Second Circuit: “Limited Partner” (I.R.C. § 1402(a)(13)) Means Limited Liability and No Managerial Control; NESE Is a TEFRA Partnership Item Reviewable in FPAA Proceedings

1. Introduction

Case: Soroban Capital Partners LP v. Commissioner of Internal Revenue (2d Cir. Sept. 17, 2026).
Parties: Petitioners-Appellants Soroban Capital Partners LP and Soroban Capital Partners GP LLC (tax matters partner) vs. Respondent-Appellee Commissioner of Internal Revenue.
Core dispute: Whether three hedge-fund principals—formally “limited partners” under Soroban’s Delaware limited partnership—could exclude roughly $141.5 million of distributive shares (2016–2017) from self-employment income under I.R.C. § 1402(a)(13).

The litigation presented two high-stakes, recurring questions in partnership tax:

• Jurisdiction/procedure: Could the IRS use TEFRA partnership-level procedures (FPAA) to adjust the partnership’s reported net earnings from self-employment (NESE), and did the Tax Court have jurisdiction to sustain that adjustment?
• Merits: What does “limited partner, as such” mean in § 1402(a)(13)—a formal state-law label, or a functional status tied to passivity/non-control?

2. Summary of the Opinion

The Second Circuit affirmed the Tax Court and held:

3. Analysis

3.1 Precedents Cited (and How They Shaped the Decision)

A. TEFRA framework and “partnership item” doctrine

• United States v. Woods, 571 U.S. 31 (2013): Used for TEFRA’s architecture—centralized partnership-level determinations—and the Tax Court’s TEFRA-limited jurisdiction. The Second Circuit relied on Woods to frame the key threshold: whether the disputed item is a partnership item.
• Addington v. Comm'r, 205 F.3d 54 (2d Cir. 2000) and Callaway v. Comm'r, 231 F.3d 106 (2d Cir. 2000): These Second Circuit TEFRA decisions supplied the “two-step” TEFRA logic—partnership items first, then partner-level “affected items”—and reinforced TEFRA’s anti-duplication purpose.
• Chimblo v. Comm'r, 177 F.3d 119 (2d Cir. 1999): Cited to show the regulatory list of partnership items is non-exhaustive; items not enumerated can still qualify. This supported treating NESE as a partnership item even though it is not expressly listed in Treas. Reg. § 301.6231(a)(3)-1(a).
• Monti v. United States, 223 F.3d 76 (2d Cir. 2000) and Alphonso v. Comm'r, 708 F.3d 344 (2d Cir. 2013): Used for standards of review (de novo) on partnership-item status and statutory interpretation within TEFRA disputes.

B. Statutory interpretation methodology and “ordinary meaning at enactment”

• Van Buren v. United States, 593 U.S. 374 (2021): “Begin with the text” canon.
• Watson v. Republican Nat'l Comm., 609 U.S. --, 146 S. Ct. 2165 (June 29, 2026) and Tanzin v. Tanvir, 592 U.S. 43 (2020): Both support the court’s key move: interpreting “limited partner” by its ordinary meaning at the time of enactment (1977).
• Dolan v. U.S. Postal Serv., 546 U.S. 481 (2006) and Mellouli v. Lynch, 575 U.S. 798 (2014): Used to justify reading § 1402(a)(13) in the context of the broader statutory scheme in § 1402(a), which distinguishes passive investment from active business income.

C. State law vs. federal tax characterization; “economic realities”

• Burnet v. Harmel, 287 U.S. 103 (1932): Central to rejecting a state-law-label test; federal tax consequences do not depend on state law unless Congress clearly says so.
• Comm'r v. Sw. Exploration Co., 350 U.S. 308 (1956) and PPL Corp. v. Comm'r, 569 U.S. 329 (2013): Cited for the principle that tax law turns on economic realities, not formalities—supporting the functional inquiry into actual managerial control.

D. Social Security purpose and interpretive backdrop

• Mayo Found. for Med. Educ. & Rsch. v. United States, 562 U.S. 44 (2011) and Social Sec. Bd. v. Nierotko, 327 U.S. 358 (1946): Used to explain why NESE and self-employment tax exist (funding Social Security/Medicare) and why Congress cared about “work” replacing lost earnings, not passive investment.
• Loper Bright Enters. v. Raimondo, 603 U.S. 369 (2024): Used to justify consulting contemporaneous agency interpretations (the SSA’s 1978 regulation) as “especially useful,” without treating them as controlling.

E. Weight of nonbinding administrative materials and legislative inaction

• United States v. Josephberg, 562 F.3d 478 (2d Cir. 2009): Cited to discount IRS publications/instructions (e.g., Form 1065 instructions) as non-authoritative sources of law.
• Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994): Used to caution against overreading congressional “inaction” (here, the 1997 moratorium on § 1402(a)(13) regulations) as proof of statutory meaning.

F. Emerging circuit-level alignment (and possible divergence)

• K Alain L.L.L.P. v. Commissioner of Internal Revenue, 184 F.4th 766 (5th Cir. 2026): The Second Circuit noted the Fifth Circuit’s recent functional approach—“plays no significant role in managing or running a business”—and largely harmonized its own rule with that concept.
• Denham Cap. Mgmt. LP v. Commissioner of Internal Revenue, No. 25-1349 (1st Cir. Feb. 8, 2026): Identified as pending, signaling the issue’s national significance and the possibility of further refinement or a circuit split.

3.2 Legal Reasoning

A. Jurisdiction: Why NESE is a TEFRA “partnership item”

TEFRA limited partnership-level proceedings (and Tax Court review under those proceedings) to “partnership items.” Under former I.R.C. § 6231(a)(3), an item is a partnership item if:

1. Subtitle A prong: the item is “required to be taken into account” for the partnership taxable year under Subtitle A; and
2. Regulatory prong: regulations say it is “more appropriately determined” at the partnership level.

The Second Circuit’s reasoning is notable for treating NESE not as a partner-by-partner computation, but as a partnership-level characterization of income components.

• Subtitle A prong satisfied: The court emphasized that partnerships compute taxable income under Subtitle A (e.g., I.R.C. § 703(a)), and NESE appears in Subtitle A as part of the system defining self-employment income. TEFRA, the court stressed, concerns “treatment” of items, not the final tax liability of each partner.
• Regulatory prong satisfied: Even though NESE is not enumerated, Treas. Reg. § 301.6231(a)(3)-1(b) includes “legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income.” Whether income is NESE affects the characterization and amount of taxable items, and the components of NESE (income, distributive shares, guaranteed payments) are explicitly partnership items.
• TEFRA purpose: Partner-level litigation of NESE would replicate the same inquiry across partners—precisely what TEFRA sought to prevent (as explained in Callaway v. Comm'r and United States v. Woods).

B. Merits: The Second Circuit’s definition of “limited partner, as such”

The court built a multi-source interpretive case for a functional definition tied to the 1977 understanding of limited partnerships:

• Ordinary meaning in 1977: Dictionaries and treatises described limited partners as contributing capital, having limited liability, and taking no part in running the business.
• ULPA/RULPA backdrop: Under ULPA § 7 (1916) and RULPA § 303(a) (1976), taking part in control historically jeopardized limited liability. Congress legislated against a legal environment where “limited partner” implied non-control.
• The phrase “as such”: “As such” means “in that capacity.” This signals that the exemption is for distributive shares earned in the partner’s capacity as an investor-like limited partner, not as a manager.
• Guaranteed payments carveout: § 1402(a)(13) taxes guaranteed payments for services actually rendered—consistent with the work/investment divide. The court rejected the idea that this carveout implies limited partners can freely manage the business; services are not the same as control.
• Statutory structure: Other NESE exclusions in § 1402(a) consistently remove passive investment returns, while keeping business/earned income in the base.
• 1977 legislative purpose: The court emphasized Congress’s aim to prevent passive limited partners from buying Social Security credits via limited partnership distributions—benefits designed to replace “lost earnings from work.”

C. Application to Soroban’s principals

On the undisputed record, the principals:

• worked full-time (roughly 2,300–2,500 hours/year);
• managed investments, trading, and risk;
• sat on governing committees and exercised operational control; and
• played essential roles in generating firm income.

Under the Second Circuit’s rule, these facts are disqualifying: the principals were not limited partners “as such,” so their distributive shares were NESE subject to self-employment tax.

3.3 Impact

A. Direct doctrinal impact (Second Circuit precedent)

• Functional test adopted: The Second Circuit cements that “limited partner” in § 1402(a)(13) is not merely a state-law label. The controlling inquiry is whether the partner runs/manages/controls the business.
• TEFRA legacy jurisdiction clarified: For TEFRA years (through 2017), NESE can be adjusted via FPAA, consolidating disputes at the partnership level.

B. Practical impact on partnership planning and audits

• Investment-management and professional firms: Structures allocating large “profits interests” to active principals labeled “limited partners” face increased risk of reclassification into NESE in the Second Circuit.
• Compensation engineering pressure: The opinion implicitly reduces the tax advantage of shifting compensation from guaranteed payments (clearly taxed) into distributive shares claimed exempt under § 1402(a)(13).
• Audit strategy and litigation posture: Because NESE is a partnership item under TEFRA, taxpayers cannot easily force the issue into individualized partner-level forums for TEFRA years.

C. National impact and potential Supreme Court interest

The Second Circuit expressly engaged with K Alain L.L.L.P. v. Commissioner of Internal Revenue and flagged Denham Cap. Mgmt. LP v. Commissioner of Internal Revenue as pending. If circuits diverge on how much participation is “significant,” or on administrability boundaries, Supreme Court review becomes more plausible—particularly given the dollar stakes and prevalence of the issue.

4. Complex Concepts Simplified

• Self-employment tax: An extra tax (funding Social Security and Medicare) imposed on “self-employment income.”
• NESE (net earnings from self-employment): The tax base for self-employment tax. For partners, it generally includes their share of partnership business income.
• Distributive share vs. guaranteed payment:
  • Distributive share varies with partnership profits (profit allocation).
  • Guaranteed payment is fixed/assured compensation for services or capital, “without regard to” partnership income.
• § 1402(a)(13) “limited partner” exception: Distributive shares of “limited partners, as such” are excluded from NESE (and thus from self-employment tax), but guaranteed payments for services remain taxed.
• TEFRA / FPAA: For older tax years, TEFRA required the IRS to adjust “partnership items” centrally at the partnership level, via an FPAA, before partner-level consequences are computed.
• “Partnership item” vs. “affected item”: A “partnership item” is decided for the partnership as a whole; an “affected item” is a partner-level consequence that depends on partnership-item determinations. The Second Circuit held NESE belongs in the first category for TEFRA years.

5. Conclusion

Soroban Capital Partners LP v. Commissioner of Internal Revenue establishes two consequential rules for TEFRA-era partnership disputes and § 1402(a)(13) planning:

• Procedural: NESE is a TEFRA partnership item, so the IRS may adjust it through an FPAA and the Tax Court may adjudicate it in partnership-level proceedings.
• Substantive: A “limited partner” under § 1402(a)(13) is not merely someone called “limited” under state law; it is someone with limited liability who does not manage, run, or control the partnership’s business.

Applied to Soroban’s principals—full-time managers with decisive authority—the court treated their large distributive shares as self-employment income. The decision narrows the ability of active owners to convert labor-like earnings into self-employment-tax-exempt allocations simply by adopting the “limited partner” label.