Another U.S. IRS Victory in the Self-Employment Tax Arena: Denham Capital Management

Here is a quick primer on the self-employment tax, the Limited Partner Exception, some of the recent case law on this issue, and a summary of key factors the Tax Court examined in the Denham case. This may be particularly relevant for fund managers that are structured as limited partnerships in considering whether their limited partners are liable for self-employment tax on their earnings.

Self-Employment Tax and the Limited Partner Exception:

• Under the Self Employment Contributions Act (“SECA”), self-employed individuals (which can include partners in a partnership) must pay self-employment taxes on their net earnings as part of annual contributions to fund Social Security and Medicare. Congress enacted SECA in part with the understanding that social security would provide financial security to individuals by replacing some of their lost earnings from work.¹ Consistent with that policy, passive income is generally excluded from the SECA tax base. The Limited Partner Exception was codified in Internal Revenue Code Section 1402(a)(13), which provides that an individual’s distributive share of items of income or loss as a limited partner is excluded in determining earnings subject to self-employment tax.
• The Limited Partner Exception was enacted in 1977, and there has been significant movement since then, both in state laws becoming more flexible and permitting limited partners to participate in management and operations of the partnership while retaining their limited liability, and in the creation of new legal entities such as limited liability companies and limited liability partnerships. The absence of clear guidance on the scope of the Limited Partner Exception seemingly created an almost optional approach to paying self-employment taxes on partnership income allocations, but the IRS seems to finally be catching up.

Prior Tax Court Cases:

• The Tax Court first weighed in on the Limited Partner Exception in 2011 in the Renkemeyer² case. Renkemeyer was a law firm organized as a limited liability partnership, and the lawyers holding limited partnership interests claimed the Limited Partner Exception. The court disagreed on several grounds, including because it found that the lawyers were more appropriately characterized as general partners, but critically the court went on to state that partners who perform services for a partnership in their capacity as partners are not eligible for the Limited Partner Exception.
• A fairly aggressive audit campaign by the IRS beginning in 2018 led to a number of investigations into fund managers, and many of those advanced to litigation. The first to reach a decision was Soroban in November 2023. There, the Tax Court found that a limited partner of a state law limited partnership who is limited in name only is not automatically entitled to the Limited Partner Exception, and that a functional analysis must be applied to determine whether a limited partner functions as such.

The Denham Decision:

• In Denham, the Tax Court reiterated its position that a functional analysis must be applied to determine whether a partner’s role and responsibilities are “more akin to those of passive investors or employees.”³ The partners at issue in the case had claimed the Limited Partner Exception with respect to their income allocations from Denham Capital Management, LP (the “Manager”), which functioned as investment manager with respect to numerous private investment funds.
• The Tax Court specifically considered (i) the source of the Manager’s income, (ii) the partners’ role in generating such income, and (iii) the relationship between the partners’ distributive shares and any capital contributions they made to the Manager. The following facts were among those highlighted by the court in concluding that the partners were not limited partners for purposes of the Limited Partner Exception. 
  
  
  • The Manager’s income consisted solely of fees it received in exchange for services provided to investors such as advising and operating the Denham funds, and the partners devoted substantially all of their business time and attention to the affairs of the Manager and its affiliates, treating their work for the Manager as their full-time employment.
  • The partners’ expertise and judgment were essential to the provision of their services, as made evident by the fact that investors could withdraw their investments if certain partners no longer participated in the Manager.  
  • The partners exercised significant control over personnel decisions, which the court saw as further evidence that the Partners were active and fundamental contributors to the Manager’s operation.
  • Each partner received a guaranteed payment from the Manager, and a distribution (and corresponding income allocation) that was multiple times larger than the guaranteed payment. A sizeable number of the Manager’s other employees received compensation packages exceeding the guaranteed payments to the partners, which the court viewed as an indication that the guaranteed payments were not designed to adequately compensate the partners for the value of their services.   
  • The Court also examined the capital contributions made by the partners (only one made a capital contribution; the others all received their interests in the Manager as profits interests). The court stated, “[w]hen the size of a partner’s investment is relatively small in comparison to the income the partnership earned for the services the partners provided, the small investment is not sufficient to classify the partner’s distributive share as a return on investment.”⁴ While one partner had made significant capital contributions, he was one of the founders, and he had a central role in the Manager and the funds’ ability to attract key investors. Additionally, the Manager carried a “key person” life insurance policy on him. In light of these factors, and because the size of his aggregate capital contributions as compared to the magnitude of fees generated and allocated to him was not characteristic of a return on investment, the court concluded that he could not be considered a passive investor. 

• In summary, the active role of the partners, the integral nature of their participation and involvement in the Manager, and the scope of their compensation, all supported the court’s decision that the partners were acting as self-employed persons rather than passive investors, despite their formal classification as limited partners for state law purposes.

Next Steps

• The Denham decision is by no means the last chapter in the story of the Limited Partner Exception. The Soroban decision is still being litigated, Denham may end up being appealed, and there is already another case (Sirius Solutions LLLP v. Commissioner) working through an appeal in the Fifth Circuit, having stipulated with the Tax Court post-Soroban so it could move directly to an appeals court. Some arguments being raised against the conclusion in Soroban (and now Denham) include that the plain language of the Limited Partner Exception should prevail, and that the Tax Court did not properly construe the meaning of “limited partner” under state law, which has never imposed a passive investor standard.  
• In the meantime, fund managers should carefully consider the legal structure of their manager entities and understand the potential risks of characterizing their partners’ allocated income as other than self-employment income, especially if the factors mentioned above in the Denham case are applicable. 
• Hogan Lovells will continue to monitor developments in this area.

Authored by Jessica Millett and John Jee.