Tax Court Ruling Could Affect Limited Partners and Self-Employment Income

Taxpayers in limited partnerships have historically relied on a state law exemption from self-employment tax. However, on November 28, 2023, the Tax Court issued a ruling that could have a wide-reaching impact on many partnerships.

In Soroban Capital Partners, L.P. v. Commissioner, the Tax Court ruled that a limited partnership must look at the “functional” actions of partners instead of state law when determining if a limited partner is subject to self-employment tax.

In Soroban, the taxpayer was a limited partnership under state law. The partnership had three limited partners who received guaranteed payments for their services. When the tax return was prepared, the entity reported the guaranteed payments as self-employment income. However, the entity did not report the ordinary income allocated to those partners as self-employment.

Generally, ordinary income generated by a partnership is considered self-employment income by those who are actively involved in the business. However, there is an exception for limited partners that are not involved in the day-to-day operations of the business.

In Soroban, the taxpayer had relied on this exception since the partners were limited partners under state law. The Tax Court concluded that Congress intended for the exception to only apply to earnings of an investment nature. As a result, the Tax Court put in place a “functional” rule that requires taxpayers to look at the activities of the limited partners when determining if they qualify for the self-employment exception.

If you have questions about how this case might affect your business, please contact your Warren Averett advisor.