Podcast Summary: How Tax Works

Episode: Self-employment Tax on Partners, Net Investment Income Tax, and Soroban Capital Partners LP v. Comm’r (Part I)
Host: Matthew Forman, Co-Chair of Falcon Rappaport & Berkman’s Taxation Practice Group
Date: October 28, 2024

Overview of Main Theme

This episode unpacks the nuanced and much-debated topic of self-employment taxes as they relate to partnership structures, focusing on the implications of the Soroban Capital Partners LP v. Commissioner case. Host Matt Forman guides listeners through the statutory language, fund structure, and practical tax controversy at the heart of the case, breaking down how a handful of ambiguous words shape significant tax outcomes. The episode also touches on related case law and sets up for further deep dives in the upcoming follow-up episode.

Key Discussion Points & Insights

1. Introduction: The Challenge of Tax Law Language

• Matt kicks off by highlighting the seemingly dry topic of self-employment tax but emphasizes its intrigue as revealed by a pivotal Tax Court case revolving around “four words and a comma.”
• He stresses the importance of precise legislative drafting and how minor ambiguities can have significant consequences in tax law.
• [00:55] “...the whole fight here is over four words and a comma, limited partner as such. What does that mean?” — Matt Forman

2. Podcast Structure & Preview

• The episode is part one of a detailed analysis (to be concluded in the next episode).
• Main topics outlined:
  • Definition and details of self-employment tax
  • The Soroban Capital case and its structure
  • Examination of related cases (Reinkmeyer, Harding, Castigliola)
  • Intro to Net Investment Income Tax and how it interacts with self-employment tax
  • Host’s personal thoughts and predictions

3. Self-Employment Tax Basics

• What is it?
  • Came from the Self Employment Contributions Act (SECA/SECA).
  • Requires owners of pass-through entities (partnerships, sole props) to pay a 15.3% tax on net self-employment income.
  • Employees pay half via withholding; self-employed individuals pay both halves but can deduct a portion.
  • Two core components:
    • Old Age, Survivors, and Disability Insurance (OASDI): 12.4% (capped)
    • Hospital Insurance (HI): 2.9% (no cap)
• [05:35] “It is gross income from a trade or business plus a distributive share. Distributive share, of course, is defined under section 702A8...and that's what is subject to this quote, unquote ‘self employment taxes’ under section 1402A13.” — Matt Forman

4. The Critical Statutory Language (“Limited partner as such”)

• Section 1402(a)(13):
  • Excludes distributive share income from self-employment tax for a “limited partner as such,” except for guaranteed payments for services rendered.
• The crux of Soroban:
  • How to interpret “limited partner as such”?
  • Does active participation nullify this exception?
  • Legislative history shows intent to carve out mere investment returns, not active labor income.

5. Structure of Soroban Capital Partners

• Typical Private Fund Structure:
  • Three key individuals (via single-member LLCs) own 99% of the LP and 100% of the GP, which owns 1% of the LP.
  • Income comes largely from management fees paid by sub-funds for investment management services.
  • The three individuals receive both:
    • Guaranteed payments: $400k+ each/year (fully subject to self-employment tax)
    • Distributive shares: $77.6M (2016), $68.3M (2017) in allocations (ultra-high, the IRS contends are also subject to self-employment tax)
• [09:11] “The way that income is earned...fees for services. That is the crux of it…there are three individuals who own both 99% in the LP and they own 100% of the GP which owns 1% of the LP.” — Matt Forman
• Capital contributions differ: One contributed millions in cash, the other two arguably contributed only “know-how” — with no formal documentation.

6. Roles & Activities of Key Partners

• Described as “principals,” with C-suite level responsibility:
  • Investment management, trade execution, daily operational authority, hiring/firing.
  • Stated workload: 45–50 hours/week, full-time effort.
• Employees are also highly compensated, with over $26M–$49M total payroll for 25–27 staff.
• [15:11] “Day to day managerial responsibilities...are consistent with C suite executives...they managed the funds, they provided investment advice…extensive analytical work...made trade orders.” — Matt Forman
• Notably, in investor/legal documents, these people are labeled as “principals,” not always as “partners.”

7. Prior Case Law: Reinkmeyer, Castigliola, Hardy

• Reinkmeyer (2011): Lawyers as “limited partners” held to be “limited in name only” due to their active involvement; subject to self-employment tax.
• Castigliola (2017): Similar to Reinkmeyer; same outcome.
• Hardy (2017): Contrasts with the above—Dr. Hardy was a limited partner with no managerial control, only performed services; not subject to self-employment tax.
• [21:31] “He had no managerial control whatsoever. And that, that right there is the important, the most important, perhaps the important fact.” — Matt Forman

8. Soroban’s Arguments (as presented in their brief)

• Distinction: The LP agreement strictly separates roles; all work as LPs falls within Delaware LP statutes.
• Even those who did not contribute cash held substantial capital accounts.
• Guaranteed payments (taxed as self-employment) are separately set in advance and are analogous to salaries.
• Argue there is no statutory support for the Tax Court’s “functional test” (looking at actual duties), but suggest if one must exist, a nine-factor test (favorable to Soroban) should be used.
• Maintains that most income is a return on investment, not compensation for services.
• Suggests that management fees—based on assets under management, not performance—are passive in nature.
• Employees do a large share of the work contributing to income; not just the three principal partners.
• [23:34] “Guaranteed payments were determined prior to the years at issue. Such as salary, you know, similar to salary. So I think that’s really an important point…” — Matt Forman
• Host notes this is reminiscent of the “reasonable compensation” debate in S Corps: is the practical issue under-compensated salary and over-allocated partnership profits?

9. Unanswered Questions & Discussion Points

• What level of involvement in management triggers self-employment tax?
• Could “reasonable compensation” doctrines migrate into limited partner analysis?
• The functional test’s existence and legitimacy—should courts create such tests at all?
• Impact of distribution ratios (huge profits vs. relatively small guaranteed payments).

Notable Quotes & Memorable Moments

• [02:21] “The overview is basically four parts. Okay, one self-employment tax, two Soroban Capital Partners versus Commissioner.” – Matt Forman
• [05:36] “It is gross income from a trade or business plus a distributive share...and that’s what is subject to this quote, unquote, self employment taxes under section 1402A13.” – Matt Forman
• [09:03] “This is not like a fund with 400 people. This is a fund where everyone knows everyone's name. They’re really involved.” – Matt Forman
• [19:38] “Partners who actively participate in a state law limited partnership are not necessarily limited partners as such. Those partners are subject to self employment tax if they are a limited partner in name only.” — Matt Forman
• [22:08] “The LP agreement provides separate roles for the general partner and the limited partners…even though two of the three partners did not in fact actually contribute money, they had significant capital accounts.” – Matt Forman
• [27:01] “A lot of this underlying problem is the fact that they got $1.2 million of guaranteed payments ... and allocations of $140 million. Their ratio is bonkers different.” – Matt Forman

Timestamps for Important Segments

• 00:55 – Explanation of why “limited partner as such” is the key statutory phrase.
• 03:35–05:36 – Breakdown of the self-employment tax and how it applies to partnership earnings.
• 09:03–13:14 – Detailed walk-through of Soroban’s fund structure and partner contributions.
• 15:11–18:55 – The role, work, and compensation of the three key principals versus other employees.
• 19:38–21:31 – Recap of relevant case law: Reinkmeyer, Castigliola, and Hardy.
• 22:08–27:01 – Soroban’s core arguments and the host’s reflections on the practicalities and loopholes revealed by applying the law to real-life fund structures.

Tone and Style

Matt Forman blends expertise with a conversational, humorous approach. He frequently references the boredom often associated with tax law while highlighting its surprisingly high stakes. He’s self-deprecating about podcasting and embraces a “breaking it down for you” attitude, using real-world analogies and encouraging listeners to stay engaged, learn, and think critically.

Next Episode Preview

Part II will analyze the IRS’s arguments, recap the legal brief, and weigh in on who may be “right”—emphasizing that both sides have merit. Net investment income tax and its interaction with self-employment tax will be explored, along with the host's closing musings and predictions on the future trajectory of this area of tax law.

For questions or feedback on the episode, Matt encourages listeners to contact him at his FRB email.