The potentially pivotal role of the phrase “as such” in determining whether state law limited partners are automatically exempt from recognizing self-employment income from the partnership was underscored in Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12.[1]

Facts of the Case

The partnership in question had a structure described by the Court as follows:

Soroban’s Limited Partnership Agreement sets forth the terms of the partnership. It states that Soroban has six partners in total, which includes one general partner and five limited partners. Petitioner is the general partner and tax matters partner. The limited partners are Eric Mandelblatt, Gaurav Kapadia, Scott Friedman, EWM1 LLC, and GKK LLC. However, because both EWM1 and GKK are single-member LLCs wholly owned by Mr. Mandelblatt and Mr. Kapadia, respectively, they are disregarded for federal income tax purposes. Therefore, for federal income tax purposes, Soroban has only three limited partners (Mr. Mandelblatt, Mr. Kapadia, and Mr. Friedman).

The Limited Partnership Agreement provides the roles and responsibilities of Soroban’s partners. It lists the general partner and its role and authority over the business affairs of the partnership; the limited partners and their roles and interests in the partnership; how the profits and losses are to be allocated; the terms surrounding capital contributions; the voting classes; and the compensation provided to the limited partners in exchange for their services. Mr. Mandelblatt, Mr. Kapadia, and Mr. Friedman received guaranteed payments in exchange for providing services to Soroban.[2]

The Court goes on to describe the reporting on the partnership’s 2016 and 2017 income tax returns, the years before the Court in this case:

Soroban filed Forms 1065, U.S. Return of Partnership Income, for the years in issue. On those returns Soroban identified petitioner as the general partner and Mr. Mandelblatt, Mr. Kapadia, and Mr. Friedman as limited partners. It reported total net earnings from self-employment of $2,035,395 and $1,901,131 for 2016 and 2017, respectively. These totals represented the guaranteed payments received by Mr. Mandelblatt, Mr. Kapadia, and Mr. Friedman for their services to the partnership, and petitioner’s share of Soroban’s ordinary business income. However, Soroban excluded Mr. Mandelblatt’s, Mr. Kapadia’s, and Mr. Friedman’s shares of Soroban’s ordinary business income in its computation of net earnings from self-employment.[3]

The IRS objected to the treatment of the limited partners’ ordinary income from inclusion as self-employment income.

Self-Employment Income for a Partner

IRC §1402(a) provides the following general rule for the computation of a partners’ self-employment income:

(a) Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member;

However, a number of exclusions from self-employment income are found following that language, one of which is found at IRC §1402(a)(13):

(13) there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, (emphasis added) other than guaranteed payments described in section 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;

The Importance of “As Such” in the View of Tax Court

The dispute centered on whether the term “limited partner” in IRC §1402(a)(13) inherently encompasses any limited partner as defined by applicable state law, thereby exempting these partners’ shares of the partnership's income under §1402(a) from being classified as self-employment income. The Tax Court noted that the IRC does not define “limited partner, as such,” as referenced in IRC §1402(a)(13):

Section 1402(a)(13) does not define the phrase “limited partner, as such.” However, legislative history and caselaw provide us with insight on Congress's intended meaning. The limited partner exception under section 1402(a)(13) was enacted in 1977 to “exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership.” Social Security Amendments of 1977, §313(b), 91 Stat. at 1536; H.R. Rep. No. 95-702, pt. 1, at 11, as reprinted in 1977 U.S.C.C.A.N. at 4168. Essentially, it was enacted to exclude earnings that are of an investment nature. H.R. Rep. No. 95-702, pt. 1, at 11, as reprinted in 1977 U.S.C.C.A.N. at 4168.[4]

In 1997, the IRS sought to define the phrase in question. Recognizing the emergence of new business entities like LLCs and LLPs, which were not prevalent when IRC §1402(a)(13) was enacted, the IRS chose not to solely rely on an individual's state law limited partner status. Instead, it introduced a series of independent tests, effectively sidelining the state law limited partner status.

In 1997 Treasury issued a proposed regulation seeking to define the scope of the limited partner exception. See Prop. Treas. Reg. § 1.1402(a)-2, 62 Fed. Reg. 1702 (Jan. 13, 1997). The proposed regulation provided that an individual would not be treated as a limited partner if the individual had personal liability for partnership debts, had authority to contract on behalf of the partnership, or participated in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year. Id. para. (h)(2), 62 Fed. Reg. at 1704.[5]

The proposed regulations sparked controversy; they were notably referred to as “stealth tax” regulations by then-Speaker Newt Gingrich.

This proposal received much criticism. That criticism led Congress to issue a moratorium prohibiting Treasury from issuing any temporary or final regulation with respect to the definition of a limited partner under section 1402(a)(13) until July 1, 1998. Taxpayer Relief Act of 1997, Pub. L. No. 105-34, §935, 111 Stat. 788, 882. Congress's reasoning behind the moratorium was that “the Senate [was] concerned that the proposed change in the treatment of individuals who are limited partners under applicable State law exceeds the regulatory authority of the Treasury Department and would effectively change the law administratively without congressional action.” Revenue Reconciliation Act of 1997, H.R. 2014, 105th Cong., 143 Cong. Rec. S6694, S6774, S6819 (1997).[6]

However, Congress did not take action before the moratorium's expiration on July 1, 1998. Since then, Congress has not directly addressed the issue through legislation. Similarly, the IRS has not issued any regulations in this area following the end of the moratorium.

Since the moratorium, Congress has briefly discussed the definition of limited partner but has not defined it. See, e.g., Staff of J. Comm. on Tax'n, 110th Cong., Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I, JCX-62-07, at 35 n.64 (J. Comm. Print 2007) (“[L]imited partner status is determined under State law. Issues have arisen under present law as to the proper [self-employment] tax treatment of individuals who may be limited partners under State law but who participate in the management and operation of the partnership.”).8 Furthermore, Treasury has yet to issue any final or temporary regulation defining “limited partner” under section 1402(a)(13).[7]

Ultimately, it was the courts that undertook the task of determining how to address these various entities and the exclusion stipulated in IRC §1402(a)(13):

In 2011 we were called upon to determine the scope of the limited partner exception. We applied statutory construction principles to determine whether partners in an LLP should be considered limited partners under section 1402(a)(13). See Renkemeyer, 136 T.C. 137. In Renkemeyer, 136 T.C. at 150, we analyzed the legislative history of section 1402(a)(13) and concluded that its intent “was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations . . . would not receive credits towards Social Security coverage.” We further found that “[t]he legislative history . . . does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes.” Renkemeyer, 136 T.C. at 150. Lastly, we held that the partners in that case were not limited partners for purposes of section 1402(a)(13) because their “distributive shares arose from legal services . . . performed on behalf of the law firm” and not “as a return on the partners' investments.” Renkemeyer, 136 T.C. at 150.

In Renkemeyer we specifically applied a functional analysis test to determine whether the limited partner exception applied. But that case specifically dealt with an LLP and not a limited partnership as present here. While there have been subsequent opinions applying Renkemeyer to determine whether taxpayers in passthrough entities are limited partners under section 1402(a)(13), we have not addressed whether a limited partner in a state law limited partnership must satisfy a functional analysis test to be entitled to the limited partner exception. See, e.g., Castigliola v. Commissioner, T.C. Memo. 2017-62, at *7-14 (finding professional LLC members not limited partners for purposes of section 1402(a)(13)).[8]

The Court describes the basic dispute between the parties as follows:

Petitioner contends that Mr. Mandelblatt, Mr. Kapadia, and Mr. Friedman are state law limited partners and therefore their distributive shares of income are excluded from net earnings from self-employment under section 1402(a)(13). Petitioner argues that because Soroban is a state law limited partnership and its Limited Partnership Agreement identified Mr. Mandelblatt, Mr. Kapadia, and Mr. Friedman as limited partners, section 1402(a)(13) is satisfied.

The Commissioner disagrees, arguing that the distributive shares of income of limited partners in state law limited partnerships are not automatically exempt from self-employment income. He asserts that the Court must apply a functional analysis test, similar to the test outlined in Renkemeyer and subsequent cases, to determine whether individuals are limited partners pursuant to section 1402(a)(13).[9]

The Tax Court aligned with the IRS in this dispute, with its rationale significantly hinging on the inclusion of the “as such” clause in IRC §1402(a)(13):

Section 1402(a)(13) excludes from net earnings from self-employment “the distributive share of any item of income or loss of a limited partner, as such.” (Emphasis added.) Neither section 1402(a)(13) nor applicable regulations define the phrase “limited partner, as such.” Therefore, we use principles of statutory construction to ascertain Congress's intent.[10]

The Court, in its opinion, emphasized the necessity to ascribe meaning to every word of the statute. It focused on Congress’ deliberate choice of words, noting that instead of broadly applying the exclusion to limited partners, Congress specifically referred to “limited partners as such.”

Under the canon against surplusage, we give effect to every clause and word of a statute. United States v. Menasche, 348 U.S. 528, 538-39 (1955). “When construing a statute, the Court must interpret it ‘so as to avoid rendering any part of the statute meaningless surplusage.’” Growmark, Inc. & Subs. v. Commissioner, No. 23797-14, 160 T.C., slip op. at 11 (May 16, 2023) (citing 15 W. 17th St. LLC v. Commissioner, 147 T.C. 557, 586 (2016)); see also Tucker v. Commissioner, 135 T.C. 114, 154 (2010) (“[W]e decline to read words out of the statute; rather, we attempt to give meaning to every word that Congress enacted. . . .”), aff’d, 676 F.3d 1129 (D.C. Cir. 2012).

Turning to the statute in question, we find that the limited partner exception does not apply to a partner who is limited in name only. If Congress had intended that limited partners be automatically excluded, it could have simply said “limited partner.” By adding “as such,” Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner.[11]

The Court dismissed the taxpayers' efforts to reference various other documents, upholding what it determined to be the plain meaning of the statute.

Petitioner’s reliance on legislative history to overcome the plain meaning of the statute is unavailing. To the extent legislative history might be used to shed light on the meaning of the phrase “limited partner, as such,” it confirms our conclusion. Congress enacted section 1402(a)(13) to exclude earnings from a mere investment. It intended for the phrase “limited partners, as such” used in section 1402(a)(13) to refer to passive investors.

Petitioner points to H.R. Rep. No. 95-702, pt. 1, at 11, as reprinted in 1977 U.S.C.C.A.N. at 4168, as support, noting that it states that section 1402(a)(13) was intended “to exclude for coverage purposes certain earnings which are basically of an investment nature.” But Congress’s express text makes clear that it was looking to the nature of the earnings. Congress intended section 1402(a)(13) to apply to partners that are passive investors.

Next petitioner cites the Sense of the Senate Resolution for support. Through that resolution, the Senate expressed its view that Treasury’s attempt to define limited partner exceeded its authority. But Treasury’s proposed regulation had several criteria that might have led to a limited partner’s earnings’ being subject to self-employment tax, even if the person was a passive investor. One such example is merely being personally liable for partnership debts. Prop. Treas. Reg. § 1.1402(a)-2(h)(2)(i), 62 Fed. Reg. at 1704. The Senate’s concern was “that an individual meeting any one of these three criteria will be treated as a general partner.” H.R. 2014, 105th Cong., 143 Cong. Rec. S6694, S6774, S6819. The Senate’s concern about the criteria set forth in Treasury’s proposed regulation does not override the plain text of the statute.

Lastly, petitioner relies on a Joint Committee on Taxation report that states: “A special rule applies for limited partners of a partnership.” Staff of J. Comm. on Tax’n, 110th Cong., Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I, JCX-62-07, at 35. In a footnote from that sentence, that report explains that “limited partner status is determined under State law.” Id. at 35 n.64. We find this unpersuasive. The report addresses only the meaning of the words “limited partner” and not the phrase “limited partner, as such.” It is those latter words that narrow the scope of the limited partner exception, which the Joint Committee Report does not address. To the extent one might read the Joint Committee on Taxation Report more broadly, it does not constitute legislative history and carries no more weight than a law review article. Gregory, 149 T.C. at 55.[12]

Ultimately, the Court dismissed further attempts by the taxpayer to argue that the state law definition should prevail in this case:

Petitioner puts forth myriad other arguments to support its definition of limited partner, but none is persuasive. Petitioner cites section 469 and compares its rules and regulations with section 1402(a)(13), but we do not find the sections analogous. Petitioner cites dicta out of context. Lastly, petitioner points to the 2016 Instructions for Form 1065 at 2 and 2017 Instructions for Form 1065 at 3 as support for its definition. The instructions state: “A limited partner is a partner in a partnership formed under a state limited partnership law, whose personal liability for partnership debts is limited to the amount of money or other property that the partner contributed or is required to contribute to the partnership.” But this definition is provided as part of the “General Instructions” and “Definitions.” This is not, and does not purport to be, a definition for purposes of self-employment tax. In discussion of self-employment tax, the instructions state: “Generally, a limited partner’s share of partnership income (loss) isn’t included in net earnings (loss) from self-employment.” 2016 Instructions for Form 1065 at 34; 2017 Instructions for Form 1065 at 36. Use of the qualifier “generally” makes clear that it is not always true that a limited partner’s share of partnership income is excluded from net earnings from self-employment.[13]

Will the Decision Survive on Appeal?

The case seems poised for an appeal in a Court of Appeals. The certainty of the Tax Court's reliance on the “as such” phrase and its interpretation that a partner must meet a functional test to qualify as a limited partner, rather than merely in name, remains uncertain for support in the appellate court. However, the potential for rejection is also unclear, especially considering the complications that could arise from treating LLC members as limited partners solely based on state law, as demonstrated in the Renkemeyer analysis.

[1] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/tax-court-can-make-limited-partner-inquiry-at-partnership-level/7hlk4 (retrieved November 28, 2023)

[2] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[3] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[4] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[5] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[6] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[7] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[8] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[9] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[10] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[11] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[12] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023

[13] Soroban Capital Partners LP et al. v. Commissioner, 161 TC No. 12, November 28, 2023