New Priority Guidance Plan Announced For Limited Partner Exception to SECA
NEW PRIORITY GUIDANCE PLAN ANNOUNCED FOR LIMITED PARTNER EXCEPTION TO SECA
For a number of years there has been an ongoing challenge by the IRS of taxpayers claiming limited partner status and exemption from the Self-Employment Contributions Act (SECA) tax. The activity in this area has greatly increased in 2023 with cases including, Soroban Capital Partners, LP -v- Commissioner, Denham Capital Management LP -v- Commissioner, Point72 Asset Management LP -v- Commissioner and Sirius Solutions LLLP -v- Commissioner pending. The IRS had launched a SECA compliance campaign selecting hundreds of partnerships for audits with particular focus on asset management, financial services, private equity and hedge fund industries operating as partnerships. Perhaps responding to criticism for its decision to mount an aggressive audit campaign and litigation rather than providing guidance, a new project on the limited partner exception to SECA tax has been added to the Treasury-IRS Priority Guidance Plan, suggesting that the government is ready to address the issue that led to a congressional moratorium on its proposed regulations 26 years ago. In addition, on November 28, 2023, the Tax Court decided the case of Soroban Capital Partners, handing the IRS a victory.
By way of background, Internal Revenue Code §1402(a)(13) generally excludes a limited partner’s distributive share partnership income from the SECA tax, although the exclusion does not apply to guaranteed payments received by the limited partner for services rendered. Because of the lack of a definition of the term “Limited Partner” in the stature or regulations, the §1402(a)(13) exception became a larger and larger issue after States began enacting statutes creating new types of pass-through entities including limited liability partnerships and limited liability companies. In an attempt to address some of the questions, the Treasury issued proposed regulations in 1997 that would have adopted a functional analysis, based on liability, management and participation (including an hours-of-service test) for determining eligibility for limited partner status under §1402(a)(13). While the proposal was a fair attempt to provide guidance, it was widely criticized and Congress imposed a one-year moratorium on finalization of the regulation. After the moratorium was ended, Treasury never finalized the proposed regulations and since that time Congress has not enacted legislation to define the term limited partner and no further regulations were proposed by Treasury. The fill the gap, the IRS turned to litigation in the Courts to argue that the SECA tax exemption applies only to passive investors and that limited partner status does not hinge on State law classifications.
The IRS has been largely successful in its arguments, most notably in Renkenmeyer, Campbell & Weaver, LLP v Commissioner, 136T.C 137(2011), holding that attorney partners who actively participated in a law firm as limited liability partners were not limited partners for purposes of the SECA exclusion and the Court outlined some of the functional tests to be viewed. Renkenmeyer was probably easier given the fact that the purported limited partners were the attorneys actually providing the legal services for the firm.
The current cases are all similar in that they involve hedge fund or private equity managers and involve entities that were structured as State law limited partners. For example, Point72 is a hedge fund based in Connecticut founded by the owner of the New York Mets. The owner indirectly wholly owns both the general partner and the sole limited partner of the management company that runs a hedge fund. While the taxpayer’s representative would claim that the IRS cannot by litigation or even by regulation expand the definition of limited partner, given that it is specific language in the statute, the IRS is having none of it. The hedge fund involves very significant amounts of potential tax liability and, if nothing else, it appears these cases and the actions of some of these large private equity management firms, have spurred Treasury and the IRS to finally propose some guidance for practitioners on the limited partner exception and in §1402(a)(13).
Most recently, the Tax Court ruled in favor of the IRS in Soroban Capital Partners, LP deciding that partners that actively participate in state law limited partnerships are not “limited partners, as such” within the meaning of §1402(a)(13), so that their distributive share of the partnership income must be treated as earnings from self-employment and subject to SECA tax. The Court adopted the functional test advanced by IRS holding that the “limited partner exception does not apply to a partner who is limited in name only”, further stating that, “by adding ‘as such’ Congress made clear that the limited partners exception applies only to a limited partner who is functioning as a limited partner”.
While we can expect an appeal of the result in Soroban and challenges to the guidance, any guidance in the form of new regulations would certainly be helpful. We have always felt that the 1997 proposed regulations were a reasonable attempt to capture what the limited partner SECA exclusion was intended to cover and it will be interesting to see what guidance comes from the new project.