In September, Treasury announced forthcoming guidance that will clarify whether the limited partner exception applies to limited partners that actively participate in their businesses (which we last discussed here).

Since 1977, limited partners have been excluded from paying self-employment tax under Code Section 1402(a)(13).  Because the statute does not define a “limited partner,” many taxpayers taken the position that a person classified as a limited partner under state law may avail themselves of the exception regardless of such person’s level of active participation in the business.  The IRS has hotly disputed this position through its ongoing audit initiative, with several cases already ending up in court.

In fact, the IRS has long been critical of reliance on state law classification, issuing proposed regulations in 1997 that would ignore state law classifications in favor of a functional analysis.  However, these proposed regulations were never finalized because of concerns that the IRS had exceeded its regulatory authority.  These rules have not been reissued since, although at a recent tax conference an IRS associate chief counsel hinted that similar rules are forthcoming, stating that “you have to be looking at what the partners are actually doing.  And that’s what we're going to be addressing in the regulations.”

The upcoming guidance may implement the functional analysis test first applied by the Tax Court in a 2011 case, where the court analyzed the extent to which a limited partner acts as a passive investor to qualify for the exception from self-employment tax.