Tax Court denies limited-partner exception to self-employment tax

The Tax Court, consistent with past cases, applied a functional analysis of a limited partnership’s individual partners’ roles and responsibilities to find they could not apply Sec. 1402(a)(13)’s exclusion of their distributive shares of ordinary business income from net earnings from self-employment, making that income subject to self-employment tax.

Facts: Denham Capital Management LP (Denham), a Delaware-based investment management firm formed as a limited partnership, provides investment advisory services to private-equity funds operating in the energy sector. Denham Capital Management GP LLC, the partnership’s general partner, was a limited partner of Denham, along with five individuals: Stuart Porter, Scott Mackin, Carl Tricoli, Riaz Siddiqi, and Jordan Marye. These individual partners were subject to the same general policies and procedures as Denham’s employees and operated similarly. None of the individual partners, except for Porter, contributed capital to obtain partnership interests and partner status. Although capital investment was lacking for most of the individual partners, they all:

• Devoted nearly all of their business time to running and operating Denham;
• Served on Denham’s investment, valuation, and management committees, frequently making investment decisions on behalf of the company;
• Had the power and authority to negotiate and sign agreements on behalf of Denham;
• Played a key role in attracting external investors by emphasizing their expertise on various marketing materials released by the company; and
• Had the ability to hire, fire, and make compensation decisions within Denham.

Additionally, Denham carried a “key person” life insurance policy on Porter, further highlighting his importance and active role within the firm.

In 2016 and 2017, Denham made guaranteed payments to the individual partners. Denham sought to classify the individual partners as limited partners under Sec. 1402(a)(13) to exclude their distributive shares of Denham’s ordinary business income from net earnings from self-employment and avoid self-employment taxes on that income. The IRS determined that the individual partners were not limited partners and that Denham’s ordinary business income was includible in net earnings from self-employment. Consequently, the Service issued Denham a final partnership administrative adjustment (FPAA) increasing its net earnings from self-employment by more than $27 million for 2016 and nearly $23 million for 2017. Denham filed a petition in Tax Court challenging the IRS’s determination in the FPAA.

Issues: Sec. 1402(a)(13) provides an exclusion from net earnings from self-employment with respect to a “limited partner, as such” (the limited-partner exception). In Soroban Capital Partners LP, 161 T.C. 310 (2023), the Tax Court held that it has jurisdiction to determine a state-law limited partner’s status for the purpose of determining the applicability of the limited-partner exception in partnership-level proceedings under the Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248, and that such determinations require a functional-analysis inquiry to ascertain the roles and responsibilities of partners to determine their status for tax purposes. Denham challenged both of Soroban’s holdings.

The Tax Court noted that it adhered to the doctrine of stare decisis, under which it will revisit its prior decisions only when presented with a special justification to do so. Finding no special justification to revisit Soroban’s reasoning, the court held that determination of the applicability of the limited-partner exception is a partnership item over which it had jurisdiction. Further, the court held that determinations under Sec. 1402(a)(13) require a functional-analysis inquiry to ascertain the individual partners’ roles and responsibilities for tax purposes.

The Tax Court found that in this inquiry, it was required to analyze the individual partners’ roles and responsibilities to ascertain whether their relationships with Denham were more akin to those of passive investors or employees. Following its reasoning in Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011), the court reviewed the sources of Denham’s income for the years in issue, the individual partners’ role in generating it, and the relationship between the individual partner’s distributive shares and any capital contributions they made to the partnership.

As the Tax Court observed, Denham’s income for 2016 and 2017 consisted solely of fees it received in exchange for services provided to investors and that the partners’ time, skills, and judgment were essential to providing these services. Denham argued that the fees earned by Denham in 2016 and 2017, which were largely distributed as profits to the partners, were returns on their investments in Denham.

Citing Renkemeyer, the Tax Court found that when the size of a partner’s investment is relatively small in comparison to the income the partnership earned for the services the partner provided, the small investment is not sufficient to classify the partner’s distributive share as a return on investment. The court concluded — considering that the partners, except Porter, paid nothing for their partnership interests — that such large portions of the individual partners’ distributive shares in 2016 and 2017 were not returns on investments.

After analyzing the partners’ roles and responsibilities, the Tax Court found that they were actively involved in Denham’s operations and were not passive investors. The court stated that the partners were “active and fundamental contributors to Denham’s operation” and that “[i]ndividuals that serve roles as integral to their partnerships as those the Partners served for Denham cannot be said to be merely passive investors.”

Holding: The court held that Denham’s individual partners were not “limited partners, as such” under Sec. 1402(a) Therefore, their distributive shares of Denham’s ordinary business income could not be excluded from net earnings from self-employment by way of the limited-partner exception.

Denham has appealed the Tax Court’s decision to the First Circuit (Denham Capital Management LP, No. 25-1349 (1st Cir. 4/11/25) (appeal docketed)).

• Denham Capital Management, LP, T.C. Memo. 2024-114

Matthew Tardif is a student in the Charles H. Dyson School of Applied Economics and Management at Cornell University. Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.