of such law firm income to the S corporation partner so that the wages paid out from the S corporation would yield a payroll tax savings. The economics to the special allocation was rejected by the Court as well. See Treas. Regs. §§1.704-1(b)(3)(i), (ii). The Court in Renkemeyer held that the interest of a limited partner in a limited partnership is similar to the interest of a passive investor. Note that the legal entity in Renkemeyer was a limited liability partnership involving professional members as required under Kansas law. This distinction between a member-partner of a LLP under state law with the rights and obligations of a limited partner has already been noted. See Castigliola v. Commissioner, T.C. Memo. 2017-62 (professional LLC members not "limited partners" for purposes of Section 1402(a)(13)). See also Hardy v. Commissioner, T.C. Memo. 2017-16 holding that a surgeon who held a minority interest in a partnership which operated a surgi-center was a limited partner for purposes of Section 1402(a)(13). The surgeon charged his fees directly to the center for surgeries he performed but had no day-to-day management responsibilities to the partnership and patients paid separate fees to the partnership. The taxpayer succeeded in contending his distributive share of partnership income was not income from self-employment. The functional analysis test, not state law, was applied by the Tax Court in Hardy.

In Soroban Capital Partners, LP, supra, the partnership, which is a New York hedge fund management company formed as a Delaware limited partnership, made guaranteed payments and distributed ordinary income to its limited partners who excluded the ordinary income distributions from the calculation of net earnings from self-employment income. The IRS would go on to challenge the taxpayer's position and resulted in a trial before the Tax Court. The Court, per Judge Buch, held that the taxpayer failed to meet its burden of proof that the earnings allocated to the limited partners, based on their functions and roles to the partnership, were investment income. See Sundstrand Corp. v. Commissioner, 98 T.C. 518, 570 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994). See also T.C. Rule 121(b) (summary judgment), FRCP 52(a). The taxpayer in Soroban Capital Partners, LP has recently filed an appeal with the Second Circuit over the Tax Court's holding that only passive investors qualify under the limited partner exception. In Soroban, the hedge fund participants are simply state law limited partners unlike lawyers in a professional LLLP (or LLC) as in Renkemeyer, supra or Castigliola, supra. The government argued that the argument failed and that the application of the functional analysis test applied to the activities and functions of the hedge fund managers results in non-application of Section 1402(a)(13). This was the first reported decision on the application of the functional analysis test to "active" limited partners of a state law partnership.

In Sirius Solutions LLLP v. Commissioner, No. 30118-21 (Tax Court 2/24/2024), appeal docketed No. 24-60240 (5th Cir. 5/15/2024), a pre-centralized partnership audit rule case controlled by the TEFRA audit rules, the government moved to assess self-employment tax on net earnings of a partnership's business income allocated to limited partners. The taxpayer was engaged in the business of consulting and was owned by one general partner and up to nine limited partners for the years in issue. The partnership excluded the limited shares of partnership income or loss in computing net earnings from self-employment for 2014 and 2015 which aggregated over $13M. The government predictably disagreed and issued a notice of final partnership adjustment to which the partnership filed a petition for readjustment with the Tax Court. See Section 6226(a). The parties filed cross motions for partial summary judgment. Again, the Tax Court, per Judge Buch, applied its "functional analysis" test in determining limited partner status for purposes of Section 1402(a)(13). Based on the record, the Court granted the government's motion for partial summary judgment applying its analysis in Soroban, supra. The taxpayer has appealed the case to the Fifth Circuit in 2024. Oral arguments were made in February, 2025 so the Fifth Circuit should be expect to issue its ruling in the near future.

Denham Capital Management LP v. Commissioner, TC Memo 2024-114, appeal pending No. 9973-23 (1st Circuit 4/7/2025).

The Tax Court again applied its functional analysis test in resolving Section 1402(a)(13) cases in Denham Capital Management LP, supra, which decision was issued last December 23, 2024, and is currently on appeal to the First Circuit Court of Appeals. Denham Capital renders investment advisory and management services to affiliated private equity funds that invest in several energy sectors. The partners functioned similarly to and were subject to the same policies and procedures as employees of the company. The general partner, Denham Capital Management, LLC, had unlimited liability for the obligations of the partnership while the limited partners' exposure to partnership liabilities was limited to their capital contributions. The contributions made by the limited partners of the Denham Capital Management LP varied between funds and the rendering of services for profits interests. Denham managed five active funds in 2016 and seven active funds in 2017, under which it had $7.5 billion and $8.3 billion of assets under management, respectively. Pursuant to investment advisory agreements between the general partner, Denham Capital Management GP LLC and each fund, Denham was expected to furnish investment advice, negotiate terms of investments, monitor the health of the investments, and complete the day-to-day administrative tasks associated with managing the funds. Readers are directed to review the facts of the case as reflected in the Court's opinion for a comprehensive summary of the record.

For the years in issue, 2016 and 2017, the IRS increased the partnership's net self-employment income by $29.25M (2016) and $24.4M (2017). During this period, Denham paid its five limited partners market-based guaranteed payments for the services they provided, and they shared in Denham's profits as limited partners. Consistent with the text of the limited-partner exception--as it had long been interpreted by both agencies responsible for administering it--the limited partners reported their guaranteed payments, but not their distributive shares, as net earnings from self-employment. The government disagreed.

As is generally the case in Tax Court litigation, the government's determinations set out in the FPAA are generally presumed to be correct which presumption may be rebutted. T.C. Rule 142(a). The burden of proof may shift, per 26 USC Section 7491, to the IRS provided specific conditions are met including the introduction of credible evidence with respect to an issue of fact. If each party meets its burden of production in moving forward, the Tax Court renders judgment in favor of the party supported by the weight of the evidence which generally remains with the taxpayer unless there is an "evidentiary tie". See Knudsen v. Commissioner, 131 T.C. 185 (2005), supplementing T.C. Memo. 2007-340. In Denham Capital the burden of proof remained with the partnership. Chief Judge Kerrigan issued the Memorandum Findings of Fact and Opinion on behalf of the Court in finding for the Commissioner in holding that five partners of a private equity firm's distributive shares of partnership income did not fall within the exception under Section 1402(a)(13) and that the aggregate amount of the proposed adjustment by the IRS was net income from self-employment as a partnership tax item.

Chief Judge Kerrigan noted the Court's recent holding in Soroban Capital Partners, LP, supra, that the Court has jurisdiction to determine a state law limited partner's status for purposes of resolving a Section 1402(a)(13) case involving the determination of the partnership's net self-employment income, and not just the partners individually. The Petitioner argued that the Court's recent holding in Soroban Capital , 161 TC 310 (2023)(J. Buch) was erroneous in that the Soroban Court did not consider a third prong of the definition of partnership items under the partnership audit rules; to-wit: that the item must affect the entire partnership, not just the partners individually. This argument was rejected by Chief Judge Kerrigan in the Court's Memorandum decision finding no "special justification" for revisiting its reasoning in the Soroban case and again held that the determination of the applicability of the limited partner exception is a partnership item for which the Court has jurisdiction. The Tax Court reaffirmed its commitment to applying the functional analysis test in determining whether the partners were "generally akin" to passive investors. The Tax Court concluded that five limited partners were more akin to employees rather than passive investors. The Court rejected the Petitioner's arguments that: (i) state partnership law is not determinative of whether a partner should be treated as a limited partner for purposes of Section 1402(a)(3); (ii) the record before the Court supports the conclusion that the Partners were operating the business as self-employed workers rather than as "limited partners" within the intended scope of the exception; and (iii) that the Partners were acting as limited partners and not on investment advisory and related services. The partnership filed an appeal with the Second Circuit Court of Appeals this Summer.

In Sirius Solutions LLLP v. Commissioner, No. 11587-20 (2024), a limited partnership argued that Section 1402(a)(13) should exclude state law limited partners from net self-employment earnings under the Self-Employment Contributions Act tax on a limited partner's distributive share of income or loss. Sirius Solutions is a Delaware limited liability limited partnership treated as a limited partnership under Delaware state law. The parties agreed that the limited partners are treated as such under Delaware law. During 2014 Sirius was owned by five limited partners and Sirius GP. All limited partners had limited liability. The limited partner were allocate a share of Sirus Solutions income for the years in issue which were 2014-2016. The government increase net self-employment income, as a partnership tax item, by $5.9M for 2014 and $7.4M for 2015. It should be noted in this instance, as in the preceding instances, the gross adjustments to net self-employment income are not tax owed but the adjustments are to be further allocated to each limited partner in determining each such limited partner's net income from self-employment subject to social security and Medicare Tax. Consistent with its analysis and holding in Soroban Capital Partners, LP, the Tax Court entered judgment in favor of the government. The taxpayer filed an appeal with the Fifth Circuit in May 2024. See Parillo, "DOJ: Limited Partner Exception Imposes Passive Investor Standard", Tax Notes (12/1/2025).

What to Expect From the Circuit Courts of Appeal?

The functional analysis standard applied by the Tax Court should be expected to be followed by the First Circuit in Denham Capital Management LP as well as by the Second Circuit in Soroban Capital and the Fifth Circuit in Sirius Solutions LLLP. The appellants arguments seem to be based on the same principle, and that is that the plain meeting of the term "limited partner" should be applied under Section 1402(a)(13). As of this date the odds-makers favor the government.

Other cases outstanding are Point72 Limited Partnership v. Commissioner, Docket No. 12752-23 and Atalaya Capital Management LP v. Commissioner, Docket No. 3253-25. In addition two New York hedge funds have recently filed Tax Court petitions challenging the IRS' position that "active" state law partners do not qualify for the limited partner exception. See Parillo, "Hedge Funds Join Tax Court Fight Over Limited Partner Exception", Tax Notes (7/21/2025)(discussing recent Tax Court petitioners for Valinor Management LP and Summit Rock Advisors LP).

This post is issued by August Tax Law, P.C. solely for informational and educational purposes and may not be used or otherwise relied upon as legal or tax advice by the reader.