How "Limited" Is The Limited Partner Exception?

The scope of the "limited partner exception" from self-employment tax continues to be the subject of significant controversy, with several cases on this issue currently making their way through the courts. While the Tax Court has applied a "functional analysis" approach that limits the exception to passive investors and requires an analysis of the specific facts and circumstances, the Fifth Circuit recently rejected that approach and interpreted the exception to cover partners in limited partnerships with limited liability, without regard to the limited partners’ specific activities. Appeals on the limited partner exception are now pending in the First and Second Circuits. The outcome of these cases will have important implications for fund managers, professional service partnerships, and other owners of passthrough businesses seeking clarity on their self-employment tax obligations.