A recent decision in the US Tax Court affects limited partners and SECA – the Self Employed Contributions Act. In this case, Soroban Capital Partners LP (a hedge fund management company) was formed as a Delaware limited partnership and had excluded self-employment tax (under SECA) and associated levies on millions of dollars of its limited partner’s income. The IRS objected to this practice and adjusted the net earnings from self-employment by increasing them to include income apportioned to its limited partners.
The plaintiff (Soroban) challenges the actions of the IRS, arguing that the clear language of SECA supported not only their actions but a request for summary judgment in the case. The associated “LP Exception” of the associated US tax law states:
“…there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services;”
In Soroban Capital Partners LP v. Commissioner, the United States Tax Court has denied a request by the plaintiffs for summary judgment and found that in order to claim the Limited Partner Exception, one must apply a “functional analysis test to determine whether a partner in a state law limited partnership is a ‘limited partner, as such’ for purposes of (the applicable tax codes in question).”
The Court’s decision noted the US tax code fails to specifically define what a “limited partner” is, and that a “functional analysis” would be required to establish whether the individual partner was, in fact, acting as a limited partner and related payments were in fact remuneration for actual services provided, or if the statute in question did not apply because the partner was actually “limited in name only.”
Continuing discovery and litigation will be focused on how a limited partner is defined (and tested) under US tax law, as well as the requirement of limited partners in the US to pay self-employment tax on distributive share allocations.
While this decision in the US Tax Court affects limited partners and SECA, it might not seem that important to most US taxpayers. However, the core issue of concern is the Court’s focus upon the term “as such” in the specific code section of US tax law (above). The plaintiffs will likely argue the Court’s position opposes the common law principle known as the “party presentation rule.” This concept discourages any Court from rendering judgment or a decision based upon an issue, theory or argument that has not been presented by the parties in the case.
The ”party presentation rule” is a fundamental due process protection against the denial of rights based upon the issue, theory or argument the party was never given the opportunity to address or argue. This is not hard law, and the Judges of US Courts are not bound to uphold it in every case. However, in the vast majority of relevant cases questions regarding inconsistencies with the party presentation rule would be initially addressed through a process involving supplemental briefs and argument.
Soroban might appeal the decision. Meanwhile, many limited partnerships are evaluating how this decision in US Tax Court affects limited partners and SECA. If a limited partner provides services to the partnership and is paid for those services, the associated income is still subject to self-employment tax. Will the income of limited partners face the same type of taxation as a sole proprietor or wage earner? Do the exemptions in SECA only apply to investment earnings? Will we see an increase in IRS SECA tax audits in the future? How does this ruling affect limited partners and/or the shareholders of closely held S Corporation?
It is important to note the present administration has asked Congress to implement a 3.8% investment income tax on US taxpayers who are not currently required to pay investment taxes or self-employment on earned income.
Do you have questions about the structure of entities and transactional planning in order to reduce taxation while protecting your assets? Are you concerned about your portfolio and domestic or international tax planning in the light of this decision? We invite you to learn more about the integrated tax, legal, accounting and business consulting services of Allen Barron and contact us or call today to schedule a free consultation at 866-631-3470.
