On Tuesday, September 22nd, we advised you that on September 17th, the 2nd Circuit affirmed the Tax Court’s decision in Soroban Capital Partners v. Commissioner, providing a major victory for the IRS in its attack on the applicability of the §1402(a)(13) limited partner exclusion to self-employment to “active” limited partners. As promised on Tuesday, we now convey a few thoughts on what promises to generate major in-depth articles on where we stand now.

In the August 12th decision in Sirius Solutions (No. 24-60240) (now named K Alain, L.L.L.P.), the 5th Circuit remanded the case to the Tax Court under a newly announced standard as to who can qualify for the limited partner exclusion from self-employment tax contained in §1402(a)(13). The standard set by the 5th Circuit is that a limited partner “is a partner who plays no significant role in managing or running a business”; however, “some participation is allowed, so long as the partners do not exercise control over the business.” (Emphasis and plural in opinion.) In doing so, the 5th Circuit rejected the Soroban “passive investor” standard and its “functional analysis test,” with the 5th Circuit indicating that the Tax Court was in error in barring “even the most minor involvement” in the partnership’s affairs as disqualifying eligibility for the limited partner SE tax exclusion.

In Soroban, the 2nd Circuit held that “for the purposes of §1402(a)(13), a ‘limited partner’ is one who has limited liability and who does not run, manage, or otherwise exert control or managerial authority over the partnership.” Some tax professionals view the standard enunciated by the 5th Circuit as different than that established by the 2nd Circuit and that there is now a conflict between the circuits. This could be the case, given that the 5th Circuit specifically was rejecting the Tax Court decision in Soroban, while the 2nd Circuit was affirming the same Tax Court decision (as Sirius technically was an appeal of the Soroban Tax Court decision). However, are the two standards enunciated by the two circuits different? In this regard, note that the 2nd Circuit acknowledged the 5th Circuit decision in the following manner:

The Fifth Circuit did not expound on what it considers to be a non-significant role, but to the extent [Sirius] holds that a limited partner may provide some services to the partnership, we do not disagree. Nor does the Commissioner. See Appellee’s Br. at 62 (“It is not the Commissioner’s position — and the Tax Court’s interpretation of §1402(a)(13) does not mean — that providing any services to . . . or having any participation in . . . a partnership renders the individual not a limited partner.”). So long as the activities in question do not constitute controlling, managing, or running the business, a partner may play a role in the partnership and still qualify as “limited” under §1402(a)(13).

Is there really a significant difference between the two positions? We shall see. What does it mean for a partner to “control” the business? Will the “two hat” separate management structure recommended by the Tax Forum for decades stand up where fair value for services rendered is provided to the management company (acting as the operating LLC manager and in control of the business) and the persons providing services through the management company own non-managing LLC interests in the operating entity while reporting their share of LLC income as non-SE income? In this regard, note that the 2nd Circuit appears to focus on the lack of investment by the Soroban partners and implies (but certainly does not hold) two hats can be accomplished:

It therefore limits the tax exclusion to income a partner earns in their capacity as a limited partner — that is, income attributable to the partner’s investment in the partnership, not to their management of the business. A partner who runs the partnership earns their distributive share of the partnership’s profits, in effect, from managing the business, such that this income is not earned in their capacity as a “limited partner.” Thus, we agree with the Tax Court that the words “as such” indicate that §1402(a)(13) only extends to limited partners who act within the bounds of a typical limited partner, by investing in but not managing the partnership. (Italics in original.)

Will the two decisions ultimately apply only to personal service businesses, and there will be the ability to separate returns on capital from compensation for services in non-personal service businesses? In this regard, keep in mind that a two-hat distinction for non-personal service businesses is contained in the 1997 proposed regulations, albeit with an inability to wear two hats where there are not any passive investors (holding at least an aggregate 20% ownership interest being a safe harbor). Will Treasury now issue new proposed regulations in this arena (a topic that currently is on the Treasury/IRS priority guidance plan). Will the Supreme Court end up hearing Sirius or Soroban (or Denham, when it ultimately is decided)? Might Congress finally be heard from?

Needless to say, Sirius and Soroban and the structuring considerations to maximize the SE tax exclusion will be a major topic of discussion at both of this year’s Tax Planning Forum® and Fundamentals of Flow-Through® programs. We hope that you will consider attending either or both of these virtual or in-person programs or our new Fundamentals QAS self-study program. Registration is in full swing, and we encourage you to register soon, especially if you are interested in either of our in-person programs in Las Vegas or Orlando where space is limited.