Second Circuit Affirms IRS Position, Resulting in Setback for New York Resident Limited Partners on Self-Employment Tax

The U.S. Court of Appeals for the Second Circuit has upheld a significant Tax Court decision that narrows the availability of the limited partner self-employment tax exemption for investment fund managers. In *Soroban Capital Partners LP v. Commissioner*, the court concluded that the three principals of Soroban Capital Partners could not claim exemption from federal self-employment taxes (SECA) on their distributive share of partnership income, rejecting their argument that any partner in a limited partnership with limited liability qualifies for the exemption. The court instead adopted a functional analysis standard, holding that "limited partner" status requires a partner to lack managerial control over the partnership's business operations.

This decision directly affects the investment funds industry, particularly hedge fund and asset management firms operating in New York, Connecticut, and Vermont. For decades, many fund managers have claimed the Section 1402(a)(13) exemption to exclude partnership income from self-employment tax, which carries rates of 12.4% for Social Security (capped) plus 2.9% Medicare tax plus an additional 0.9% for high earners—representing potential cumulative savings of 3.8% for high-income earners. The IRS has aggressively challenged these claims through ongoing audit campaigns, arguing that the exemption applies only to passive-type limited partners who do not materially participate in the partnership's business, a position the Soroban ruling now validates through appellate review.

The circuit court decision gains significance from the recent alignment of appellate authority. The Fifth Circuit initially issued a contrary opinion in *Sirius Solutions LLLP v. Commissioner* on January 16, 2026, ruling that any limited partner with limited liability qualified for the exemption. However, on August 12, 2026, the Fifth Circuit withdrew and substituted this opinion with a new decision concluding that a "limited partner" means one who plays "no significant role in managing or running a business"—aligning with the Second Circuit's functional analysis standard. This convergence across circuits eliminates the prior circuit split and substantially reduces the likelihood of Supreme Court intervention, effectively nationalizing the IRS's position on the exemption.

The practical implications are severe for fund managers facing SECA audits or settlement negotiations, particularly in the Second and Fifth Circuits, where the IRS's negotiating leverage has been substantially reinforced. Managers in these jurisdictions who previously claimed the exemption may face material tax assessments with interest and penalties. The ruling preserves exemption eligibility for truly passive limited partners—including those holding general partner stakes in transaction structures—but imposes heightened scrutiny on "dual-role" partners who perform any management services while claiming limited partner status. Asset managers operating in jurisdictions outside the Second and Fifth Circuits (such as Florida or Illinois) should immediately consult tax counsel to assess whether the current weight of appellate authority in their circuits permits continued LP exemption claims, as other circuits have not yet definitively addressed this issue.