The recent U.S. Tax Court memorandum opinion in Soroban Capital Partners LP v. Commissioner, T.C. Memo. 2025-52, provides further application of the functional analysis test previously established in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023) and applied in cases like Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114. This case underscores the critical need for tax practitioners to look beyond state law labels when determining whether a partner’s distributive share of income is subject to self-employment tax under Section 1402(a)(13).

Background of the Case

Soroban Capital Partners LP (referred to as "Soroban") was a Delaware limited partnership classified as a partnership for federal income tax purposes during the years in issue (2016 and 2017). Its principal place of business was in New York.

Soroban had one general partner, Soroban Capital Partners GP LLC (referred to as "the general partner"), a Delaware limited liability company also classified as a partnership for federal income tax purposes. The general partner was wholly owned by three individuals: Eric Mandelblatt, Guarav Kapadia, and Scott Friedman (referred to as "the Principals"). These individuals were also, directly or indirectly, Soroban’s limited partners. Taking into account both direct and indirect interests through the general partner, Soroban was wholly owned by the three Principals.

For the years in issue, Soroban’s limited partners (Messrs. Mandelblatt, Kapadia, and Friedman, via their respective LLCs or directly) received significant allocations of ordinary income. When calculating net earnings from self-employment, Soroban included only guaranteed payments made to its limited partners, excluding their remaining shares of partnership income. The guaranteed payments reported as net earnings from self-employment totaled $1,252,384 in 2016 and $1,255,171 in 2017.

The Commissioner issued Notices of Final Partnership Administrative Adjustment (FPAAs) proposing to increase Soroban’s net earnings from self-employment by including the ordinary income allocated to the limited partners. The Commissioner’s position was that these individuals were not limited partners for the purpose of section 1402(a)(13) and that a functional inquiry into their roles and responsibilities was necessary.

Legal Framework: The Functional Analysis Test

Section 1401 imposes a tax on the self-employment income of every individual, defined generally as net earnings from self-employment derived from a trade or business carried on by the individual or a partnership of which they are a member. Section 1402(a) includes an individual’s distributive share of partnership income in net earnings from self-employment. However, Section 1402(a)(13) provides an exception, excluding "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments" from net earnings from self-employment.

The core legal issue in this case, as previously decided by the Tax Court involving the same taxpayer, was whether the limited partner exception in section 1402(a)(13) applies based on state law classification or requires a functional inquiry into the partner’s role. The Tax Court had already held that section 1402(a)(13) requires a functional analysis to determine the extent to which limited partners were acting as such. This functional inquiry is a factual determination about how the partnership generated its income and the partners’ roles and responsibilities in doing so. The court reaffirmed that federal tax law, not state law labels, controls the classification of partners for federal tax purposes.

Drawing on precedent from Renkemeyer and Denham, the court explained that the functional analysis is a comprehensive inquiry into whether the partners were "generally akin" to passive investors. To exclude a partner’s distributive share under section 1402(a)(13), the surrounding circumstances must indicate the partner’s economic relationship with the partnership is one of passive investment. The analysis involves reviewing the sources of the partnership’s income, the partners’ roles in generating that income, and the relationship between the partners’ distributive shares and their capital contributions. Factors considered in applying this test include the extent to which the partners’ time, skills, and judgment were essential to the income, their roles in the business (e.g., employee, committee member, authority to bind, personnel decisions), time devoted, how the partnership advertised itself (specifically highlighting partner skills/expertise), and the nature of the capital contributions.

The court noted that petitioner (the general partner, acting as tax matters partner) bore the burden of proving the Commissioner’s adjustments were erroneous.

Application of Functional Analysis to Soroban’s Principals

The court applied the functional analysis test to the roles and responsibilities of the Principals (Messrs. Mandelblatt, Kapadia, and Friedman).

Role in Generating Income: Soroban’s income was derived entirely from fees for managing investments. The Principals’ time, skills, and judgment were found to be essential to generating this income. Mr. Mandelblatt, as CIO, managed portfolios and had final discretion. Mr. Kapadia, as Comanaging Partner, also managed portfolios. Mr. Friedman, as Head of Trading and Risk Management, executed decisions. All three were responsible for daily risk management, monitoring, hedging, and overseeing trade orders. They led the investment process and managed the investment team. This work directly contributed to Soroban’s substantial income generation.
Role in Management: All three Principals participated in Soroban’s management. They served on multiple committees overseeing operations, including Brokerage, Trade Allocation, Valuation, and Management. Through the Management Committee, the Principals made decisions regarding hiring, firing, promoting, and evaluating employees. While other employees handled daily operations, these employees reported to Messrs. Mandelblatt and Kapadia, and the Principals maintained control over personnel decisions. Mr. Mandelblatt could bind Soroban as Managing Partner of the general partner, and Mr. Kapadia could act on behalf of the general partner. The court concluded the Principals were crucial and active parts of Soroban’s business.
Time Devoted: All three Principals treated Soroban as their full-time jobs, estimating 2,300 to 2,500 hours annually. They were required to devote their full attention to the business and were generally prohibited from other investment-related opportunities. Soroban represented to investors that the Principals devoted 100% of their time to Soroban’s management and investment activities. The court found they devoted their full-time efforts to actively pursuing the business.
Marketing the Principals’ Role: Soroban explicitly advertised the unique skills, talents, and experience of the Principals to potential investors. The Principals were highlighted in organizational charts and marketing materials with their professional biographies and career timelines. Mr. Mandelblatt’s participation was advertised as critical to the funds’ success, and his absence would constitute a "Key-Man Event" giving investors withdrawal rights. Furthermore, if none of the Principals were available, the funds would liquidate. The court found the Principals were publicly held out as essential to Soroban’s operation.
Capital Contributions: The court found the Principals’ capital contributions were insignificant compared to their distributive shares of income, indicating the income was not a return on investment. Messrs. Kapadia and Friedman made no cash capital contributions. Mr. Mandelblatt contributed approximately $4.35 million between 2010 and 2013. The court compared this to the approximately $247 million in revenue Soroban generated in the years at issue and Mr. Mandelblatt’s $80 million cumulative distributive share over those two years. Citing Renkemeyer and Denham, the court concluded this disproportion was not indicative of a return on an investment of capital.

Petitioner’s Proposed Factors and Motion to Reopen the Record

Petitioner proposed its own nine-factor test for the functional analysis. The court considered these factors but noted that many relied on state law labels, which are less relevant than the economic reality of the partner’s relationship with the entity. The court rejected the argument that the Principals were merely acting under authority delegated by the general partner, viewing this as a legal fiction that ignores the reality of their essential roles, unique skills, and participation.

Petitioner also filed a motion to reopen the record to introduce Forms 1065 for years before and after the years in issue (2010-2015 and 2018-2023). Petitioner argued these returns, particularly showing substantial capital contributions in later years (2019-2021), were material to demonstrating that distributions were returns on investment. The Commissioner objected, citing prejudice from lack of opportunity for cross-examination.

The court has discretion to reopen the record, balancing diligence against potential prejudice and considering whether the evidence is material and would likely change the outcome. The court determined that while the evidence might not prejudice the Commissioner (because it likely wouldn’t change the outcome), that fact favored exclusion. Reviewing a table derived from the proffered returns, the court found the data did not address the Principals’ functional roles. More importantly, the data itself showed the Principals’ income shares bore no relationship to their capital contributed or their capital accounts, further reinforcing the court’s conclusion that the earnings were not of an investment nature. The court also noted that information from years after the years in issue was of limited probative value and that later years introduced new ownership changes not explained in the record.

Despite these findings, for the sake of completeness, the court exercised its discretion to supplement the record with Soroban’s Forms 1065 for the years 2010 through 2015 only.

Conclusion

Applying the functional analysis, the Tax Court concluded that Soroban’s limited partners—Messrs. Mandelblatt, Kapadia, and Friedman— were limited partners in name only. Their roles were inconsistent with that of passive investors. They were deemed essential to generating the business’s income, oversaw day-to-day management, worked full time, and were publicly held out as essential to the business. Their capital accounts demonstrated that their earnings were not primarily a return on investment.

Therefore, the court held that the Principals were not limited partners within the meaning of section 1402(a)(13) for the years in issue, and their distributive shares of ordinary income constitute net earnings from self-employment. Decisions were entered for the Commissioner .

Key Takeaway for CPAs:

This case reinforces the court’s stance that state law limited partner status is not determinative for purposes of the section 1402(a)(13) SECA tax exception. Tax practitioners must perform a thorough functional analysis, examining the partner’s actual involvement in the business’s income generation and management, the time devoted, how they are marketed, and whether their income is truly a return on capital investment or compensation for services, regardless of their title or state law classification. The bar for excluding active partners’ distributive shares under this exception continues to be high.

Prepared with assistance from NotebookLM.