Appeals Courts Threaten Hedge Funds’ Tax Strategy

Federal appeals courts have revived a dispute over whether active limited partners at hedge funds and private equity firms must pay a 3.8% federal self-employment tax. In September the U.S. Court of Appeals for the Second Circuit held in the Soroban Capital Partners case that active limited partners can be liable for the tax on more than $141 million in earnings for 2016 and 2017.

The controversy centers on a 1977 provision that generally excludes limited partners from self-employment tax. Many fund managers relied on that provision to treat partnership income as exempt. The IRS launched a formal challenge to that interpretation in 2018.

The U.S. Tax Court ruled for the government in the Soroban matter in 2023. The Fifth Circuit issued a ruling in August that supported the IRS after reversing an earlier panel decision, and the Second Circuit reached a similar conclusion in September. A separate case is pending in the First Circuit.

The Second Circuit’s jurisdiction includes New York, where many alternative investment managers are based. The Soroban ruling involved three partners and more than $141 million of reported earnings for 2016 and 2017, and the court said partners who actively manage or control their businesses can be treated as subject to self-employment tax.

The self-employment tax at issue includes a 3.8% Medicare-related component that is not capped like the Social Security portion of the tax. Because of that difference, the potential liability can apply to very large amounts of compensation.

Some prominent firms have faced audits or cases tied to the question. New York Mets owner and Point72 founder Steve Cohen has been connected to an IRS case on the issue; his firm declined to comment. Treasury Secretary Scott Bessent, who previously ran Key Square Group, acknowledged during his confirmation process that he had used the limited-partner approach, set aside funds to cover a possible liability and would follow court outcomes. Bessent later settled his self-employment tax matter with the government this summer, according to a person familiar with the case.

The IRS began its challenge in 2018 and has pursued the issue across administrations. With circuits split and at least one appeal still pending, further appellate rulings or a Supreme Court decision could determine the final scope of the tax’s application to active limited partners.