Key Takeaways
- • The US Court of Appeals for the Second Circuit ruled in September 2026 that active limited partners in hedge funds can be liable for the 3.8% federal self-employment tax, overturning a decades-long interpretation of a 1977 tax provision that had exempted limited partners from this obligation.
- • The Second Circuit decision involved Soroban Capital Partners and three of its partners with more than $141 million in earnings from 2016 and 2017; a separate Fifth Circuit ruling in August reached the same conclusion, establishing multi-circuit precedent against the hedge fund industry's tax strategy.
- • The rulings carry material financial consequences for fund managers because the Medicare component of self-employment tax lacks the earnings cap applied to Social Security, potentially exposing substantial income at upper earnings levels to the additional levy.
- • High-profile figures including Steve Cohen's Point72 and Treasury Secretary Scott Bessent (formerly of Key Square Group) have faced IRS disputes over this issue; Bessent settled his case with the federal government over the summer following his 2025 confirmation process.
- • The IRS launched a formal challenge to the limited-partner tax strategy in 2018, with multiple cases now in litigation or under review across federal courts, suggesting additional exposure remains for hedge fund and private equity executives with open tax disputes.
Summary
Recent appellate court decisions have fundamentally undermined a longstanding tax-planning strategy that has allowed hedge fund managers to reduce their self-employment tax obligations by claiming limited-partner status despite actively managing their businesses. The US Court of Appeals for the Second Circuit ruled in September 2026 that active limited partners can be liable for the 3.8% federal self-employment tax, directly challenging an interpretation of a 1977 tax provision that had generally excluded limited partners from this obligation. This decision followed a Fifth Circuit ruling in August that reached the same conclusion, establishing a clear trend in judicial interpretation against fund managers' previous tax treatment.
The Second Circuit's ruling holds particular significance for the hedge fund industry because the court's jurisdiction encompasses New York, the geographic center of the alternative investment management sector. The case involved Soroban Capital Partners and three of its partners, with the disputed earnings exceeding $141 million for the years 2016 and 2017. The Tax Court had initially ruled in favor of the government in 2023 before the litigation progressed through the appeals process, demonstrating the sustained nature of this dispute within the tax system.
The financial impact of these rulings extends across the hedge fund and private equity sectors. Unlike the Social Security component of self-employment tax, which operates under an earnings cap, the Medicare component applies without limitation to income at higher levels. This structure means that fund managers and private equity executives face potentially substantial additional tax liability on their carried interest and other earnings. The cumulative effect across multiple years can result in millions of dollars in additional tax obligations.
High-profile cases illustrate the breadth of the issue. Steve Cohen's Point72, owned by the New York Mets proprietor, has faced an IRS dispute related to this tax strategy, though the firm declined to comment on the matter. Treasury Secretary Scott Bessent, who previously ran hedge fund Key Square Group, used the limited-partner approach during his tenure and acknowledged this during his 2025 confirmation process. Bessent subsequently settled his self-employment tax dispute with the federal government in the summer of 2026 after setting aside funds to cover potential liability.
The IRS commenced a formal campaign against this tax strategy in 2018, and the issue has persisted across multiple administrations. Beyond the Soroban and Fifth Circuit decisions, another case remains pending before the First Circuit, suggesting that additional rulings and clarifications may emerge. Fund managers with open disputes or tax years under IRS review face material exposure as courts continue to align with the government's interpretation that active involvement in fund management disqualifies limited partners from the self-employment tax exemption.
The Second Circuit's ruling holds particular significance for the hedge fund industry because the court's jurisdiction encompasses New York, the geographic center of the alternative investment management sector. The case involved Soroban Capital Partners and three of its partners, with the disputed earnings exceeding $141 million for the years 2016 and 2017. The Tax Court had initially ruled in favor of the government in 2023 before the litigation progressed through the appeals process, demonstrating the sustained nature of this dispute within the tax system.
The financial impact of these rulings extends across the hedge fund and private equity sectors. Unlike the Social Security component of self-employment tax, which operates under an earnings cap, the Medicare component applies without limitation to income at higher levels. This structure means that fund managers and private equity executives face potentially substantial additional tax liability on their carried interest and other earnings. The cumulative effect across multiple years can result in millions of dollars in additional tax obligations.
High-profile cases illustrate the breadth of the issue. Steve Cohen's Point72, owned by the New York Mets proprietor, has faced an IRS dispute related to this tax strategy, though the firm declined to comment on the matter. Treasury Secretary Scott Bessent, who previously ran hedge fund Key Square Group, used the limited-partner approach during his tenure and acknowledged this during his 2025 confirmation process. Bessent subsequently settled his self-employment tax dispute with the federal government in the summer of 2026 after setting aside funds to cover potential liability.
The IRS commenced a formal campaign against this tax strategy in 2018, and the issue has persisted across multiple administrations. Beyond the Soroban and Fifth Circuit decisions, another case remains pending before the First Circuit, suggesting that additional rulings and clarifications may emerge. Fund managers with open disputes or tax years under IRS review face material exposure as courts continue to align with the government's interpretation that active involvement in fund management disqualifies limited partners from the self-employment tax exemption.
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