Avoiding Self-Employment Taxes May Become More Difficult

By Matthew Landon January 9, 2025

Executive Summary: Some partners have attempted to characterize their involvement with their partnerships as simultaneously “active” and “passive” to allow the passive portions of their overall incomes from the entity to escape self-employment taxes. Some recent and ongoing court cases may make those efforts more difficult or ultimately unsuccessful.

A recent update in the partnership tax arena involving the application of self-employment taxes on a partner’s distributive share of partnership income has unfolded, which provides some insight into the Tax Court’s attitude towards the application of the Section 1402(a)(13) limited partner exception and their intent to follow a “functional analysis” test in determining whether a limited partner’s interest will be respected as being exempt from the application of self-employment taxes. A newly decided case, Denham Capital Management LP v. Commissioner, analyzed whether an investment advisory and management services firm’s partners, who actively managed the firm’s business of advising affiliated private equity funds, could be treated as limited partners on their distributive shares of partnership income. The partners took the position that the majority of their income had pertained to their interests as state law limited partners, as opposed to compensation for services through guaranteed payments, which would otherwise be subject to self-employment taxes. In this case, the Tax Court attempts to shed light on whether a partner can effectively wear two hats at the same time – one as an active, self-employed individual providing services to the partnership and the other as a passive investor who qualifies for the limited partner exception from self-employment taxes.

The IRS has been attacking the use of a limited partner wrapper to side-step self-employment taxes in situations where the facts don’t align with practical reality. One approach that many consulting and advisory firms have taken is to use a passthrough entity with a limited partner (or equivalent) designation to bifurcate returns between a “salary” through the taking of a guaranteed payment for services, while characterizing their distributive share of the remaining partnership income (which typically represents the bulk of the income generated by the partnership for the tax year) as being passive for self-employment tax purposes. Although limited partners, as such, are exempt from self-employment tax, there is no specific definition of a “limited partner” in the Internal Revenue Code or the Treasury Regulations. A limited partner in the traditional sense of the term might be thought of as an investor who would generally have limited involvement with managing business affairs and who holds an expectation to receive a positive return based on their invested capital.  Alternatively, the generation of business profits through the provision of personal services in the act of managing and operating an investment fund or consulting practice where capital is not a material income producing factor (at least with respect to the amount of capital contributed by the partners who are the service providers) might be more properly characterized as an allocation of the business profits to those partners based on the services being performed and not a return on invested capital. Another relatively recent Tax Court case, Soroban Capital Partners LP v. Commissioner, sought to apply a “functional analysis” test to determine whether the activities of partners who are actively performing services for a partnership should be permitted to rely upon state law classification as a limited partner for an exception from self-employment taxes. The court decided that a look-through approach should be taken to determine how the partners’ distributive shares of income were being generated. Consequently, a better fact pattern to achieve the desired result of exempting returns from self-employment taxes might involve a partner with substantial “skin in the game” who is investing alongside other limited partners through their economic contributions as an investor in the business and tying those returns back to invested capital. However, such an approach doesn’t often align well with the service provider’s interests or relative position in the capital structure. Returning to the facts in Denham, the company’s income for the years in question consisted solely of fees for services and most of the partners had received their limited partnership interests through the issuance of profits-interests in the company, without making any direct capital contributions and stripping out most of their distributive shares of income through partnership distributions each year, while receiving relatively nominal guaranteed payments for services rendered. Ultimately, the court decided that it was improper for the partners of Denham to exclude their distributive shares of income from the computation of net earnings from self-employment based on their active roles in the company and the manner in which those profits were generated.

On a related note, what about application of the Net Investment Income Tax (“NIIT”)? Shouldn’t this additional 3.8% surtax serve the purpose of capturing the additional Medicare tax where the traditional self-employment tax regime doesn’t come into play? Based on the interpretation of relevant guidance, many taxpayers take the position they are “active” in their business roles for purposes of exemption from the NIIT, while at the same time being “passive” for purposes of determining self-employment taxes by virtue of their limited partner status, thereby effectively avoiding the imposition of both NIIT and self-employment tax on their distributive shares of partnership income. However, based on the outcome of recent court cases and the trajectory of the Service in attacking this type of “heads I win, tails you lose” strategy, a day of reckoning may be coming closer to realization. A series of tax court cases are lined up on the docket through which the Service is challenging similar tax controversies and will try to build on its latest success with Denham. As such, taxpayers may need to rethink their tax positions in light of recent events and consult with their advisors to determine whether their existing tax strategy is still deemed appropriate.

For more information, please contact Matt Landon or your BNN tax advisor at 800.244.7444.