U.S. Tax Court Rules That Limited Partners Must Pay Self-Employment Tax on Partnership Income

Recent U.S. Tax Court (the Tax Court or the Court) rulings have tightened the conditions for limited partners to exclude income from self-employment taxes, potentially increasing tax liabilities for business owners actively involved in their partnerships. These decisions focus on a partner’s actual role in the business rather than their title. With this added complexity, it is crucial for tax professionals to stay updated and provide accurate guidance.

In December of 2024, the Tax Court issued a memorandum opinion in the case of Denham Capital Management LP v. Commissioner (T.C. Memo. 2024-114). The issue centered on whether a limited partner in a state law limited partnership can exclude their distributive share of partnership income from self-employment income. This ruling has important implications for partnerships and their limited partners, especially those actively involved in the business.

Background and Case Overview

Denham Capital Management LP (Denham), a Delaware limited partnership, made guaranteed payments and distributed ordinary income to both its limited partners and its general partner. Each limited partner was actively engaged in the partnership’s trade or business on a full-time basis. On its original tax filings for the years at issue, the partnership only reported guaranteed payments as self-employment earnings on the K-1s distributed to the limited partners. Denham’s position to exclude the limited partners’ distributive share from self-employment income relied on Internal Revenue Code (IRC) Section 1402(a)(13), which provides that “the distributive share of any item of income or loss of a limited partner, as such” is excluded from net earnings from self-employment. The Internal Revenue Service (IRS), however, argued that this exclusion did not apply.

The Court’s Functional Analysis and Decision

The Court’s findings in Denham aligned with its 2023 decision in the Soroban Capital Partners, LP case. In both cases, the Court applied a “functional analysis” to determine if a state law limited partner truly qualifies as a “limited partner, as such” as outlined in the statute. The Court concluded that the limited partners in both Denham and Soroban did not meet the criteria for the Section 1402(a)(13) exclusion, making their distributive share of partnership income or loss subject to self-employment income.

In Denham, the Court assigned significant weight to key facts in its functional analysis that included:

• Denham’s income solely consisted of fees for services, and the limited partners’ time, skills and judgment were essential to the provision of these services.
• The limited partners dedicated substantially all of their time to the partnership and participated in the management either through their committee roles or by exercising delegated authority to conduct Denham’s business.
• The limited partners’ knowledge and judgement were attractive for fund investors, as reflected in the firm’s marketing materials that highlighted their significant role in Denham’s operations.
• The limited partners had significant control over personnel decisions.

Implications for Tax Professionals

The Denham case reinforces the IRS’ active stance in this area. Tax service professionals must consider these rulings when preparing partnership and individual returns. It is important to inquire from clients the roles and responsibilities of limited partners to determine the consequences of the functional analysis used by the Court in Soroban and Denham.

Understanding how these rulings affect your business can be challenging. Our experienced professionals can guide you through the latest rulings and regulations, evaluate your partnership structure and ensure compliance while optimizing your tax strategy. Contact us today.

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