Evaluating SECA Exposure for Limited Partners

Key Takeaways:

Recent Tax Court rulings apply a functional analysis to decide if limited partners qualify for the SECA exemption.

Partners who actively participate in management or operations may be ineligible for exemption even in state law limited partnerships.

Partnerships should reassess roles, responsibilities, and hours worked to evaluate SECA exposure for filings.

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Partnerships — especially those operating management entities in investment and private equity structures — face renewed scrutiny of how limited partners are classified for purposes of self‑employment tax. The IRS has continued to challenge claims of exemption from the Self‑Employment Contributions Act (SECA), and recent Tax Court decisions reinforce that state law labeling does not control federal tax treatment.

In December 2024, the Tax Court issued another significant decision in Denham Capital Management LP v. Commissioner, reaffirming the approach first articulated in Soroban Capital Partners LP v. Commissioner. Together, these decisions narrow the application of the limited partner exemption under Section 1402(a)(13) and provide a blueprint for how courts will analyze partner activity going forward.

For partnerships preparing filings, these rulings raise important questions about how partner roles are documented and whether current SECA positions stay defensible.

The Shift From Labels to Functional Analysis

Under Section 1402(a)(13), limited partners are generally exempt from SECA tax on their distributive shares of partnership income — other than guaranteed payments for services. Historically, many state law limited partnerships relied on entity form alone to assert the exemption.

However, Soroban and Denham make clear that federal law governs the classification of partners for SECA purposes, and that state law titles are not conclusive.

The Tax Court has adopted a functional analysis, which evaluates:

How the partnership earns its income

Whether partner activities contribute materially to that income

The extent of partner involvement in operations, decision‑making, and management

In Denham, this analysis determined the outcome.

What Happened in Denham Capital

Denham Capital operated as a Delaware limited partnership providing investment advisory and management services to private equity funds. Although partners held limited partner interests under state law, the court focused on the substance of their activities.

The court found:

The partnership’s income came solely from advisory and management services, not investment activity.

Partners devoted nearly all their working time to the business and played central operational roles.

Many partners had decision‑making authority over investments, valuations, personnel, and fund activity.

Marketing materials highlighted partner involvement as a key value driver for investors.

Guaranteed payments did not reflect the value of partner services, indicating distributive shares reflected compensation rather than a return on capital.

Only one partner had contributed capital to obtain an interest. The rest functioned as service providers essential to the partnership’s operations.

Ultimately, the court held these individuals were not limited partners “as such” under Section 1402(a)(13), and their distributive shares were subject to SECA tax.

Why This Matters for Partnerships

The IRS has treated Denham as a significant win. The decision underscores that:

Service‑based partnerships face the highest SECA risk

State law entity form does not control SECA eligibility

Daily activities, authority, and judgment exercised matter more than titles

Profit allocations reflecting service value may undermine exemption claims

For private equity, hedge fund, venture capital, real estate, and professional service partnerships, the functional analysis signals where IRS challenges may continue.

What Partnerships Should Evaluate Now

Partnerships should revisit self‑employment tax positions for partners claiming exemption under Section 1402(a)(13). Key areas to review include:

1. Partner Responsibilities and Hours

Under the 1997 proposed regulations (still influential despite not being finalized), a partner is not considered a limited partner if they:

Have personal liability

Have authority to contract on behalf of the partnership

Work more than 500 hours in the business

While not binding, courts continue to view this framework as instructive.

2. Where Income Comes From

Service‑based income — such as management fees, carried interest allocations tied to services, or advisory revenue — heightens the risk, especially if partners materially contribute to generating that income.

3. Governance and Committee Roles

Participation in:

Investment committees

Valuation committees

Hiring and personnel decisions

Fund oversight can show an active, non‑limited partner role

4. Compensation Structure

Large distributive shares relative to guaranteed payments may imply that profits represent compensation for services rather than passive returns.

5. Documentation

Partnership agreements, side letters, job descriptions, and fund offering documents may all be reviewed by the IRS. They should accurately reflect partner roles and expectations.

Graphic showing key areas partnerships should review for self-employment tax positions for partners claiming exemption under Section 1402(a)(13)

Preparing SECA Positions

Given the direction of Tax Court analysis, partnerships should consider:

Reviewing partner roles against the functional analysis framework

Reassessing SECA positions for partners performing operational or managerial functions

Evaluating compensation structures align with economic activity

Updating agreements or internal documentation where roles have evolved

Modeling potential tax impacts if SECA applies

Clear and consistent documentation will be increasingly important as audits continue.