A limited partner in a Delaware LP wired $1.2 million to the IRS last quarter — not because the law changed, but because a Tax Court judge looked at how the partner actually spent their workdays and concluded the "limited" label on the partnership agreement was a piece of paper, not a tax shield.
That partner is not alone. Since the Tax Court's November 2023 decision in Soroban Capital Partners v. Commissioner, and the doubling-down in Denham Capital and Point72 Asset Management in 2024 and 2025, the IRS has won every contested case on whether so-called limited partners owe 15.3% self-employment tax on their distributive share. The result is a quiet repricing of partnership compensation across hedge funds, private equity firms, professional service LLCs, and family businesses that thought a state-law label was enough.
If you're a partner, member, or fund manager who has been excluding distributive share from self-employment tax based on a limited partner designation, the rules you learned in 2010 no longer match the rules you'll be audited under in 2026. Here's what changed, how the new functional test actually works, and what to do before the IRS notice arrives.
What Section 1402(a)(13) Actually Says
The exemption every partner relies on lives in a single sentence of the Internal Revenue Code. Section 1402(a)(13) excludes from net earnings from self-employment:
"the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services."
Three phrases carry all the weight in modern audits:
- "Limited partner" — the IRS now argues this is a functional concept, not a state-law label
- "As such" — meaning the partner must be acting in the capacity of an investor, not a service provider
- "Other than guaranteed payments" — service-related guaranteed payments are always subject to SE tax, no matter how the partnership agreement labels them
The exemption was added by the Tax Reduction Act of 1977 to keep passive investors out of Social Security coverage they did not want or need. When Congress wrote it, "limited partner" meant the silent capital partner in an oil-and-gas drilling LP with no management rights and no liability beyond contributed capital. Today's "limited partners" frequently run the firm, sign contracts, hire staff, and earn nine-figure distributive shares. The IRS noticed the mismatch. The Tax Court agreed.
The 1997 Proposed Regulations That Never Became Final
Before the modern cases, practitioners pointed to the 1997 proposed regulations under Section 1402, which would have defined a limited partner as one who: (a) lacked personal liability for partnership debts, (b) did not have management authority, and (c) did not work more than 500 hours during the taxable year. Failure on any one of those tests would disqualify the partner.
Congress responded with a one-year moratorium on finalizing the rules. Treasury never finished the project. The proposed regulations sit in limbo to this day, frequently cited in arguments and rarely cited as authority. The IRS has refused to issue updated guidance, and the resulting vacuum is exactly what the Tax Court has been filling with case-by-case rulings.
The practical implication: there is no bright-line safe harbor. There is only the body of case law that has formed since 2011 — and that case law has trended steadily in the IRS's favor.
The Renkemeyer Origin Story
The functional analysis test traces back to Renkemeyer, Campbell & Weaver, LLP v. Commissioner (136 T.C. 137, 2011), a Kansas law firm organized as a limited liability partnership. Three attorney-partners excluded their distributive shares from SE tax on the theory that LLP partners were equivalent to LP limited partners under Section 1402(a)(13).
The Tax Court rejected the argument and articulated the test that has governed every case since: the limited partner exception applies only when the partner's distributive share is "generally akin to a return on the partner's investment," not when it represents compensation for services rendered to the firm. The attorney-partners earned their income by practicing law, not by deploying capital. They owed SE tax on their shares.
Renkemeyer settled the question for LLPs and, by extension, for LLC members. What it did not settle was whether a state-law limited partner in a true LP — the original 1977 fact pattern — automatically qualified for the exemption regardless of function. That question waited twelve years for Soroban.
Soroban Capital Partners: The Decision That Changed Everything
Soroban Capital Partners LP v. Commissioner (161 T.C. No. 12), decided November 28, 2023, is the case fund managers cannot afford to ignore. Soroban is a New York hedge fund organized as a Delaware limited partnership. Its three limited partners received guaranteed payments for services and also took allocations of ordinary business income — and they excluded those allocations from SE tax based on the state-law limited partner status.
The IRS issued a Final Partnership Administrative Adjustment (FPAA) reclassifying roughly $142 million of distributive share as subject to SE tax over three years. Soroban filed a motion for summary judgment arguing that state-law limited partner status alone resolved the question.
The Tax Court denied the motion. Judge Marvel held that Section 1402(a)(13) requires a functional inquiry into whether the partner is acting "as a limited partner" — and that the state-law label is not dispositive. The case extended Renkemeyer's reasoning to its logical end: function controls, form does not.
The merits trial followed in 2024. The Tax Court found that Soroban's limited partners were heavily involved in the firm's operations, sat on the investment committee, made portfolio decisions, and were the firm's marquee talent. They failed the functional test. Their distributive shares were fully subject to SE tax.
Denham Capital, Point72, and the Functional Test in Practice
After Soroban, the Tax Court has applied the functional test repeatedly. In Denham Capital Management LP, decided December 2024, the court reaffirmed the analysis for a private equity fund and found that the limited partners — who were in fact senior investment professionals — owed SE tax on roughly $25 million of distributive share. In Point72 Asset Management, decided in mid-2025, Steve Cohen's firm lost on similar facts.
The factors the court examines have stabilized into a recognizable list:
- Time commitment: Do the partners work full-time at the firm? More than 500 hours? Are they identified as senior staff on the firm's website?
- Management role: Do they sit on investment committees, hire and fire employees, sign leases, or otherwise direct firm operations?
- Compensation structure: Is the distributive share calibrated to performance and labor, or to capital invested?
- Source of income: Does the firm earn fees and carry primarily through the partner's services, or primarily through deployed capital?
- Holding out to the public: Do third parties — clients, vendors, regulators — view the partner as an active principal?
A partner who fails on three or more of these factors will almost certainly be reclassified. The court is unimpressed by partnership agreements that recite "limited partner" status while describing duties that look identical to those of a managing partner.
The Fifth Circuit Wildcard
In April 2025, the U.S. Court of Appeals for the Fifth Circuit reversed a related Tax Court decision and held — at least for cases appealable to the Fifth Circuit — that "limited partner" in Section 1402(a)(13) refers to a state-law limited partner with limited liability, and that no functional analysis is required. The opinion is a meaningful disagreement with the Tax Court's settled position.
The practical effect for planners is narrow but real:
- Cases appealable to the Fifth Circuit (Texas, Louisiana, Mississippi) may follow the state-law standard
- Cases appealable to other circuits remain governed by the functional test the Tax Court is applying
- The IRS has not changed its enforcement posture nationwide
The Fifth Circuit ruling is a useful argument and a serious split, but it is not a national rule. Until the Supreme Court resolves the conflict or Congress legislates, a partner outside the Fifth Circuit who relies on state-law limited partner status alone is taking a position the Tax Court has rejected at every opportunity.
The Proposed Regulations Released by Treasury in 2024
In November 2024, Treasury released REG-105299-22, proposed regulations that for the first time in nearly three decades attempted to formalize the limited partner concept for SE tax purposes. The proposal codifies the Tax Court's functional approach and adds an anti-abuse rule directed at recharacterization schemes.
Highlights of the proposed framework:
- A partner is treated as a limited partner only if the partner does not actively participate in the partnership's business
- The proposed regs explicitly reject state-law limited partner status as the controlling factor
- An anti-abuse rule targets two-tier structures where a partner contributes services through a passive holding entity
- The 500-hour proxy from the abandoned 1997 proposal does not appear; instead, the analysis is intentionally facts-and-circumstances based
Public comments closed in early 2025. The regulations are expected to be finalized in late 2026 or 2027. When finalized, they will retroactively apply the Tax Court's interpretation to taxable years beginning after the publication date.
Guaranteed Payments: The Trap That Always Applies
Even partners who clearly qualify for the limited partner exemption owe SE tax on guaranteed payments under Section 707(c) made "for services actually rendered to or on behalf of the partnership." The statutory carve-out is explicit and has never been controversial.
The planning consequence: relabeling a guaranteed payment as a "preferred return" or "priority allocation" does not change the answer if the underlying economics compensate the partner for services. The Tax Court looks at substance. A payment that varies with hours worked, performance milestones, or service quality is a service payment regardless of what the operating agreement calls it.
For S-corporation owners who have considered switching to an LP or LLC to escape FICA on owner compensation: this is the wall the strategy runs into. The IRS will recharacterize service compensation as a guaranteed payment, subject the rest of the distributive share to SE tax under the functional test, and assess underpayment penalties on top.
The Six Planning Moves That Survive the New Regime
If you are organizing a new partnership or restructuring an existing one in 2026, six approaches still hold up under the functional test:
- Genuine passive capital partners still qualify for the exemption. A family member or outside investor who contributes capital, takes a return, and does not participate in operations is the original 1977 fact pattern. The exemption works as intended.
- Two-class partnership structures can isolate service partners from capital partners. The service partners take guaranteed payments and a smaller distributive share that all gets SE tax treatment; the capital partners take a return on capital that does not. The economics must be defensible — disproportionate carry to capital partners who do not work invites recharacterization.
- S-corporation blocker entities remain a viable structure for service partners who want to control FICA exposure. The service partner forms an S corp, contributes services through the S corp, pays a reasonable W-2 salary, and takes distributions. Payroll tax savings are real but constrained by the Glasshouse Systems line of cases on reasonable compensation.
- Activity-based allocation assigns service income to guaranteed payments and capital income to distributive share, with documentation that supports the split. This works when the partnership has both a meaningful capital base and meaningful service revenue.
- State-law limited partners with no management role — true silent partners — continue to qualify even under the functional test. Do not list them on the website, do not give them committee seats, do not have them sign anything, and do not let them work more than 500 hours.
- Geographic positioning for Fifth Circuit appeal is a long-shot strategy. Forming partnerships in Texas and structuring litigation venue to fall under Fifth Circuit jurisdiction is technically permissible but practically difficult, and a circuit split is unlikely to last.
What Bookkeeping and Recordkeeping Have to Do With It
The functional test runs on facts. Facts come from records. A partner who claims passive limited partner status with no contemporaneous documentation of how they spent their year is the partner who loses the audit. Three categories of records carry the most weight when the IRS shows up:
- Time records: a real calendar that shows hours billed, meetings attended, and decisions made — or, for true passive partners, the absence of all three
- Compensation records: clearly separated guaranteed payment ledgers, distributive share allocations, and an audit trail showing the economic basis for each
- Operating role documentation: org charts, signature authorities, board minutes, and partnership agreements that match the underlying reality
This is also where bookkeeping discipline pays off. A partnership that runs its books on paper or in a black-box accounting platform faces a hard time producing the granular records the functional test demands. Partnerships that keep clean, line-item ledgers — separating service compensation from investment returns at the transaction level — produce the kind of evidence that wins cases.
The Renkemeyer Hangover for LLCs and LLPs
Most working partnerships in the U.S. are LLCs taxed as partnerships, not LPs. Renkemeyer settled long ago that LLC members and LLP partners do not get the Section 1402(a)(13) exemption when they perform services for the partnership. That answer has not changed.
What did change is the level of IRS interest in the question. Pre-2023, the IRS rarely audited a service-firm LLC over the SE tax treatment of distributive shares — the recovery per case was modest, and the legal terrain was settled. Post-Soroban, the agency has expanded SE tax exam coverage to mid-size LLCs in professional services: medical groups, law firms, consulting firms, dental practices, architecture firms.
If you are a partner in a service LLC and you have been splitting your annual compensation between a guaranteed payment and a "distributive share" that escapes SE tax, you are sitting on the same factual pattern Renkemeyer lost on, with no functional change in your favor. The exam letter is increasingly likely to find you.
The Cost of Getting It Wrong
The financial exposure for a misclassified partner is straightforward and painful:
- 15.3% SE tax on the reclassified distributive share, up to the Social Security wage base ($176,100 for 2026), and 2.9% Medicare on the unlimited remainder
- 0.9% Additional Medicare Tax on partner earnings over $200,000 single / $250,000 joint
- 20% accuracy-related penalty under Section 6662 if the IRS finds substantial understatement
- Underpayment interest at the federal short-term rate plus 3%, currently around 8%, compounded daily back to the original due date
- Three to six years of exposure depending on whether the IRS argues a substantial omission under Section 6501(e)
For a partner with $5 million per year of reclassified distributive share over three audit years, the combined assessment can exceed $3 million before considering interest and penalties. That is more than enough motivation to get the structure right before the FPAA arrives.
What to Do Before Filing 2026 Returns
Three steps belong on every partnership's mid-year checklist:
- Audit your partnership's SE tax position now. Identify every partner who is excluding distributive share from SE tax under Section 1402(a)(13) and evaluate whether they would survive the functional test under current case law. Document the analysis.
- Update partnership agreements to align labels with reality. If a partner is genuinely passive, the agreement should restrict them from management, set firm hour limits, and clarify economic returns are tied to capital. If a partner is active, stop calling them a limited partner.
- Build the recordkeeping infrastructure that survives audit. Granular time tracking, clearly separated compensation categories, and clean general ledger entries that distinguish service compensation from capital returns are not luxuries — they are the difference between winning and losing.
Keep Your Partnership Finances Audit-Ready From Day One
Defending a Section 1402(a)(13) position depends on records the IRS examiner can trace at the transaction level: guaranteed payments separated from distributive share, service compensation segregated from investment returns, and a clean audit trail that maps to the partnership agreement. Beancount.io gives you plain-text partnership accounting that is fully transparent, version-controlled, and ready for examiner review — no proprietary file format, no black-box reports, no surprises when the FPAA arrives. Get started for free and put your partnership records on a foundation that holds up under scrutiny.