The United States Court of Appeals for the Second Circuit recently held in Soroban Capital Partners LP v. Commissioner of Internal Revenue, --- F.4th ---, 2026 WL 2751819 (2d Cir. 2026), that approximately $141.5 million in partnership income allocated to the three principals of an investment management firm was subject to self-employment tax, even though the principals held their interests as limited partners under state law. The decision is significant for owners of limited partnerships and, potentially, LLCs and other pass-through entities who actively manage their businesses and have relied on the "limited partner" exception to reduce their Social Security and Medicare tax exposure.
Background
Under the Internal Revenue Code of 1986, as amended (Code), a partner's distributive share of partnership income is generally treated as net earnings from self-employment and is subject to self-employment tax, which funds Social Security and Medicare. The combined base rate is 15.3 percent, of which 12.4 percent goes for Social Security (up to the annual wage base) and 2.9 percent for Medicare, which has no cap. High-income taxpayers may also owe an additional 0.9 percent Medicare tax above statutory thresholds.
Section 1402(a)(13) of the Code, however, excludes the distributive share of a "limited partner, as such," from net earnings from self-employment, other than guaranteed payments for services actually rendered to the partnership.
Soroban Capital Partners, LP (Soroban), a Delaware limited partnership, serves as investment manager to a group of hedge funds and earned about $247 million in 2016 and 2017. Soroban's three founding principals were limited partners of Soroban and members of the LLC that served as its general partner. They worked full time in the business – approximately 2,300 to 2,500 hours per year – managed the funds' portfolios, sat on all of Soroban's governing committees in 2016 and all but one in 2017, and participated in hiring, firing, promotion, termination, and evaluation decisions, although they contributed relatively little capital to the business.
For their services, they received about $2.5 million in guaranteed payments, on which they paid self-employment tax. Soroban, however, excluded the principals' roughly $141.5 million in distributive shares – more than 55 times the guaranteed payments – from self-employment income on the theory that the principals were limited partners.
After an audit, the IRS disagreed and adjusted Soroban's returns. The Tax Court sided with the IRS, applying a "functional analysis" and concluding that the principals were "limited partners in name only." Soroban appealed.
The Court's Analysis
The Second Circuit affirmed both issues before it.
First, the court held that the Tax Court had jurisdiction. For the 2016 and 2017 years at issue, the court held that net earnings from self-employment were a "partnership item" properly determined in a single partnership-level proceeding under the TEFRA partnership audit rules. TEFRA has since been replaced by the centralized partnership audit regime enacted in the Bipartisan Budget Act of 2015, so the procedural rules applicable to current tax years differ.
Second, and more importantly for business owners, the court held that a "limited partner" under Section 1402(a)(13) is a partner who has limited liability and who does not run, manage, or otherwise exert control or managerial authority over the partnership. The court relied on the ordinary meaning of the term "limited partner" at the time Congress enacted the exception in 1977, as reflected in contemporaneous dictionaries, treatises, and the uniform limited partnership acts then in effect. It also emphasized that the words "as such" limit the exclusion to income earned in a partner's capacity as an investor, and that Congress adopted the exception to address passive investors who were using small limited partnership investments to earn Social Security credits. The court rejected Soroban's arguments that state-law limited partner status alone should control, reasoning that "tax law deals in economic realities, not legal abstractions."
The court clarified that a limited partner may provide some services to the partnership and still qualify for the exception, so long as those activities do not amount to controlling, managing, or running the business. Because the principals plainly managed Soroban, their distributive shares were subject to self-employment tax.
The Second Circuit's decision aligns with the Fifth Circuit's recent decision in K Alain L.L.L.P. v. Commissioner, 184 F.4th 766 (5th Cir. 2026), which held that a limited partner is "a partner who plays no significant role in managing or running a business." The Second Circuit observed that, if its reading of K Alain is correct, there appears to be little daylight between the Fifth Circuit's position and the Tax Court's approach in Soroban, and that the Soroban principals would fail to qualify as limited partners under the Fifth Circuit's rule as well. A similar case is pending before the First Circuit.
Why This Matters to Business Owners
Many owners of closely held businesses, including professional services firms, investment managers, and family businesses, hold their interests as "limited partners" and do not pay self-employment tax on their share of the profits. Soroban and K Alain make clear that, in the Second and Fifth Circuits, respectively, state-law status or a title in a partnership agreement is not necessarily enough. If an owner works in and manages the business, the IRS may treat the owner's distributive share of the partnership's trade-or-business income as self-employment income, subject to the Code's other applicable exclusions.
The stakes can be substantial. The 2.9 percent Medicare portion of the tax is uncapped, so for owners with large profit allocations, the exposure grows with the business. In Soroban, the IRS adjustments increased the partnership's net earnings from self-employment by more than $77 million for 2016 and nearly $64 million for 2017. Because partnership audits generally are conducted at the partnership level, a single audit can affect every owner at once, and the consequences may extend to open prior tax years and may include resulting interest and, depending on the circumstances, penalties.
Although Soroban involved a state-law limited partnership and did not decide how Section 1402(a)(13) applies to members of LLCs taxed as partnerships, LLC owners should also take note. The IRS has long taken the position that the limited-partner exception may not protect active LLC members, and the Second Circuit's emphasis on managerial control adds to the broader authority favoring a functional rather than purely formal analysis.
A Practical First Step
Neither Soroban nor K Alain provides a bright-line test for determining when an owner's involvement crosses the line from permissible participation to management or control. A practical place to start is an honest inventory of each owner's role. For each owner who is treated as a limited partner (or as a non-self-employed LLC member), business owners should document:
- whether the owner works in the business and approximately how much time the owner devotes to it;
- whether the owner holds a management title, sits on governing or management committees, or has authority to bind the entity or make hiring, firing, and compensation decisions;
- how much capital the owner has contributed relative to the profits allocated to the owner; and
- how the owner's compensation is structured, including whether the owner receives guaranteed payments and how those payments compare to the owner's distributive share.
Comparing that inventory against the entity's governing documents and the self-employment income reported on its returns will help identify whether the current reporting position is consistent with Soroban and K Alain. Depending on the results, owners may wish to evaluate their reporting positions for open years, the structure of owner compensation, and whether their entity structure still fits how the business actually operates. Because these decisions turn heavily on the specific facts and can carry significant tax consequences, they should be made with the assistance of experienced tax counsel.
We will continue to monitor developments, including the pending First Circuit appeal and any further IRS guidance. If you have questions about how the Soroban decision may affect you or your business, please reach out to Blake Harper, William E. Robinson, or any member of Baker Donelson's Tax Group.