Thursday, November 30, 2023

TC Holds That Functional Test Determines Limited Partner Status

The Tax Court has determined in Soroban Capital Partners LP, 161 TC No. 12 (11/28/2023)  that the limited partner exception in Code Sec. 1402(a)(13) does not apply to a partner who is limited in name only. In addition, since net earnings from self-employment is a partnership item, the functions and roles of a limited partner is a factual determination that is properly determined in a TEFRA proceeding. 

Soroban Capital Partners is a limited partnership subject to the TEDRA audit and litigation procedures. Soroban made guaranteed payments and distributed ordinary income to its limited partners. On its returns for the years in issue, Soroban reported as net earnings from self-employment its guaranteed payments to its limited partners plus the general partner's share of ordinary business income. However, Soroban excluded from its computation of net earnings from self-employment the ordinary income distributions to its limited partners. 

After An Audit, The IRS Increased Soroban's Net Earnings From Self-Employment To Include The Shares Of Ordinary Business Income Allocated To The Limited Partners, Taking The Position
That They Were Limited Partners In Name Only.

In the Tax Court, Soroban made two arguments. 

  1. That the ordinary business income allocated to Soroban's limited partners is excluded from its net earnings from self-employment because those partners are state law "limited partners." 
  2. That the Tax Court could not inquire into the functional roles of Soroban's limited partners in a partnership-level proceeding.

The Tax Court determined that Congress intended for the limited partner exception to apply to earnings of an investment nature (i.e., to a limited partner who is functioning as a limited partner). Thus, to determine whether the earnings allocated to limited partners were of an investment nature, the court was required to inquire into the functions and roles of the limited partners.

Since the partnership was required to calculate net earnings from self-employment at the partnership level, any adjustment to the calculation must be made in a partnership-level proceeding. Thus, contrary to Soroban's argument, the court had jurisdiction to determine whether the ordinary business income allocated to Soroban's limited partners were excluded from net earnings from self-employment in the current partnership-level proceeding.

The Tax Court also rejected Soroban's argument that since it is a state law limited partnership and its limited partners are "limited partners" under state law, their distributive shares of income are excluded from net earnings from self-employment under Code Sec. 1402(a)(13). The court found that before the partners' distributive shares could be excluded the court needed to find that they were functioning as "limited partners."

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