New Rulings Expand Self-Employment Tax for Limited Partners

New Rulings Expand Self-Employment Tax for Limited Partners

Recent U.S. Tax Court rulings have narrowed the conditions under which limited partners can exclude income from self-employment taxes. This may increase tax liabilities for business owners who actively participate in their partnerships. These rulings are more interested in looking at a partner’s role in the business rather than their title.

Summary of Recent Tax Court Decisions

In Soroban Capital Partners LP v. Commissioner (November 2023), the court ruled that limited partners who provide services or take on active roles in a partnership must include their share of ordinary income in self-employment tax calculations. Historically, IRC Section 1402(a)(13) allowed limited partners to exclude ordinary income from self-employment taxes if the income was considered an investment. However, the court decided that Congress did not intend this exemption to apply to partners actively participating in the partnership’s day-to-day business.

The decision was reaffirmed in Denham Capital Management LP v. Commissioner (December 2024), which held that active limited partners in a state law limited partnership are not entitled to the “limited partner exception” for self-employment taxes.

Implications for Business Owners

These rulings call for a functional analysis over titles. This means that limited partners who manage operations, make decisions, or provide services are likely to be classified as active participants. This means that their ordinary income is potentially subject to self-employment taxes. Guaranteed payments for services have always been subject to self-employment tax, but now distributions of ordinary income may also be included if the partner is determined to have an active role.

The court did not clarify what constitutes “active participation,” which leaves businesses in a gray area. That opens questions for partnerships with limited partners who occasionally take on active roles.

 Active limited partners may now owe self-employment taxes on ordinary income, making it important for businesses to evaluate roles and compliance.

Industry Considerations

Certain industries are likely to be more affected than others, especially where partnerships and LLCs are common, and where limited partners often play active roles in operations. These industries include:

• Real Estate Development: Active limited partners who oversee development projects, leasing, or asset management may see additional tax obligations on their distributions.
• Private Equity and Venture Capital: Limited partners providing strategic guidance or serving on boards may now see changes to self-employment taxes.
• Financial Services: Hedge funds and investment firms with limited partners managing client relationships or investment portfolios may face increased scrutiny.
• Professional Services: Law firms and consulting firms with limited partners providing services or managing operations could be at greater risk of tax liability.

On the other hand, businesses with truly passive limited partners, who do not engage in operational or decision-making activities, are less likely to be impacted. For example, passive real estate investors in a limited partnership who do not participate in leasing or development activities, or venture capital limited partners who solely provide capital without serving on boards or advising portfolio companies, are less exposed.

In practice, the rulings state that the IRS will focus on roles and responsibilities rather than titles. Limited partners will want to assess whether their involvement crosses into active participation, which could subject their ordinary income to self-employment taxes. Partnerships will also want to carefully document roles and income reporting practices to ensure compliance and avoid unexpected tax liabilities.

Steps to Take

• Review Agreements: Partnerships will want to examine operating agreements and clearly define partner roles and responsibilities.
• Assess Active Roles: Partners in management or operations may need to include ordinary income in self-employment tax calculations to avoid penalties.
• Document Involvement: Partnerships will want to keep clear records of each partner’s level of participation to support tax filings.

Looking Ahead

These rulings signal increased scrutiny from the IRS and courts on whether limited partners qualify for self-employment tax exemptions. Partnerships will want to evaluate their reporting practices and make adjustments to remain compliant and avoid penalties. If you have questions on this developing situation or need help on another tax issue, contact Jennifer French, Partner on PBMares’ Construction & Real Estate team.