How Tax Works – Episode 12 Summary

Podcast: How Tax Works
Host: Matthew Foreman (Co-Chair, Taxation Practice Group, Falcon Rappaport & Berkman LLP)
Episode Title: Self-employment Tax on Partners, Net Investment Income Tax, and Soroban Capital Partners LP v. Comm’r (Part II)
Date: November 12, 2024

Main Theme and Purpose

This episode is the second and concluding part of Matthew Foreman’s deep dive into the Soroban Capital Partners LP v. Commissioner tax court case. The episode explores the complexities of self-employment tax as it pertains to partners in partnerships, analyzes the arguments from both Soroban and the IRS, and briefly addresses the net investment income tax (NIIT) interplay. The goal is to illuminate how courts and the IRS interpret “limited partner” status and its impact on tax obligations, with a focus on substance-over-form and practical planning considerations for tax professionals.

Key Discussion Points and Insights

Episode Intro and Context [00:00–01:30]

• Matt Foreman welcomes listeners and emphasizes this is a continuation of the previous episode's case analysis.
• Stresses the potential confusion if the prior episode is skipped, humorously likening it to starting an Edgar Allan Poe story on page three.

Soroban Capital Partners Case Overview [01:45–03:45]

• Case Structure Recap:
  • General partner (an LLC taxed as a partnership) owns 1% of Soroban, a limited partnership.
  • Three individuals own the GP, receive management fees & guaranteed payments (~$1.2M/yr), and additional significant allocations of income (approx. $140M in total).
  • Core question: Is this income subject to self-employment tax?
• Statutory Background:
  • Section 1402(a)(13) excludes “limited partners as such” from self-employment tax except for guaranteed payments for services.
  • Active participation may forfeit “limited partner” exemption.

Interpretative Tension: Function vs. Formalism [03:45–09:36]

• IRS Argument:
  • Soroban is a registered investment advisor; all its income is for providing investment-related services.
  • Income is “service income” as declared on tax returns.
  • IRS position likened to “Christian Okoye running straight through you”—direct and forceful ([05:02]).
• Soroban’s Argument:
  • Claims income is derived from employee activity, but lacks clarity on specific employee functions.
  • Relies on state law formalism and precedent, but IRS insists on a “function-based” test—substance of what partners actually do.
• Notable Quote:
  • “The IRS’s brief is Christian Okoye… his running style was to attempt to run over you… This is the Mack truck Christian Okoye running straight through you.” – Matt Foreman ([05:02])
• Case law references (Renkemeyer, Castigliola, Hardy) distinguish between limited partners in name only vs. real, passive investors.

LLCs and Limited Partner Status [08:35–09:00]

• Open question whether LLC members can be “limited partners as such” for self-employment tax purposes.
• IRS focus: Ignore state law labels; look at the real functions and activities.

Managerial Control and Substance Over Form [09:00–13:37]

• Emphasizes the importance of managerial control—those deeply involved (like Soroban’s principals) likely forfeit the limited partner exemption.
• Soroban’s internal documents highlight principal involvement, undermining their argument.
• Guaranteed payments vs. distributions: discrepancy in amounts suggests that “guaranteed payment” designation may be superficial.
• Notable Moment:
  • “You can say what things are, but your documents are saying otherwise. The facts are kind of saying otherwise. And it’s tough.” – Matt Foreman ([13:38])

Who Is Right? Matt Foreman’s Analysis [13:31–16:06]

• Both IRS and Soroban arguments are “literal”; IRS is too formalistic, Soroban a bit too clever and reliant on form over substance.
• Cites a humorous South Park reference: “I would hope that those students and their parents who question my qualities will simply look at my opponent… their argument is stinky. It is a turd sandwich.” ([14:31])
• IRS has the stronger argument, but acknowledges the issue is nuanced and unresolved.
• Raises potential audit and litigation-planning implications, especially as IRS increases scrutiny of partnership compensation.

Practical Considerations and Evidence [16:05–19:08]

• Critiques Soroban’s approach for lack of detailed value/time allocation between employees and principals.
• Guaranteed payments set too low to reflect market reality for principal talent; this undermines their limited partner stance.
• Notes IRS is pushing to establish new precedent; expects extended litigation through appellate courts.

Net Investment Income Tax (NIIT) Overview [19:08–22:59]

• Definition & Thresholds:
  • 3.8% tax on net investment income per §1411, applies to individuals/estates/trusts above income thresholds.
  • Income thresholds: $200,000 (single), $250,000 (married filing jointly), $125,000 (married separate); not indexed for inflation.
• Types of Income Subject:
  • Interest, dividends, annuities, royalties, rents, capital gains, income from passive activities ([20:29]).
• Active vs. Passive Distinction:
  • Tax does not apply to income from “active” businesses, unless income is from a passive activity (as defined by §469).
  • For NIIT, only 100 hours of significant (not 500 hours of material) participation per tax year may suffice to avoid the tax ([21:56]).
• Notable Quote:
  • “There are certain things limited partners are allowed to do… You could actually get out of the net investment income tax as a fairly passive investor. 100 hours is not a lot, two hours a week.” ([21:56])

Takeaways & Predictions on Soroban Case [23:02–25:53]

• Foreman shrugs: outcome is genuinely uncertain, could go either way in tax court.
• If tax court rejects a functional test, could trigger law firms to restructure for tax advantage and invite congressional response.
• Planning point: the outcome will have broad implications for structuring partnerships, especially in professional service fields.
• Reiterates: while he conceptually sides with the IRS, acknowledges Soroban’s arguments are well-founded and substantive.
• Notable Quote:
  • “Congress, when they passed this, they envisioned roughly this situation. It is not the purview of the Internal Revenue Service or the courts to say, we don’t like this…” ([24:05])
• Functional test for “limited partner as such” is implied by statute’s drafting but still open for judicial interpretation.

Upcoming Content Preview

• Next episode will cover passive activity loss rules under §469, described as highly complex and “interesting,” and promises a deep technical dive.

Notable Quotes & Memorable Moments

| Timestamp | Speaker | Quote / Moment | |-----------|-------------|--------------------------------------------------------------------------------------------------------| | 00:15 | Matt Foreman| “If you're not listened to the 11th episode, I strongly recommend you do… or else it'll be like the time I read an Edgar Allan Poe story starting on page three.” | | 05:02 | Matt Foreman| “The IRS’s brief is Christian Okoye…his running style was to attempt to run over you…Mack truck Christian Okoye running straight through you.” | | 13:38 | Matt Foreman| "You can say what things are, but your documents are saying otherwise. The facts are kind of saying otherwise. And it’s tough." | | 14:31 | Matt Foreman| "…the IRS is actually really saying, look, like we don’t actually know what the answer is. But they don’t either. An argument is okay and their argument is stinky…It is a turd sandwich." | | 21:56 | Matt Foreman| "You could actually get out of the net investment income tax as a fairly passive investor. 100 hours is not a lot, two hours a week." | | 24:05 | Matt Foreman| "Congress, when they passed this, they envisioned roughly this situation. It is not the purview of the Internal Revenue Service or the courts to say, we don’t like this…" |

Timestamps for Key Segments

| Timestamp | Topic | |-----------|--------------------------------------------------------------| | 00:00 | Introduction, context, admin notes | | 01:45 | Soroban facts and case background | | 03:45 | Statutory language and core legal issues | | 05:02 | IRS vs. Soroban legal strategies (football metaphors) | | 08:35 | LLCs as limited partners? Functional test discussion | | 09:36 | Managerial control & further factual application | | 13:30 | Who is right? Both sides analyzed | | 14:31 | Colorful critique of both arguments (South Park reference) | | 19:08 | Net Investment Income Tax (definition, impact) | | 21:56 | How to avoid NIIT as a “limited partner” | | 23:02 | Closing thoughts, case outcome predictions | | 25:53 | Preview of next episode (section 469) |

Engagement and Tone

• Conversational, candid, with humor and frequent sports/pop culture references (Edgar Allan Poe, football, South Park).
• Balances technical detail and real-life application, especially relevant for professionals dealing with partnership taxation.
• Encourages critical thinking on both statutory interpretation and practical tax planning.

Takeaways for Listeners

• IRS is intensifying scrutiny of partnership compensation, focusing on what partners actually do over partnership labels.
• Both service income classification and partnership structure will continue to be high-stakes battlegrounds.
• Knowing the details and substance behind your partnership’s roles and compensation is critical to avoiding adverse tax outcomes.
• Watch for future legal and regulatory developments in this area, especially as court decisions and appeals play out.

For more details on partnership taxation and forthcoming changes, Matt Foreman’s practical style and deep dives in "How Tax Works" provide valuable, accessible guidance.