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The U.S. Court of Appeals for the Second Circuit held on September 17 in Soroban Capital Partners v. Commissioner of Internal Revenue [1] that a partner does not qualify for the federal limited-partner exclusion from self-employment tax merely because the partner has limited liability under state law. The court affirmed the U.S. Tax Court’s decision but formulated a slightly different test: to qualify for the exclusion, the partner also must not run, manage or control the partnership’s business.

The Statutory Framework

Federal law imposes Social Security and Medicare taxes on an individual’s self-employment income.[2] If an individual is a partner in a partnership, their distributive share of income from the partnership’s trade or business is generally included in their net earnings from self-employment (NESE).[3] A statutory exclusion exists for the distributive shares of “a limited partner, as such,” other than guaranteed payments for services actually rendered to or on behalf of the partnership.[4] But neither the Internal Revenue Code nor related Treasury regulations define “limited partner,” leaving open the question of how to determine whether an individual who is a limited partner at the state level and actively participates in a partnership’s business can exclude their distributive share from their NESE.

A Divided Approach Among the Courts

The Tax Court applies a “functional analysis,” a facts-based approach to evaluate whether the partner’s economic relationship with the partnership is generally akin to passive investment. Relevant considerations include the partner’s role in generating income, the partner’s role in management, the partner’s time devoted to the business, the partnership’s marketing of the partner’s services, and the partner’s capital contributions.[5]

In the August 12 decision K Alain v. Commissioner,[6] the Fifth Circuit rejected the Tax Court’s broader passive-investor formulation, concluding that it could capture minimal, ordinary limited-partner activity. The Fifth Circuit held instead that a limited partner must not play a significant role in managing or running the business. The First Circuit heard argument on the issue on February 5 in Denham Capital Management v. Bessent,[7] but an opinion is pending.

The Second Circuit’s Perspective

Soroban Capital Partners LP, an investment-management company organized as a Delaware limited partnership, had an LLC general partner and three principals with direct or indirect limited-partnership interests. The three principals were also members of the general partner, and two held their limited-partnership interests through disregarded single-member LLCs.

In Soroban, the court held the three principals did not qualify for the “limited partner” exclusion because a limited partner must have two features: (1) limited liability and (2) lack of managerial control over the partnership’s business. The court declined to treat the principals’ management activities as irrelevant merely because they exercised authority through the general partner; it focused on the economic reality that the principals controlled and ran Soroban’s business. Accordingly, the distributive shares allocated to the principals’ purported limited-partnership interests, including interests held through disregarded single-member LLCs, were not eligible for the limited-partner exclusion and were subject to self-employment tax. Soroban had already treated the general partner’s distributive share as NESE.

Broader Implications for Clients

The decision is particularly relevant to private-fund management companies and operating businesses that allocate substantial ordinary income to working owners holding limited-partnership interests, even if such owners also hold a general partner interest. Such entities should consider the narrow reading of a limited partner when strategizing for future tax planning and compliance. The Second Circuit did not address whether, or under what circumstances, an LLC member may qualify for the exclusion.