Soroban Decision Adds Pressure on Limited Partner Tax Exemption

In Soroban Capital Partners LP v. Commissioner, the Second Circuit affirmed the Tax Court’s functional analysis for determining whether state law limited partners qualify for the self-employment tax exemption under Internal Revenue Code (“IRC”) § 1402(a)(13), holding that Soroban LP’s limited partners did not qualify for the exemption because they exercised managerial control. The ruling increases appellate pressure in a significant partnership tax controversy and may heighten the possibility of Supreme Court review, particularly in light of the Fifth Circuit’s revised decision in K Alain, L.L.L.P. v. Commissioner.

The Limited Partner Exception 

Under IRC § 1402(a)(13), a limited partner's distributive share of partnership income is excluded from net earnings from self-employment and therefore is not subject to Self-Employment Contributions Act (“SECA”) taxes, the self-employed counterpart to Social Security and Medicare taxes imposed under the Federal Insurance Contributions Act. The SECA tax rate is 15.3% on self-employment income, plus an additional 0.9% Medicare surtax for high earners, which generally affects partners in investment firms, hedge funds, and other partnerships generating significant fee income.

Because the exemption affects whether partners' distributive shares are subject to SECA taxes, the unresolved definition of “limited partner” has significant consequences for partnerships, particularly in industries where active owners receive substantial allocations of ordinary business income.

The Soroban Case

Soroban Capital Partners LP (“Soroban LP”) is a New York-based investment management firm organized as a Delaware limited partnership. Soroban LP’s sole general partner, Soroban Capital Partners GP LLC (“Soroban GP”), held approximately a 1% interest in the firm. The firm’s three limited partners were individuals, collectively owning 100% of Soroban GP in approximately the same proportions as their limited partnership interests.

Soroban LP earned fee income by providing investment management services to affiliated funds. On its partnership tax returns, Soroban LP reported the limited partners’ distributive shares of ordinary business income as exempt from SECA taxes under § 1402(a)(13), while reporting guaranteed payments and the general partner’s share of income as subject to self-employment tax.

The IRS challenged this treatment, asserting that Soroban LP’s limited partners were “limited in name only” and that their distributive shares should be included in net earnings from self-employment. In its landmark 2023 decision, Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), the Tax Court sided with the IRS. The Tax Court held that § 1402(a)(13) was intended to exempt passive investors and that a “functional analysis” test must be applied to determine whether a partner’s actual role in the partnership justifies limited partner treatment for SECA purposes.

In a subsequent 2025 memorandum opinion, Soroban Capital Partners LP v. Commissioner, T.C. Memo. 2025-52, the Tax Court applied its functional analysis and concluded that Soroban LP’s limited partners were actively and extensively involved in its operations. The court rejected Soroban LP’s argument that the principals performed services only in their capacity as members of the general partner entity, otherwise known as “bifurcation,” finding instead that the economic substance of the arrangement showed income attributable to services.

The Second Circuit’s Ruling

On September 17, 2026, in Soroban Capital Partners LP v. Commissioner, No. 25-2250, the United States Court of Appeals for the Second Circuit affirmed the Tax Court’s judgment in a unanimous opinion authored by Judge Denny Chin and joined by Judges Guido Calabresi and Sarah A. L. Merriam.

The Second Circuit accepted the Tax Court’s analysis, finding that Soroban LP’s limited partners were not genuinely limited within the meaning of the statute. The court noted that these individuals “exerted managerial control” over Soroban LP, including the power to “hire, fire, promote, terminate, and evaluate Soroban's employees.” According to the Second Circuit, the limited partners’ deep involvement in the day-to-day operations placed them well outside the scope of the exemption Congress intended with IRC § 1402(a)(13).

Soroban LP argued that its limited partners qualified for the SECA exclusion solely because they held limited liability under state law. The Second Circuit rejected that position, concluding that state law limited partner status alone does not control the federal tax analysis.

The Circuit Split: Second Circuit vs. Fifth Circuit

The Second Circuit’s ruling creates a widely anticipated circuit split with the Fifth Circuit’s decision in K Alain, L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. Aug. 12, 2026). 

The Fifth Circuit’s path in this area has itself been notably winding. In its original January 2026 opinion, the Fifth Circuit held that a “limited partner” for purposes of IRC § 1402(a)(13) simply means a partner in a state law limited partnership who has limited liability. That holding was a victory for taxpayers and a direct repudiation of the Tax Court’s analysis in Soroban.

However, on August 12, 2026, the Fifth Circuit withdrew its January opinion and issued a materially revised decision, instead holding that the original public meaning of limited partner from the statute’s origin in 1977 is “a partner who plays no significant role in managing or running a business.” Although the Fifth Circuit upheld its outcome (remanding for further proceedings and vacating the Tax Court decision), the legal standard changed significantly. 

As a result, the Tax Court and the Second Circuit expressly employ a functional analysis focused on whether the partner is a passive investor, while the Fifth Circuit’s revised opinion frames the inquiry around whether the partner plays a significant role in managing or running the business. The standards differ in wording and emphasis, but each looks beyond state law limited partner status and focuses on the partner’s actual role in the partnership.

The First Circuit: A Third Front

A third appellate case in this area, Denham Capital Management LP v. Commissioner, No. 25-1349, is currently pending before the First Circuit. Oral argument was held on February 5, 2026, but the court’s questioning focused primarily on whether the Tax Court has jurisdiction under the Tax Equity and Fiscal Responsibility Act of 1982 to determine net earnings from self-employment at the partnership level. If the First Circuit resolves Denham on jurisdictional grounds, it may leave the substantive limited partner issue for another case.

Looking Ahead

The decision is most directly relevant to state law limited partnerships whose individual limited partners also exercise meaningful control over the partnership’s business. 

The Second Circuit’s decision has immediate and practical consequences for investment fund managers, hedge funds, private equity sponsors, and other businesses organized as limited partnerships.  The formal label of “limited partner” is no longer enough.  Designating partners as limited partners will not guarantee SECA tax exemption.  Partners participating in the active management of the partnership, including in the hiring/firing, investment decisions, or other core operations, will face significant exposure to SECA tax on their distributive shares. Importantly, the Fifth Circuit declined in K Alain to extend the holding to LLCs or LLPs, meaning the application of the § 1402(a)(13) exception outside of a limited partnership remains unresolved. 

With the Second Circuit and the Fifth Circuit now applying different formulations of the § 1402(a)(13) inquiry, the possibility of further appellate review, including potential Supreme Court review, has increased. The likelihood of review may depend on whether future decisions sharpen the scale of conflict and whether the varying courts of appeals diverge in outcomes and reasoning.

In the meantime, Congress could also take legislative action to define the term “limited partner” for SECA purposes, a definition that Treasury and the IRS have attempted to provide through proposed regulations in the past without success. Until additional clarity arrives through the Supreme Court or Congress, partnerships and their advisors should carefully evaluate the actual roles and functions of individuals designated as limited partners and consider the self-employment tax risks.