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Second Circuit holds managing limited partners owe self-employment tax

Second Circuit holds managing limited partners owe self-employment tax

Rule Changes

Appeals court affirms the functional test for the limited partner exception; the Fifth Circuit already aligned

Today: Second Circuit affirms Tax Court in Soroban

Overview

Updated 1 hour ago

Soroban Capital's three founding partners held limited partner status under Delaware law, the kind that caps personal liability. The Second Circuit ruled this month that their profit shares are still subject to the 15.3% self-employment tax, because they ran the firm.

The court held that a "limited partner" must have limited liability and not manage, run, or control the business to use the exception in Section 1402(a)(13) of the tax code. The Fifth Circuit briefly disagreed, then withdrew that ruling in August and aligned with the same test. The decision binds fund managers in New York, Connecticut, and Vermont.

Why it matters

Fund managers in the Second Circuit who claimed the limited partner tax break now owe self-employment tax on their profit shares — a 15.3% levy.

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Key Indicators

15.3%
Combined self-employment tax rate
Social Security's 12.4% plus Medicare's 2.9%, applied to the principals' distributive shares.
$184,500
2026 Social Security wage base
The full 15.3% rate applies up to this cap; the 2.9% Medicare rate applies above it.
2
Circuits using the functional test
Second and Fifth Circuits align; the First Circuit's Denham appeal is pending.

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People Involved

SP
Soroban's Three Principals
Founding partners of Soroban Capital Partners LP
Distributive shares now subject to self-employment tax
 Commissioner of Internal Revenue
Commissioner of Internal Revenue
Appellee representing the Internal Revenue Service
Prevailed in both the Tax Court and the Second Circuit

Organizations Involved

Soroban Capital Partners LP
Soroban Capital Partners LP
Investment firm
Petitioner-appellant

New York-based investment partnership whose three principals claimed the limited partner exception on their 2016-2017 profit shares.
Internal Revenue Service
Internal Revenue Service
Federal tax agency
Prevailed in Soroban; pressed the functional test across circuits

The IRS argued that a partner's actual role, not formal state-law status, decides eligibility for the limited partner exception.
U.S. Court of Appeals for the Second Circuit
U.S. Court of Appeals for the Second Circuit
Federal appeals court
Affirmed the Tax Court in Soroban

The New York-based appeals court that hears cases from New York, Connecticut, and Vermont.
U.S. Tax Court
U.S. Tax Court
Special federal trial court
Ruled for the IRS in Soroban and Denham

The Washington, D.C.-based court that hears federal income tax disputes before tax is paid.
United States Court of Appeals for the Fifth Circuit
United States Court of Appeals for the Fifth Circuit
Federal appeals court
Withdrew a contrary ruling, then aligned with the functional test

The New Orleans-based appeals court covering Texas, Louisiana, and Mississippi.

Timeline

1977 September 2026

6 events Latest: Today
Tap a bar to jump to that date

  1. Second Circuit affirms Tax Court in Soroban

    Today Court Decision

    Appeals court holds a limited partner must have limited liability and not run, manage, or control the business to use Section 1402(a)(13).

  2. Fifth Circuit withdraws and re-issues Sirius

    Court Decision

    The re-issued opinion holds a limited partner must play no significant role in managing the business, aligning with the functional test.

  3. Fifth Circuit creates a circuit split in Sirius

    Court Decision

    Initial Sirius Solutions ruling holds any limited partner with limited liability qualifies for the exception, rejecting the IRS's passive investor test.

  4. Tax Court rules Soroban principals are not limited partners

    Court Decision

    Soroban II (T.C.M. 2025-52) applies the functional analysis test, finding the principals manage the business.

  5. Tax Court issues first Soroban ruling

    Court Decision

    161 T.C. 310 addresses the limited partner exception; litigation continues over the principals' status.

  6. Congress enacts Section 1402(a)(13)

    Legislation

    Lawmakers exclude "limited partners" distributive shares from self-employment tax, assuming limited partners were passive investors.

Scenarios

1

First Circuit joins the functional test — Denham loses

Likely Resolves by Sep 22, 2027

Discussed by: Tax analysts at RSM, KPMG, and Bloomberg Tax

Denham Capital Management's appeal before the First Circuit is the next live test of the functional test. The Tax Court ruled against Denham in late 2024 on facts similar to Soroban. If the First Circuit affirms, the Second, Fifth, and First circuits all adopt the IRS position, and the limited partner exception becomes effectively unavailable to working fund managers nationwide.

2

First Circuit rejects the functional test, reopening a split

Possible Resolves by Sep 22, 2027

Discussed by: Tax practitioners weighing circuit strategy

If the First Circuit reverses in Denham and adopts formal state-law limited liability as sufficient, a genuine circuit split returns. That would make Supreme Court review far more likely, and could encourage the IRS to settle or seek a national rule through legislation rather than piecemeal litigation.

3

Congress rewrites the limited partner exception

Unlikely Resolves by End of 2027

Discussed by: Tax policy observers tracking the next major tax bill

The converging case law removes urgency for the IRS, but fund industry lobbying could push Congress to clarify Section 1402(a)(13). A bill could codify the functional test, narrow the exception further, or restore a formal-status rule. Any change would come through a broader tax package, which makes timing uncertain.

Historical Context

3 moments from history that rhyme with this story — and how they unfolded.

1976

Revised Uniform Limited Partnership Act (1976)

The uniform act barred limited partners from participating in control of the partnership's business. When Congress enacted Section 1402(a)(13) a year later, the term "limited partner" carried that passive-investor meaning.

Then

Congress designed the self-employment tax exception around limited partners who were purely passive.

Now

Courts now use that 1977 meaning to decide that managing limited partners never qualified for the exception.

Why this matters now

The Second Circuit's historical analysis anchors its holding that managerial control disqualifies a limited partner.

2012

S-corporation salary cases (2012)

Courts including the Eighth Circuit, in cases like David Watson, P.C. v. United States, held that S corporation shareholder-employees who take distributions instead of paying themselves a reasonable salary still owe employment taxes. The courts applied an economic reality test rather than accepting the shareholders' formal label.

Then

Shareholders owed back payroll taxes and penalties.

Now

Established that the substance of an owner's work, not entity elections, controls federal payroll tax liability.

Why this matters now

The same form-versus-substance principle underlies the IRS's fight to limit the partnership exception.

2013

Renkemeyer, Campbell & Weaver LLP v. Commissioner (2013)

A Kansas law firm organized as a limited liability partnership claimed its lawyer-owners were limited partners exempt from self-employment tax. The Tax Court rejected that, holding owners who work in the business are subject to SECA regardless of their entity form.

Then

The lawyers owed self-employment tax on their shares. The ruling created the functional analysis the IRS has pressed ever since.

Now

It became the foundation of the IRS's position that legal form alone does not defeat self-employment tax.

Why this matters now

The Second Circuit's Soroban ruling applies the same logic the Tax Court used in Renkemeyer more than a decade earlier.

Sources

(9)
+3
Bloomberg Tax U.S. Court of Appeals for the Second Circuit KPMG TaxNewsFlash RSM US Current Federal Tax Developments Mondaq Legal 500 Liskow & Lewis CourtListener