Net earnings from self-employment (NESE) are subject to payroll taxes. A partner's distributive share of partnership income generally is NESE unless the partner is a "limited partner, as such." Section 1402(a)(13). The IRS Large Business & International Division (LB&I) launched a compliance campaign in March 2018 asserting that some partners have inappropriately claimed to be limited partners to exclude their distributive share of partnership income from NESE, thereby avoiding payroll taxes. In Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023) (Soroban I), the Tax Court held that the limited-partner exception applies only to a partner who functions as a limited partner. The other shoe dropped last month when the court held that Soroban's limited partners did not function as limited partners and so must treat their distributive share of partnership income as NESE subject to payroll taxes. Soroban Capital Partners LP v. Commissioner, T.C. Memo 2025-52 (Soroban II).

Soroban I addressed a purely legal question: is a partner's status as a "limited partner" under state law sufficient for the partner to qualify for the "limited partner, as such" exception in section 1402(a)(13)? Focusing on the "as such" language, the Tax Court said no: "[T]he limited partner exception applies only to a limited partner who is functioning as a limited partner" (emphasis added). A factual inquiry was required to determine whether Soroban's limited partners met this standard. We wrote about Soroban I here.

The court undertook this factual inquiry in Soroban II by reviewing Soroban's income sources for the year at issue, the limited partners' roles in generating this income, and the relationship between the limited partners' distributive shares and any capital contributions they made to the partnership. Soroban generated income from fees charged to clients for managing investments. The court found that the limited partners' "time, skills, and judgment were essential to these services." They participated in Soroban's management, devoted significant time to the business, and were held out in marketing materials as essential to Soroban's operations. The court also said that the limited partners' insignificant capital contributions show that their distributive shares of partnership income were not returns on investment. Based on these facts, the court held that "Soroban's limited partners were limited partners in name only" and, therefore, ineligible to rely on the section 1402(a)(13) exception to NESE.

Soroban II is the second time the Tax Court has applied the functional test from Soroban I and the second time the IRS has won under this test. The first was Denham Capital Management LP v. Commissioner, T.C. Memo 2024-114, which the taxpayer has appealed to the Court of Appeals for the First Circuit. Once final, the Soroban decision may be appealed to the Court of Appeals for the Second Circuit. Several other cases involving disputes over the functional test from Soroban I or the application thereof are pending in the Tax Court or are on appeal therefrom. Partnerships facing these issues are likely hoping for a circuit split to materialize.

For more information, please contact:

James R. Gadwood, jgadwood@milchev.com, 202-626-1574

Andy L. Howlett, ahowlett@milchev.com, 202-626-5821

Omar M. Hussein, ohussein@milchev.com, 202-626-1578

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