New Self-Employment Tax Risks For U.S. Investors In Global Funds

Forbes

18-06-2025

A new Tax Court ruling is a warning for U.S. limited partners in global funds, imposing new ... More self-employment (SECA) tax risks. U.S. limited partners in foreign funds like Cayman or Luxembourg partnerships must ensure passive roles to avoid costly SECA tax liabilities.
The U.S. Tax Court decided Soroban Capital Partners LP v. Commissioner (T.C. Memo 2025-52) in May 2025 leaving financial, tax and legal advisors concerned. The court upended assumptions about the self-employment tax exemption for limited partners in hedge funds, and by analogy to venture capital, and private equity partnerships both in the U.S. and abroad. U.S. citizens and green card holders who are limited partners in hedge funds or similar businesses, including those in foreign countries, should understand the effects of this decision. The case signals a shift away from a state or local law definition of a 'limited partner' toward a more comprehensive evaluation of the partner's actual role to determine if the 'limited partner' exclusion from Self-Employment Contributions Act taxes should apply.
The Soroban court applied a 'functional analysis test' to determine whether limited partners' distributive share of partnership income is subject to SECA taxes. The decision has far-reaching SECA implications for how limited partners will structure their roles and manage their tax obligations. This article explores the Soroban ruling, what it means for U.S. limited partners, especially for those working with hedge funds or other businesses abroad that use a limited partnership structure.
First, it is helpful to understand generally why funds often use a limited partnership vehicle. A limited partnership for U.S. purposes is comprised of both general and limited partners. General partners manage the fund and have unlimited liability. Limited partners contribute capital, and their liability is limited to their investment.
The limited partnership structure is tax transparent for U.S. tax purposes, meaning it provides pass-through taxation of income, credits and deductions to its partners. The partnership entity itself is not subject to U.S. income tax, and the partners report their distributive shares on their individual U.S. tax returns. The structure also provides significant flexibility in governance. For all these reasons, the limited partnership is often ideal for private funds.
Self-employment income is taxed at a rate of 15.3% (12.4% for Social Security and 2.9% for Medicare). A SECA exclusion exists under Internal Revenue Code Section 1402(a)(13) for a limited partner's distributive share of partnership income.
The Tax Court rejected the notion that state law classifications of limited partners should be determinative for purposes of this exclusion. Instead, it applied a functional analysis test to Soroban's limited partners and concluded that these partners were 'limited in name only.' As such, the limited partners' distributive share did not qualify for the SECA exclusion.
The court carefully examined the activities of the limited partners and found they were heavily involved in generating the partnership's income by overseeing day-to-day management, working full-time for the business, and that marketing material listed them as essential to the success of the partnership. In addition, the capital contributions made by the limited partners were viewed as insignificant when compared to the fees Soroban charged. This comparison suggested that the limited partner's distributive share was not a passive return on investment but rather compensation for active participation.
The label 'limited partner' alone, is not enough to guarantee the SECA exclusion. Instead, the functional analysis test requires a thorough analysis of the facts and a careful examination of the partner's role in the enterprise. The factors include how integral the partner is in generating revenue, the degree of participation in the business, whether the partner is working full-time in the business, whether marketing materials indicate the partner plays a key role and whether the partner's capital investments truly reflect a passive investment.
For U.S. limited partners, particularly those in hedge funds or other investment vehicles, the Soroban holding invites the IRS and courts to closely scrutinize the actual activities of limited partners to determine SECA liability.
While the Soroban case focused on a U.S. hedge fund, its principles can apply to any partnership structure in which U.S. citizens or green card holders are limited partners. The holding can apply to a vast range of industries operating globally where U.S. partners are contributing expertise and management.
Private equity firms, venture capital funds, and other businesses often use a limited partnership structure. A limited partner in an overseas real estate partnership or tech startup fund could face scrutiny if the role involves active management or income generation. Only truly passive investors are meant to benefit from the SECA exclusion and while local law will be important in the analysis, the IRS will be looking beyond any local law label of 'limited partner' to scrutinize eligibility.
Various jurisdictions have limited partnership structures closely resembling the U.S. model. The most popular jurisdictions having limited liability for limited partners as well as generally having flow-through tax treatment include the Cayman Islands, British Virgin Islands, Luxembourg, Hong Kong and Ireland. While these jurisdictions appeal to global funds because of their tax and regulatory regimes which parallel the U.S. in important respects, limited partners should be ready to consider a heightened compliance burden given the holding in Soroban. Adding to the additional possible tax burden, the U.S. limited partner abroad will be unhappy to learn that self-employment income subject to SECA tax is not reduced by the foreign earned income exclusion.
U.S. limited partners should reassess their involvement in the partnership to make sure they qualify as passive investors entitled to the SECA exclusion. This may mean a significant reduction of day-to-day management responsibilities or restructuring their roles to emphasize capital investment over active participation.
For U.S. limited partners in foreign funds, the statute of limitations for SECA tax assessments is generally three years from the due date or actual filing date of the income tax return, whichever is later. However, the statute of limitations for tax matters can be extended several years and even indefinitely, depending on the facts. Crucially, if a U.S. partner fails to file a required foreign information return, such as Form 8938 (Statement of Specified Foreign Financial Assets) or Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships), the statute of limitations does not start for the entire tax return. This gives the IRS the ability to assess SECA tax at any time in the future.
U.S. limited partners should be proactive and planning for a possible IRS challenge to a claimed exclusion from SECA. U.S. limited partners should first consult an experienced tax advisor to assess their involvement in the fund and optimize tax outcomes. Next, meticulously document management roles, time commitments, and public representation to ensure compliance with IRS scrutiny and minimize the risk of tax exposure.
Partnership agreements should be examined. If feasible, partnership agreements may need to be amended to clarify the role of limited partners as passive investors, emphasizing capital contributions over operational involvement. Limited partners who blur the line between passive investment and active management could find a surprising increase in their U.S. tax liability with their distributive shares subject to SECA taxes.
The Soroban case may be appealed, and staying informed on this topic is critical. Investors should be looking out for any future IRS guidance or legislation that might refine the functional analysis test.
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