The tax code classifies partnerships as “flow through entities”. This means that all income is taxable to the partners regardless of whether cash is distributed or not, who report the income on their individual returns The income is not taxed at the entity or partnership level. Each partner will receive a “Schedule K-1,” which details their proportional share of the entity’s income and deductions which they must report on their personal tax returns.
While this is generally a straightforward process, the distributed income of certain partnerships may be subject to self-employment tax (essentially 15.3% additional tax on certain types of income).
General Partners Versus Limited Partners
What is the difference between a General Partner and a Limited Partner? In general, General Partners participate in the daily operations of the partnership and have unlimited personal liability for all debts, obligations, and lawsuits of the partnership. On the other hand, Limited Partners are more like passive investors and have liability limited only to the amount of their investment—hence the term “limited.” A Limited Partner’s involvement in day-to-day operations is generally minimal. However, over time, the responsibilities and duties of General Partners and Limited Partners may vary from business to business, with Limited Partners not simply being passive investors, but taking a more active involvement in the partnership operations.
What is the Limited Partner Exception?
IRS Code Section 1402(a)(13) implies that a limited partner’s distributive share of partnership income is generally not subject to self-employment tax, regardless of their involvement. The IRS has continued to challenge this interpretation, resulting in many court cases arguing the true meaning of this law.
Recent Court Cases
In Soroban Capital Partners LP v. Commissioner (2023), the US Tax Court ruled that the determination of self-employment status for tax purposes would not rest solely on state law designation of limited partnership interest, but instead required a functional analysis of how the partners were engaged with the partnership. For example, having management authority or control of a partnership or providing core services that are key to generating the income may result in the imposition of income taxes regardless of the partner’s legal “limited partner” status.
In Sirius Solutions, LLLP v. Commissioner (5th Circuit 2026), the Fifth Circuit court ruled that a partner’s limited liability was enough to allow exclusion of income from self-employment tax.
Contact Us with Questions about Self-Employment Tax
The question of whether your partnership income may be subject to self-employment tax is a complicated one. This area continues to spur contentious debate between the IRS and partnership businesses. Flow-through entity income and partner responsibilities are commonly reviewed by the IRS. We are happy to have a discussion with you regarding your partnership and partners’ particular facts and circumstances to assist in determining the best position to take. In addition, we are monitoring developments for pending cases in both the First and Second Circuits. We will keep you up to date with any further developments related to the taxation of self-employment taxes for Limited Partners.
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