Taxpayer in Soroban Unsurprisingly Loses in Trial on the Merits
Yesterday, the Tax Court issued its taxpayer-adverse decision in
Soroban Capital Partners LP v. Commissioner, TC Memo 2025-52 (May 28, 2025). Surprise! Surprise! One can hardly be shocked by this taxpayer loss, given the taxpayer’s loss in
Denham Capital Management LP v. Commissioner, TC Memo 2024-114 (Dec. 23, 2024). As in
Denham, the Tax Court in
Soroban (same court, but different judge) took an all-or-nothing approach to whether the hedge fund manager income allocated to limited partners qualified for the §1402(a)(13) exclusion from self-employment tax. The Tax Court applied a “functional analysis” to determine if the partners who worked approximately 2,300 to 2,500 hours per year “were generally akin to passive investors,” concluding that they were not. The court also found that the capital contributions ($4 million vs. $247 million of gross income generated in the two years at issue), which were made by only one of the three limited partners, were “insignificant” and that “the small investment is not sufficient to classify the partner’s distributive share as a return on investment.”
Nowhere in the decision is there a discussion of the concept that a partner can “wear two hats,” one as a service provider and one as an investor. It remains to be seen whether the First Circuit decision will differ in the
Denham appeal (Dkt. No. 25-1349) or something different will come from the Fifth Circuit in the appeal of
Sirius Solutions G.P. LLC v. Commissioner (Dkt. No. 60240). Of course, both these cases involve personal service-type businesses, with respect to which the appellate courts could conclude are not appropriate to “split the baby.” In the meantime, one of our seminar attendees emailed us while we were inking this email blast and suggested that, more than ever, it makes sense to follow the
Tax Forum's recommendation that we have been making for decades – establish a separate management company that is paid fair value (or receives an appropriate priority allocation of profits) for services rendered (supported by a compensation study where there is not independent negotiation of the SE income to be received) and have limited partner interests or non-managing LLC interests received in exchange for capital contributions (which would include the value of any sweat equity) provided to the operating entity. Whether this approach “works” in a personal service-type business remains to be seen, and perhaps the appellate courts will provide some clue when their decisions are rendered. Outside the personal service-type business, rumor has it that the IRS is more flexible in “splitting the baby.”
Needless to say, the availability and breadth of the §1402(a)(13) SE tax exclusion is one of today’s most contentious issues in the partnership arena, and it will be a hot topic discussed this year at our
Tax Planning Forum® and
Fundamentals of Flow-Through® programs. Registration remains open for our final spring
Fundamentals program, which will be held on June 17-19, and registration is open for all our fall and winter
Forum and
Fundamentals programs presented both virtually and in-person.