March 21st, 2026

Limited partners in partnerships, or entities treated as partnerships for federal tax purposes, have tried through various methods and arguments that the distributive share of a limited partner's income sourced from services or active business operations is not net income for self-employment taxes under the limited partner exception in Section 1402(a)(3). The Tax Court has not been that receptive to these reporting positions taken and upon IRS challenge has repeatedly held that the determination of this question is based on review of all facts and circumstances which in many cases results in finding of active business income or income from services. The issue cannot be resolved in the taxpayer's favor simply based on a limited partner's status under state law as has been argued by various partnerships and partners. The Tax Court's recent decisions in the Soroban Capital Partners LP cases again puts tax practitioners and their clients on notice that it continues to apply its "functional analysis" standard.

But Tax Court's functional analysis standard has recently be rejected in Sirius Solutions LLLP v. Commissioner, wherein the Fifth Circuit reversed the Tax Court's standard and held a limited partner can qualify for the self-employment income exception simply based on achieving limited partner status under state law, i.e., limited liability. Taxpayers subject to audit and review in the Fifth Circuit may rely upon such holding under the Tax Court's Golsen Rule. Therefore, partnerships entitled to rely upon, as direct precedent, decisions of the Fifth Circuit, can be "serious" about "Sirius" and achieve the desired outcome. Perhaps migration of investment funds and private equity partnerships to Texas, Louisiana, and Mississippi, may have as a factor this particular issue. There is also substantial authority for those who do not fall within the direct precedent of the Fifth Circuit.

The issue is presently before the First and Second Circuit Courts of Appeals. This post provides an overview or summary of these developments. As with other posts on this site, readers may not rely upon the information set forth here as legal advice. This would include procedural issues as well including full review of the centralized partnership audit rules including the "election out" provision. This blog post is provided solely for educational and informational purposes only. Persons interested in this issue are urged to consult with their tax advisors on this subject. For an excellent review of these current developments see Schwidetzky, "Sirius Solutions LLLP: The Fifth Circuit's Disappointing Opinion", Tax Notes (3/2/2028)

In Sorobon Capital Partners v. Commissioner, TC Memo. 2025-52 (5/28/2025) the United States Tax Court, per the Memorandum decision of Judge Ronald L. Buch, held: (i) the limited partners of the taxpayer-limited partnership were not "limited partners" under the limited partner exception for the self-employment tax under Section 1402(a)(13) of the Code; and that the Court would use its discretion to supplement the record and grant taxpayer's motion to reopen. The partnership filed an appeal with the Second Circuit and the parties' briefs have recently been submitted. The case is presently under appeal with the Second Circuit Court of Appeals, and the Partnership is relying upon the reasoning and analysis of the Fifth Circuit in Sirius Solutions, LLLP v. Commissioner, Nos. 11587-20 and 30118-21 (T.C. Feb. 20, 2004), vac't'd No. 2406-240 (5th Cir. 2026).

Underlying Facts of Soroban Capital Partners LP v. Commissioner

Soroban Capital Partners LP (Soroban) is a Delaware limited partnership having its principal place of Sorobon's hedge fund business at the time was New York, New York. Soroban Capital Partners GP LLC, is a Delaware limited liability company and the only general partner of the limited partnership. The petitioner-limited partnership had three, single member LLCs each treated as a defective entity under the check-the-box regulations.

For the years in issue Soroban was actively engaged in maintaining, operating, and owning a hedge fund business. Its sources of gross income were fees charged for investment advisory services to its clients. Soroban managed 11 funds: (1) Soroban Master Fund LP (Master Fund), (2) Soroban Fund LLC, (3) Soroban Intermediate Fund LP, (4) Soroban Cayman Fund Ltd., (5) Soroban Opportunities Master Fund LP (Opportunities Fund), (6) Soroban Opportunities Fund LLC, (7) Soroban Opportunities Intermediate Fund LP, (8) Soroban Opportunities Cayman Fund Ltd., (9) Soroban Special Investment Master Fund SPC (Special Fund), (10) Soroban Special Investment Fund LLC, and (11) Soroban Special Investment Fund SPC. The funds compensated Soroban according to the value of the fund assets and asset appreciation or performance. The funds paid Soroban quarterly investment management fees in amounts equal to 0 to 1.5% of the values of the funds. A Soroban affiliate annually receive annual performance-based compensation, ranging from 17% to 35% of the capital appreciation of the fund assets. Any management fees based on the value of the fund assets were charged at the master fund level. For the years in issue, Soroban's gross income represented amounts paid by the Master Fund and the Opportunities Fund. In 2016, the Master Fund and the Opportunities Fund paid Soroban $88,509,662 and $27,910,903, respectively, totaling $116,420,565. In 2017, the Master Fund and the Opportunities Fund paid Soroban $93,078,116 and $37,916,496, respectively, totaling $130,994,612. The other funds did not pay Soroban fees in the years in issue. On its returns for the years in issue, the partnership reported as net earnings from self-employment its guaranteed payments to its limited partners plus the general partner's share of ordinary business income. The financial facts are set out in some detail to impress the reader with the size of Soroban which can also be said for recent cases in this area on the application of the limited partner exception.

The Commissioner adjusted Soroban's net earnings from self-employment by increasing it to include the shares of ordinary business income allocated to the limited partners, asserting the "limited partners" were limited partners in name only and did not qualify under the limited partner exception in Section 1402(a)(13). The partnership taxpayer disagreed and filed a petition for judicial review. The Court therefore had to determine whether the three individual limited partners, Mandelblatt (58%), Kapadia (33%) and Friedman (6.5%) as such, for purposes of Section 1402(a)(13), were entitled to exclude their distributive share of the partnership's ordinary business income as limited partners under the self-employment exception. However, the three individuals reported as self-employment earnings the entire amount of income allocable to certain management fees reported as either a distributive share of ordinary income or, as guaranteed payments. The record established that Mandelblatt, Kapadia and Friedman managed both the investments and the operations of Soroban and the funds it managed, including: (i) daily "risk management oversight"; (ii) managed trade orders and monitored hedging transactions: (iii) managed investment personnel; (iv) served on committees that oversaw the operations of Soroban; (v) control over hiring decisions; (vi) Mandelblatt could bind the partnership and further sign over-the-counter derivative master agreements, confirmations and modifications; (vii) the three were involved full-time with respect to Soroban's operations'; (vii) review of capital contributions and distributions; (viii) role in advertising business, etc. As the opinion notes, "But for the three principals, Soroban would not exist".

Section 1401 Tax on Net Earnings from Self Employment

A short review of Section 1401 may be helpful. Under Section 702(a)(8), each partner is required to separately take into account his distributive share of the partnership's “taxable income or loss. The characterizing of partnership tax-items is generally determined at the partnership level. That would include what is and what isn't income from self-employment. That results that each individual partner is required to include his distributive shares of partnership income that represents "net earnings from self-employment. See, e.g., Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137, 146 (2011). To further refresh our collective memories, Social Security taxes for OSDI are 12.4% tax on net earnings from self-employment (NESE). The tax is adjusted for inflation and applies to NESE of up to the wage base ceiling amount which is $184,500 for 2026. The other tax for Medicare (HI) under Section 1401(b)(1), imposes a 2.9% tax on all of a taxpayer's NESE. There is no cap on the Medicare portion of the tax. Section 1401(b)(2) further imposes an additional Medicare Tax of .9% on self-employment income above a threshold amount. This results in a total marginal rate of Medicate (HI) tax of 3.8%. NESE does not include certain kinds of passive and investment income. Note further that Section that Section 1411 imposes a tax of 3.8% on the lesser of: (i) net investment income or (ii) the excess of modified adjusted gross income over a certain threshold amount. Let's focus on the limited partner exception to self-employment income tax.

While Section 1401(a) imposes a tax on NESE, Section 1402(b) defines “self-employment income” as “net earnings from self-employment derived by an individual (other than a nonresident alien ...) during any taxable year.” See Reg. Section 1.1401-1(c). Section 1402(a) defines net earnings from self-employment as “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions” attributable to the business, as well as an individual's “distributive share” of income or loss from a partnership. As to an individual partner, Section 1402(a)(3) specifically excludes from "net self-employment income" an individual-limited partner's “distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments” described in Section 707(c). Section 1402(a)(13) does not define, and neither do the regulations, the operative phrase used for the limited partner exception. However, the legislative history to Section 1402(a)(13), enacted in 1977, indicates that Congress wanted 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.” A proposed regulation issued in 1997 by the Treasury attempted to limit the scope of the limited partner exception , i.e., an individual would not be treated as a limited partner where the individual had personal liability for partnership obligations, had authority to contract on behalf of the partnership or participated in the partnership's business for more than 500 hours during the partnership's taxable year. This proposed regulation was roundly criticized by the service industry and professionals. Note further that at this time the advent of the limited liability company and other limited liability juridical entities was not commonly utilized or available under many states' laws. Note further that the partnership-items include not only each partner's share of such items but the legal and factual determination that underlie the determination of the amount, timing and characterization of items of income, credit, loss and deduction, including characterization of net earnings from self employment.

This led to a moratorium issued by Congress prohibiting the Treasury from issuing, in final form, the controversial proposed regulation. Tax Reform Act of 1997, Pub. L. No. 105-34, Section 935. The rationale for Congress' intervention in this area was concern from the Senate Finance Committee that the proposed change in the treatment of individuals who are limited partners under applicable state law exceeded the regulatory authority of the Treasury. It required proper congressional action. See Revenue Reconciliation Act of 1997, H.R. 2014, 105th Cong. (1997). In 2011 the Tax Court in Renkemeyer, supra, had to address Section 1402(a)(13) to lawyers in a law firm and concluded that the intent of Congress as to the limited partner exception was to "ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations....would not receive credits towards Social Security coverage." Congress also did not intend for limited partners actively rendering services for a partnership in their capacity as a partner would be immune from self-employment tax. In Renkemeyer, the lawyers were "limited partners" in a limited liability partnership (LLP) under state law, actively rendered legal services on behalf of the law firm and were not "mere investors". They were practicing law not merely investing in a business or assets held for appreciation. The standard is referred to as the "functional analysis" test. The Renkemeyer case involved a limited liability limited partnership which is a type of general partnership with limited personal liability for each member of the firm. A law firm, such as in Renkemeyer, may organize and operate as a LLLC or LLLP to limit or avoid individual member unlimited liability attributable to the negligence of another member of the firm engaged in a different practice. For background see Kleinberger, "Two Decades of "Alternative Entities": From Tax Rationalization Through Alphabet Soup To Contract As Deity", 14 Fordham J. Corp. & Fin. 445 (2008).

The Renkemeyer case had another issue related to the general partner in the law firm, an S corporation that had a 10% interest in the law firm. The S corporation was owned by a tax-exempt ESOP whose beneficiaries were the three lawyer limited partners. For the year in issue, the law firm allocated close to 9% of its net business income to the S corporation. The IRS objected to the special allocation as lacking economic substance in violation of Section 704(b) and the Court agreed. The facts in Renkemeyer were presumably viewed by the Service and the Tax Court as reflecting an overly aggressive tax reporting positions maintained by the taxpayers involved. This special allocation of 90% of law firm income to the general partner is not present under the facts in the Soroban Capital case. There is also an underlying factual aspect to Renkemeyer that provides an additional ground or rationale to reject the claimed limited partner exception in that case. It also involved a limited liability partnership and not a plain-vanilla limited partner in a limited partnership. In Soroban Capital, Judge Buch recognized this distinction and noted that it the first time the Court had to apply the functional analysis test to a limited partner under state law for purposes of the exception in Section 1402(a)(13). See also Castigliola v. Comm'r, T.C. Memo. 2017-62 (professional LLC members not limited partners). The point here is that the Tax Court in Renkemeyer correctly decided the NESE issues but the facts in the case make it distinguishable from the general funds manager or similar service infused limited partner cases presently before the courts.

Tax Court's Decision in Favor of Commissioner in Soroban Capital ("Soroban I"), 161 T.C. 2023 (2023)

In 2022 the Service issued two FPAAs to the Soroban Partnership for 2016 and 2017 respectively. Each proposed the recharacterization of the ordinary income allocated to the limited partners as net earnings from self-employment. Of course, the guaranteed payments made by the partnership and received by the limited partners did not qualify for the exception and were not in issue. The aggregate amounts involved were approximately $78M for 2016 and $64M for 2017. On its returns for the years in issue, the partnership reported as NESE the guaranteed payments plus the general partner's share of ordinary business income. Excluded from the partnership's computation of NESE were ordinary income distributions made to its limited partners.

Specifically, the Commissioner alleged the individual limited partners were not to be treated as limited partners for purposes of the Section 1402(a)(3) exception despite the fact that they were limited partners under state law. Messrs. Mandelblatt, Kapadia, and Friedman were limited partners in name only and did not qualify as limited partners for the purpose of section 1402(a)(13). After reviewing its prior decisions in this area. in Soroban I the Tax Court held: (i) the Court Tax Court had jurisdiction to determine whether a state law limited partner should be characterized as a limited partner for federal self-employment tax purposes; and (ii) granted the Government's motion for partial summary judgment that Section 1402(a)(13) requires a functional inquiry into the roles of the partners to determine whether they are bona fide limited partners. A limited partner's role must be passive in nature and that of a "mere investor" in order to qualify under the exception.

The Petitioner argued that the plain meaning of the statute supported its right to qualify each limited partner under Section 1402(a)(3). The Tax Court would disagree and ruled that each limited partner's distributive share of business income was not NESE under its functional analysis test. See Reg. Section 301.6231(a)(3)-1(b); Olsen-Smith, Ltd. v. Comm'r, T.C. Memo. 2005-174. In a case of first impression pertaining to a limited partner under Section 1402(a)(13), the Court concluded that the issue should be determined at the partnership level. Citing Gluck v. Comm'r, T.C. Memo. 2020-66. The Court again concluded that the appropriate legal standard is the "functional analysis" test to determine whether a partner in a state law partnership is a limited partner under Section 1402(a)(13) for a TEFRA partnership. In other words, state law by itself was not controlling. The Tax Court opined that Congress intended that the exception required a factual inquiry.

Tax Court Decision in Favor of Commissioner in Soroban II, T.C. Memo. 2025-62

The Tax Court then decided whether the purported limited partners were "limited partners" under the functional analysis test. It noted that it had recently applied the "functional analysis" test in a factually analogous case, Denham v. Commissioner, 2024 TC Memo. 114. In Denham Capital Management, the Tax Court, per Judge Kathleen Kerrigan, held that limited partners of a partnership were not "limited partners" for purposes of Section 1402(a)(13). Another hedge fund case, Denham had approximately $8B! of assets under fund management and a sizeable management and workforce in place. The proposed audit adjustments for self-employment tax in Denham were $27.5M for 2016 and $23M for 2017. The Petitioner failed to meet its required burden of proof and the case is now on appeal to the First Circuit Court of Appeals. See Tax Court Rule 142(a). Judge Koch stated that it would again apply the same standard it had recently applied in Denham, supra, to the case at bar. This required looking at the subject limited partners' role in generating income, management, time devoted to the business, role in the business, capital contributions and distributions, and additional factors including whether the limited partner has contractual authority to bind the partnership. In the Court's words: "A partner labeled a limited partner who works for the business full time, whose work is essential to generating the business's income, who is held out to the public as essential to the business, and who contributes little or no capital, is not functioning as a limited partner regardless of the label placed on that partner."

The taxpayer moved for the Court to reopen the record to receive additional evidence for prior years to show that distributions that Mandelblatt received were a return of investment capital The Government objected claiming such additional evidence to be introduced now was prejudicial. The Court went over its prior precedents on the issue of receiving additional evidence in ruling on the merits on the ultimate issue before the Court. The Court decided it would exercise its discretion to supplement the record by admitting into evidence Sorobans' partnership returns for 2010-2016. It did not change the result and that the limited partners shares of operating income were subject to self-employment taxes. The Court again emphasized that federal law, not state law, sets forth the consequences to the treatment of individuals and organizations for federal tax purposes and such outcomes need not be identical to the state law treatment or result. See Estate of Steffke v. Comm'r, 538 F.2d 730 (7th Cir. 1976), aff'g 64 T.C. 530 (1975). The Partnership appealed to the Second Circuit on May 28, 2025. The appeal is presently pending.

Sirius Solutions LLLP v. Commissioner: Fifth Circuit Rules in Favor of Limited Partner Under State Law Wins 165 F4th 374 (5th Cir. 2026).

In a somewhat noteworthy as well as surprising development in this area is the Fifth Circuit Court of Appeals recent decision in Sirius Solutions, LLLP. In Sirius Solutions the Fifth Circuit reversed the Tax Court and held that a limited partner for purposes of the self-employment exception is based on state law and whether the limited partner has limited liability. The majority court of the Court, in a 2-1 decision, rejected the Tax Court's passive investor standard, i.e., the functional analysis test. The Second Circuit in Soroban I and II, has the opportunity to put the Circuit Courts in conflict by affirming the functional analysis test of the United States Tax Court.

As previously mentioned, there is another case pending before the First Circuit Court of Appeals in Denham Capital Management LP v. Commissioner. Oral arguments were made to the Court last month. The taxpayers again advanced the argument that persuaded the Fifth Circuit in Sirius Solutions that a state law limited partner is sufficient to meet the requirements of the exception. The Tax Court in Denham Capital, T.C. Memo. 2024-114, held that a private equity firm's five partners did not qualify as limited partners for the exception under Section 1402(a)(13). In Denham, the FPAA adjustments for two years (2016 and 2017) aggregated $50M. The petitioner failed in its efforts to persuade the Court that the proposed adjustment increasing self-employment income to the limited partners should be rejected. Instead, the Tax Court found for the Commissioner once again applying its functional analysis test.

There will obviously be more to report on in this important area. Perhaps Congress will take the issue on and provide a statutory test or standard. It is reported that even our able Secretary of Treasury has taken a Fifth Circuit position on this issue while in the private sector. See Duehren, "The IRS Tried to Stop This Tax Dodge. Scott Bessent Used It Anyway", NY Times (11/12/2025). Other partnerships and limited partners residing outside of the Fifth Circuit should understand that the Tax Court will continue to apply on its "functional analysis" test in evaluating a self-employment tax case. This issue is of particular importance to hedge fund managers, investment managers, private equity fund managers as well as entrepreneurs engage in business operations in partnership form. But it also has application to other partnerships, even the small law, accounting, engineering or other service-based company.