Hedge Fund managers and other investment advisors are on high alert following the May 2025 Tax Court decision in Soroban because it signals a greater risk that a share of their earnings could be subject to self-employment tax.
In Soroban, the U.S. Tax Court held that Soroban’s investment manager limited partners were active limited partners, and thus ineligible for the limited partners exception to self-employment tax. Under the functional analysis applied by the Tax Court, it isn’t clear whether many investors who currently claim limited partner status can continue to reap the resulting tax benefits.
On May 28, 2025, the U.S. Tax Court issued a memorandum opinion (T.C Memo. 2025-52) concluding that Soroban’s limited partners were limited partners in name only. The Tax Court applied the “functional analysis” test from prior caselaw and examined the roles and responsibilities of the limited partners and found they were not akin to passive investors. The court held as follows –
- Soroban’s limited partners were limited partners in name only. They were essential to generating the business’s income, they oversaw day-to-day management, they worked for the business full time, and they were held out to the public as essential to the business. Their capital accounts make clear that their earnings were not of an investment nature. They are not limited partners within the meaning of section 1402(a)(13), and their earnings constitute net earnings from self-employment for the years in issue.
Other recent court cases have held similarly that the limited partner exception to self-employment tax does not apply to partners who are limited in name only.
Investment firms commonly are organized as limited partnerships under state law. Limited partners typically are passive investors that do not actively manage the business. But the line between limited and general partners is unclear, and the functional analysis does not provide the clarity that the industry needs. The lack of clarity means that many partners who previously claimed the limited partner exception may now be subject to self-employment tax if their roles and responsibilities within the partnership are similar to those of employees.
Additionally, the position of the IRS and the Tax Court challenges a decades-old industry reporting stance that limited partner interests are exempt from self-employment tax. This likely will lead to increased scrutiny of past tax filings and potential adjustments for partnerships that have relied on the limited partner exception.
There are many more hedge fund self-employment tax cases working their way through the courts, and some of them are currently on appeal. There is more to come on this issue and we will continue to keep our eye on these cases as they develop.
Author: Ed Leitinger, CPA, Tax Principal | [email protected]
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