In a common partnership, you will find a) general partners – running the business and responsible for the debts and b) limited partners – similar to investors where the money at risk is the amount contributed and not being involved in the day to day.

The general partners will be subject to the self-employment tax which is 15.3%, consisting on two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance) up to the ceiling of $176,100 for 2025, and then, 2.9% (the 2.9% Medicare is for all your net earnings).

In order to save on self-employment taxes, you need to make sure that the roles and functions of the limited partners do not include active management and/or control of the business. There has been certain tax court cases where the limited partners have “extra limited” their functions and then, being subject those taxes. Note that the Tax Adviser article, lists up to eight items, individually or in aggregate, that does not generate control of the business:

  1. “… being a contractor for or an agent or employee of the limited partnership or of a general partner or being an officer, director, or shareholder of a general partner that is a corporation;
  2. consulting with and advising a general partner with respect to the business of the limited partnership;
  3. acting as surety for the limited partnership or guaranteeing or assuming one or more specific obligations of the limited partnership;
  4. taking any action required or permitted by law to bring or pursue a derivative action in the right of the limited partnership;
  5. requesting or attending a meeting of partners;
  6. proposing, approving, or disapproving, by voting or otherwise, one or more of the following matters: (i) the dissolution and winding up of the limited partnership; (ii) the sale, exchange, lease, mortgage, pledge, or other transfer of all or substantially all of the assets of the limited partnership other than in the ordinary course of its business; (iii) the incurrence of indebtedness by the limited partnership other than in the ordinary course of its business; (iv) a change in the nature of the business; (v) the admission or removal of a general partner; (vi) the admission or removal of a limited partner; (vii) a transaction involving an actual or potential conflict of interest between a general partner and the limited partnership or the limited partners; (viii) an amendment to the partnership agreement or certificate of limited partnership; or (ix) matters related to the business of the limited partnership not otherwise enumerated in this subsection (b), which the partnership agreement states in writing may be subject to the approval or disapproval of limited partners;
  7. winding up the limited partnership pursuant to Section 803; or
  8. exercising any right or power permitted to limited partners under this act and not specifically enumerated in this subsection (b).”

There are multiple court opinions from nearly every state examining the issue of whether a limited partner should lose the cloak of limited liability due to activities they undertook on behalf of the limited partnership.

Note that in some cases, the Court has deemed a different between “activity” and control” such us in Grainger v. Antoyan.  As described in the Tax Adviser article about this case, “… the plaintiff claimed that the limited partner’s position as a sales manager of an auto dealer partnership rendered him personally liable. The court ruled for the limited partner, however, because despite the facts that he had the authority to sell cars, had other salesmen working under him, and on several occasions cosigned checks, he had little say in the actual ongoing operations of the business. He did not have any authority as to (1) hiring or discharging personnel, (2) purchasing new cars, (3) determining the selling price of cars and the trade-in allowances for customers buying new cars, or (4) evaluating the creditworthiness of prospective customers.”

In the recent case of Soroban Capital Partners LP v. Commissioner, the state law limited partner definition was disqualified for Federal tax purposes (note that the Federal tax code does not have a definition of limited partner). The functional analysis performed by the IRS determined that the limited partners were not passive investors (receiving $2m per year per their services) but active participant in the business.

To summarize, the limited partner will lose the favorable tax treatment if

  1. had personal liability for partnership debts,
  2. had authority to contract on behalf of the partnership, or
  3. participated in the partnership’s trade or business for more than 500 hours during the partnership’s tax year.

Due to the significant tax impact, we recommend reviewing the partnership operating agreement to ensure the role of limited partners do not generate any conflict with the regulations. Additionally, we recommend reviewing the day to day operations and de facto control by the limited partners to avoid any discrepancy with the governing documents that might generate additional taxes. We believe this is an area of special focus for the IRS and their targeted approach to partnerships and other entities.

Link The Tax Adviser – Limited partners and self-employment tax: A new test

Link IRS – Self-employment tax (Social Security and Medicare taxes)