Will Looming Decision Clarify the Limited Partner Exception?

The Tax Court recently ruled in Denham Capital Management LP v. Commissioner (T.C. Memo. 2024-114) that partners in an asset management firm did not qualify for the exception to the net earnings from self-employment tax (“NESE Tax”) for limited partners in §1402(a)(13) (the “Limited Partner Exception”). There is disagreement between taxpayers and the IRS as to the criteria to qualify for the Limited Partner Exception. Some taxpayers, including the litigants in the cases discussed below, argue that being a bona fide limited partner of a state law limited partnership qualifies one for the exception (the “State Law Standard”). Soroban Capital Management LP v. Commissioner, 161 T.C. No. 12 (2023); Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114; Sirius Solutions LLLP v. Commissioner, No. 24-60240 (5th Cir.). The government argues, and the Tax Court has agreed, that one must be akin to a passive investor (the “Passive Investor Standard”), to qualify as a limited partner for purposes of the Limited Partner Exception. The IRS position is that a functional analysis of the roles and responsibilities of the partner is necessary to determine a particular limited partner is akin to a passive investor under the Passive Investor Standard. Soroban Capital Management LP v. Commissioner, 161 T.C. No. 12 (2023); Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114; Sirius Solutions LLLP v. Commissioner, No. 24-60240 (5th Cir.). Denham is appealable to the United States Court of Appeals for the First Circuit. Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114. Six additional cases where the criteria to qualify for the Limited Partner Exception is at issue are docketed at the Tax Court as of the time this article went to press. Ustaxcourt.gov. In addition, the United States Court of Appeals for the Fifth Circuit recently heard oral arguments in Sirius Solutions LLLP v. Commissioner where the same question is at issue. No. 24-60240 (5th Cir.). This article will review the most recent NESE Tax cases and describe why, after all is said and done, there may be different standards in place depending on where the taxpayer is located.

The NESE Tax and the Limited Partner Exception

Section 1401(a) imposes a tax on an individual’s net earnings from self-employment (“NESE”). Section 1402(a) provides the general rule that NESE includes a partner’s distributive share of partnership income or loss from a trade or business carried on by the partnership less certain deductions. The Limited Partner Exception provides an exception to the general rule: "[T]here 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 §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.” [Emphasis added.] The disagreement noted above centers on interpretation of the meaning of “limited partner, as such.” In other words, what is required to qualify as a “limited partner, as such” and thus qualify for the Limited Partner Exception?

The Passive Investor Standard and a Functional Analysis

The Tax Court established the Passive Investor Standard in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. 136 T.C. 137(2011). The Renkemeyer Court further instructed that, in order to determine if the limited partners met the Passive Investor Standard, the Court must conduct a functional analysis of the roles and responsibilities of the limited partners in the limited liability partnership. Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011). The Renkemeyer Court focused on how the partnership generated its revenue, the partners’ role in generating that revenue, and the relationship between the partners’ distributive share and the amount of contributed capital. The Court did not, however, clarify that the above factors are an exclusive list of factors to be considered in the functional analysis, how much weight was or should be accorded to each factor, or how other factors might be relevant to a functional analysis.

In Soroban Capital Management LP v. Commissioner, 161 T.C. No. 12, p. 11 (2023), the Tax Court, ruling on motions for summary judgment, extended the Renkemeyer holding to limited partners in state law limited partnerships (as opposed to the limited liability partnership that was the relevant entity in Renkemeyer). The taxpayer in Soroban argued that the State Law Standard should apply.

The Soroban Court rejected the taxpayer’s argument, focusing on the “as such” language in §1402(a)(13). The Court viewed Congress’ inclusion of “a limited partner, as such” in §1402(a)(13) as narrowing the meaning of “limited partner.” Specifically, in the Court’s view, "[b]y adding ‘as such,’ Congress made clear that the Limited Partner Exclusion applies only to a limited partner who is functioning as a limited partner.” [Emphasis added.] 161 T.C. No. 12, p. 11. (2023). Thus, as in Renkemeyer, the Court cited a Passive Investor Standard saying: “Congress intended §1402(a)(13) to apply to partners that are passive investors.”

Because Soroban was a ruling on motions and not dispositive of whether the Soroban partners qualified for the Limited Partner Exception, the Court did not conduct a functional analysis of the roles and responsibilities of the partners to determine if Passive Investor Standard was met, and thus whether the partners qualified for the Limited Partner Exception. The Court’s relevant holding was limited to clarifying that the Passive Investor Standard established in Renkemeyer also applies to a limited partner in a state law limited partnership and a functional analysis must be conducted to make that determination. The Court again did not clarify how the functional analysis should be performed or what factors should be considered.

The Denham Case

Denham Capital Management LP (the “Partnership”) is an asset management firm organized as a Delaware state law limited partnership with a general partner that is an LLC and five individuals that were limited partners (the “Limited Partners”). The Limited Partners were also members of the LLC general partner. Four of the five Limited Partners contributed no capital to the Partnership. The Limited Partners provided services to the Partnership, had authority to bind the Partnership contractually, and exercised control over management of the company. T.C. Memo. 2024-114. In return for the Limited Partners’ services, the Partnership received fees from the portfolio companies. The Partnership issued K-1s to the Limited Partners for tax years 2016 and 2017 reporting the amount of guaranteed payments as subject to the NESE Tax and excluding the distributive share of Partnership income from the NESE Tax. The IRS audited the Partnership and issued a Notice of Final Partnership Administrative Adjustment increasing the amounts subject to the NESE Tax to include the Limited Partners’ distributive share of Partnership income. The Partnership filed a petition in Tax Court asserting that the IRS erred in increasing the amount subject to the NESE Tax.
The Court in Denham Capital Management LP v. Commissioner performed a functional analysis of the Limited Partners’ roles and activities in the Partnership and determined that the Limited Partners did not meet the Passive Investor Standard and thus were not “limited partners, as such” and not eligible for the Limited Partner Exception. T.C. Memo. 2024-114.

With respect to the factors involved in a functional analysis, the Denham Court seemed to focus on three factors in performing the functional analysis:the source of the Partnership’s income, the Limited Partners’ role in generating that income, and the relationship between the amount of the Limited Partners’ distributive share and their capital contributions. The Partnership’s income was derived from fees the Partnership received in exchange for asset-management services provided in part by the Limited Partners. T.C. Memo. 2024-114 at 15. Also, the Court concluded that the Limited Partners’ distributive share of partnership income could not be attributed to return on investment. (It is also noteworthy that the Partnership in Denham presented arguments regarding why Soroban should be overturned and the State Law Position should be adopted. The Court rejected those arguments (without explanation of the Court’s perceived flaws in the merits of the arguments), reaffirming the Passive Investor Standard. U.S. Tax Court Docket No. 9973-23, Petitioner’s Simultaneous Opening Brief, Document No. 63; T.C. Memo. 2024-114.)

Sirius Solutions LLLP v. Commissioner

As noted above, there are other cases docketed in various stages of litigation where the applicability of the Limited Partner Exception is at issue. Baker Bros Advisors LP v. Commissioner, Riverstone Equity Partners LP v Commissioner; Point72 Asset Management LP v Commissioner; MKP Capital Management v. Commissioner. Most notably is Sirius Solutions LLLP v. Commissioner. U.S. Court of Appeals for the Fifth Circuit, Case No. 24-60240. In Sirius, the taxpayer requested the Tax Court to enter a final judgment against it based on Soroban so that it could immediately move on to appeal. United States Tax Court Order, Docket No. 30118-21. Sirius Solutions filed that appeal to the Fifth Circuit Court of Appeals and oral arguments were heard February 6, 2025.

Sirius Solutions made two interrelated arguments. First, it argued the ordinary meaning of “limited partner” in §1402(a)(13) means a bona fide state law limited partner. [Brief of Appellants pp.6-8] Second, Sirius Solutions argued, the Tax Court erred in interpreting “limited partner” to mean a partner functioning as a passive investor. [Brief of Appellants pp. 8-9].

Observers of the oral arguments, including this author, noticed that the number of and tone of the questions and comments the Court directed to the government during oral arguments suggested at least two of the Court’s three judge panel were skeptical of the Passive Investor Standard established by Soroban. 186 Tax Notes Federal 1157 (Feb. 10, 2025). Perhaps most notably, Justice Andrew S. Oldham commented on the number of factors the government argued should be considered in the functional analysis, saying “That’s an extraordinary list of factors. As somebody who has to deal with multifactor balancing tests for a living, it sort of blanches even me, because I’m not sure how in the world I would apply it.” 186 Tax Notes Federal 1157 (Feb. 10, 2025).

The Golsen Rule

In Golsen v. Commissioner, the Tax Court set forth what has become known as the “Golsen Rule.” Golsen v. Commissioner, 54 T.C. 742(1970). Under the Golsen Rule, the Tax Court must follow the precedent on an issue, if one has been established, by the Circuit Court to which the taxpayer would appeal an adverse decision. For example, assume Circuit Court A holds that taxpayer X qualifies for a certain exception and Circuit Court B holds taxpayer Y, who is identically situated to taxpayer X, does not qualify for the same exception. Taxpayer Z is also identically situated to taxpayers X and Y. If taxpayer Z resides in a state that falls within Circuit Court A’s jurisdiction, it must hold that Z qualifies for the exception. If taxpayer Z resides in a state that falls within Circuit Court B’s jurisdiction, it must hold that Z does not qualify for the exception.

Conclusion

As noted above, Denham is appealable to the First Circuit. Also noted above, Sirius was heard by the Fifth Circuit and a decision is looming. Soroban, assuming it holds similarly to Denham, will be appealable to the Second Circuit. Because of the Golsen Rule, there could be three different standards to qualify for the Limited Partner Exception depending on which Circuit Court the taxpayer resides in. One circuit could adopt the Passive Investor Standard and identify three specific factors that the functional analysis must consider. Another circuit could adopt the Passive Investor standard and identify three different factors that the functional analysis must consider. And another circuit could adopt the State Law Standard. Accordingly, there could be three different standards to qualify for the Limited Partner Exception that the Tax Court would have to apply. Further, the remaining Circuit Courts could remain silent on the issue. In other words, we are certain to get further guidance on how one qualifies for the Limited Partner Exception, but it is far from certain we will get clarity on the issue absent Congressional intervention.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Joseph Vetting is a Managing Director in the Deloitte Tax LLP Washington National Tax Passthroughs Group.

The author thanks Matt Cooper, Steve Gilbert, and John Hynes for their thoughtful comments.

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