The Tax Court’s decision in Denham Capital Management LP v. Commissioner, TC Memo 2024-114 addresses whether a state law limited partner’s distributive share of partnership income is subject to self-employment tax. The court concluded that the partners were not “limited partners, as such” under section 1402(a)(13), and their distributive shares were included in the partnership’s net earnings from self-employment (NESE). This conclusion is consistent with the court’s prior ruling in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), which held that a partner’s status as a limited partner for purposes of the limited partner exception is determined by a functional analysis of their roles and responsibilities, not solely on their state law designation

Facts of the Case

In Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114, the Tax Court addressed whether certain partners in a state law limited partnership, Denham Capital Management, LP (Denham), qualified for the limited partner exception under section 1402(a)(13), which would exclude their distributive share of partnership income from net earnings from self-employment (NESE). The case is significant because it applies the functional analysis test established in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), and reinforced in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), to a state law limited partnership, determining that the partners’ roles and responsibilities, rather than their state law designation, dictate their status for self-employment tax purposes.

Background of Denham Capital Management, LP

Denham was organized as a limited partnership under Delaware law, with its principal place of business in Massachusetts. The partnership provided investment advisory and management services to affiliated private equity funds that invested in the energy sector, specifically oil and gas, mining, and power. Denham’s services included furnishing investment advice, negotiating investment terms, monitoring investments, and handling day-to-day fund administration. The partnership’s general partner, Denham Capital Management GP LLC, a Delaware limited liability company, was also the tax matters partner.

During the tax years in question, 2016 and 2017, Denham had five limited partners in addition to the general partner: Stuart Porter, Scott Mackin, Carl Tricoli, Riaz Siddiqi, and Jordan Marye. These partners functioned similarly to employees, subject to the same general policies and procedures as Denham employees. Despite being designated as limited partners under state law, the court examined their actual roles within the partnership to determine their status for self-employment tax purposes.

The Fifth Amended and Restated Limited Partnership Agreement (LPA), effective May 1, 2014, governed the obligations and authority of Denham’s partners for the years in issue. Under the LPA, the general partner had “unlimited liability” for Denham’s debts, while the limited partners enjoyed limited liability, only being held personally liable to the extent of their capital contributions. All management authority was vested exclusively in the general partner, but the limited partners had authority to the extent it was delegated to them by the general partner. For example, three of the limited partners and several key employees were authorized to execute any agreement or document on the general partner’s behalf. The LPA also required each partner, except for Mr. Porter, to devote substantially all of his or her business time and attention to the affairs of Denham and its affiliates.

The founding partners were Messrs. Porter, Siddiqi, and Tricoli. Mr. Porter made an initial capital contribution of approximately $8 million in 2007 in exchange for his limited partner interest. The other partners received their limited partner interests through grants of profits interests at various times. No other capital contributions were made to Denham by any of the partners, though Messrs. Porter and Siddiqi testified that the other partners paid Mr. Porter directly for their interests, however, no such written agreements were provided as evidence. The partners had the authority to remove partners by consensus.

Partners’ Roles and Responsibilities

The partners held various roles and responsibilities, which were not explicitly outlined in the LPA. Mr. Porter oversaw Denham’s investment strategy, managed the risk group, and spent time meeting with lower level employees. Denham carried total life insurance coverage on Mr. Porter of $90 million in 2016 and $30 million in 2017. Messrs. Tricoli, Mackin, and Marye each held the title of managing partner and led deal teams within their respective sectors, with Messrs. Tricoli and Mackin also holding the title of co-president. Mr. Siddiqi served as managing partner and led the portfolio services group.

The partners’ role with Denham was so fundamental to the firm’s operation that investors had the right to withdraw their investments early if one or more of the partners died, became disabled, or could no longer devote substantially all business time to the funds. Although each fund’s “key person” provision referred to Mr. Porter, all five partners were considered a key person by at least one of the funds. The partners also served on various committees, including management, valuation, and investment committees. The management committee, which included Messrs. Porter, Tricoli, and Mackin, discussed issues such as budgeting, employee hirings or departures, and expansion. Excluding Mr. Porter, the partners frequently served on the boards of directors of the portfolio companies, but they were not compensated for this.

The partners actively engaged in fostering and attracting investor relationships, traveling to meet with potential and current investors for fundraising purposes, with travel reimbursements provided by Denham.

Denham’s Operations and Revenue

Denham managed five active funds in 2016 and seven in 2017, with $7.5 billion and $8.3 billion of assets under management, respectively. Each fund was a separate limited partnership entity with another limited partnership as its general partner. The partners and employees of Denham were the partners of the limited partnerships that served as the funds’ general partners. The funds’ investors were primarily institutional, and they had no decision-making authority.

Denham generated revenue from management fees paid by each fund in exchange for its advisory services. The management fees typically ranged from 0.75% to 1.75% of capital committed by investors. Denham generated $69,903,232 and $61,280,194 in total revenue for 2016 and 2017, respectively, derived solely from its investment management services.

Denham’s investment process included deal teams, investment committees, and valuation committees. Deal teams generated investment proposals, which were presented to the investment committees. The investment committees, which included Messrs. Porter, Tricoli, and Siddiqi for every fund, as well as Mr. Mackin for the commingled commodity funds and Mr. Marye for the oil and gas fund, met weekly to vote on potential new investments and significant decisions. All voting members of the investment committee were required to unanimously approve an investment recommendation, meaning a single partner could effectively reject a proposal. The valuation committees reviewed and approved valuation recommendations, and all five partners served on the valuation committees during the years in issue. As with investment committees, the valuation committee required a unanimous vote to approve a recommendation.

Denham’s Private Placement Memorandums (PPMs) represented to investors that “[t]he overall direction of the firm is guided by its partners,” and the partners’ experience was influential to investors.

Denham’s Financial and Tax Reporting

Denham worked with PricewaterhouseCoopers, LLP (PwC) to audit its financial statements and prepare its Forms 1065. PwC’s audit report described the partners as “active limited partners,” a term provided by Denham.

Denham Capital Management GP LLC (the general partners) did not make any guaranteed payments or distributions to the partners in 2016 or 2017. In each of those years, Denham (the limited partnership) made guaranteed payments and capital distributions to the partners and the general partner. The guaranteed payments were intended to represent the partners’ salaries, and included the value of typical employment benefits. The distributions to the partners were tied to their distributive shares of Denham’s income and calculated on the basis of their profits interests. There was no guaranteed minimum for the partners’ distributive shares for the year, and they varied as they were tied to the profits of the firm.

When computing the partners’ NESE for the years in issue, Denham included their guaranteed payments but excluded their distributive shares of ordinary business income. The following table shows the amounts reported on Denham’s returns for 2016 and 2017:

	Ordinary Income	Guaranteed Payments	NESE	Distributions
2016
General Partner	$33,813	—	$33,633	$39,574
Stuart Porter	10,027,043	$427,178	427,178	8,723,326
Scott Mackin	3,990,985	241,565	241,565	3,030,423
Carl Tricoli	6,931,842	350,820	350,820	5,656,821
Riaz Siddiqi	2,456,321	382,820	382,820	2,083,944
Jordan Marye	4,068,995	342,516	342,516	2,424,961
2017
General Partner	$28,088	—	$28,268	$24,705
Stuart Porter	6,554,420	$382,959	382,959	7,091,483
Scott Mackin	2,662,994	179,704	179,704	2,919,166
Carl Tricoli	6,890,616	389,633	389,633	7,316,065
Riaz Siddiqi	1,412,031	47,175	47,175	1,434,193
Jordan Marye	5,398,806	367,809	367,809	5,331,920

Denham reported total NESE of $1,778,532 and $1,395,001 for 2016 and 2017, respectively.

IRS Adjustments

On March 27, 2023, the IRS issued Notices of Final Partnership Administrative Adjustment (FPAA) for the years in issue, increasing Denham’s NESE to $29,253,718 and $24,314,415 for 2016 and 2017, respectively. These adjustments were based on the IRS’s position that the partners’ distributive shares of ordinary business income were not excludable from NESE under the limited partner exception of section 1402(a)(13). In other words, the IRS determined that the partners did not qualify for the limited partner exception and their distributive shares should be included in the partnership’s NESE. The IRS included the partners’ distributive share of the ordinary income in NESE. The court noted that Denham reported $547 less of total NESE than the sum of the NESE reported on the partners’ Schedules K-1 for 2017. However, the court noted that this error did not affect the resolution of the case.

The Court’s Analysis and Decision

The Tax Court’s analysis of the applicable law and authorities, as well as how they applied to these facts are summarized below.

Core Issue: Determining Net Earnings from Self-Employment (NESE) and the Limited Partner Exception

At the heart of the case is the determination of Denham’s Net Earnings from Self-Employment (NESE). The IRS issued Notices of Final Partnership Administrative Adjustment (FPAA) that increased Denham’s NESE for 2016 and 2017. The court had to determine (1) whether adjustments to a partnership’s NESE are partnership items subject to determination at the partnership level, and (2) whether the income of five of Denham’s partners could be excluded from NESE under the limited partner exception provided by section 1402(a)(13) of the Internal Revenue Code.

Jurisdiction and the Partnership Item Determination

The court first addressed whether it had the jurisdiction to determine if a partner qualified for the limited partner exception, which was challenged by the petitioner. The court relied on its prior holding in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), where it determined that it did have jurisdiction to decide a state law limited partner’s status when determining the applicability of the limited partner exception in partnership-level proceedings.

The court rejected the petitioner’s argument that Soroban failed to consider whether the item affected the entire partnership, noting that it adheres to the doctrine of stare decisis and would only revisit prior decisions when presented with special justification, which it found was not present. The court concluded that the determination of the applicability of the limited partner exception is a partnership item over which it has jurisdiction.

The Functional Analysis Test and the “Limited Partner, as Such”

The court then turned to the critical question of whether the five partners qualified as “limited partners, as such” under section 1402(a)(13). This section excludes from NESE a limited partner’s distributive share of partnership income, except for guaranteed payments for services. The court clarified that this section is an exception to NESE, which is construed narrowly to achieve the congressional intent of ensuring that the maximum number of individuals are covered under the Social Security framework. The Court applied a functional analysis to determine whether the partners were limited partners, as such, which the court initially adopted in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011).

The functional analysis test, as described in Renkemeyer, examines whether a partner’s role is akin to that of a passive investor or an active participant in the business. The court noted that Congress intended for section 1402(a)(13) to apply to passive investors, not partners actively engaged in the partnership’s business. The court stated that the legislative history indicates that the intent of section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations would not receive credits toward Social Security coverage.

The court rejected the petitioner’s argument that the functional analysis test should be based on whether the partners maintained their limited liability status under state law or the Revised Uniform Limited Partnership Act. It emphasized that having limited liability under state law was not sufficient for a partner to be considered a limited partner for purposes of section 1402(a)(13). In Renkemeyer, the court had already concluded that a limited partner interest was similar to that of a passive investor. The court highlighted that federal law, not state law, determines the classification of individuals and organizations for federal tax purposes. The court cited Treas. Reg. § 301.7701-1(a) and Kraatz & Craig Surveying Inc. v. Commissioner, 134 T.C. 167, 180 (2010), in support of this point.

Application of Functional Analysis Test

The Court in Denham Capital Management looked at the source of Denham’s income, the partners’ roles in generating the income, and the relationship between their distributive shares and any capital contributions. The court found that Denham’s income was generated from fees charged for its investment advisory services and that the partners’ time, skills, and judgment were essential to providing these services. It contrasted the large distributive shares the partners received with the relatively small amount of capital they contributed (most partners contributing no capital). The court cited Renkemeyer in noting that a small investment compared to the income generated is insufficient to classify the distributive share as a return on investment.

The Court noted that all the partners, except Mr. Porter, were required to “devote substantially all of their business time” to Denham. It emphasized the partners’ participation in the management of the firm through their service on various committees. The Court found that the partners’ expertise was a draw for fund investors, and their decisions directly affected the operation of the business. It also noted the partners’ control over personnel decisions, which further supported the conclusion that they were active participants in the firm.

Rejection of Petitioner’s Arguments

The court specifically rejected the argument that the partners were acting in their capacity as members of the general partner, stating that their work was focused on benefiting and being compensated by Denham, the limited partnership, not the general partner. The court also rejected the argument that a passive investor standard would render the guaranteed payment carveout meaningless because partners could receive guaranteed payments, and still be passive investors in other areas. The court emphasized that it must make a comprehensive inquiry and decide whether, based on all facts and circumstances, the partners were “generally akin” to passive investors.

Conclusion

The court concluded that the partners were not “limited partners, as such” under section 1402(a)(13) and that their distributive shares could not be excluded from Denham’s NESE. The Court found that the partners’ relationships with Denham were more akin to those of employees or self-employed individuals than passive investors. The court’s decision was based on the weight of the evidence, which demonstrated the partners’ active and integral roles in the business, rejecting the petitioner’s argument that compliance with state partnership law was sufficient to qualify the partners as limited partners. The court stated that because the partners were not limited partners, as such, the distributive shares of income are subject to self employment tax under the Internal Revenue Code.

Why Did the Decision Not Rely Simply on the State Law Definition of a Limited Partner?

Why did the Tax Court emphasize the term “limited partner, as such” and applied a functional test instead of relying solely on state law definitions of what is a limited partner? Why is “as such” such a big deal? The reasons are outlined below.

The Core Issue: The Limited Partner Exception and Self-Employment Tax

The crux of the matter lies in Section 1402(a)(13) of the Internal Revenue Code, which provides an exception to the general rule that a partner’s distributive share of partnership income is subject to self-employment tax. Specifically, it states that a “limited partner, as such” may exclude their distributive share of income or loss, except for guaranteed payments for services rendered, from net earnings from self-employment (NESE). The critical phrase here is “limited partner, as such.” The court’s analysis in Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114, hinges on how this phrase is interpreted.

Why Not Just State Law?

The petitioner in Denham Capital Management argued that if a partner is designated as a “limited partner” under state law, that should be sufficient to qualify them for the exception under section 1402(a)(13). The Tax Court rejected this argument, emphasizing that federal tax law defines these terms, not state law. The court’s reasoning is deeply rooted in legal precedent and the intent of the tax code:

Federal Law Governs Tax Classification: The court explicitly stated that federal law, not state law, dictates how individuals and organizations are classified for federal tax purposes. This principle is supported by Treasury Regulation § 301.7701-1(a). The court also cited Kraatz & Craig Surveying Inc. v. Commissioner, 134 T.C. 167, 180 (2010), and Estate of Steffke v. Commissioner, 538 F.2d 730, 732 (7th Cir. 1976), which state that the meaning and legal status of terms under federal tax law need not be identical to their state law counterparts.
“Limited Partner, As Such” is Not a Simple Label: The court reasoned that the phrase “limited partner, as such,” implies more than just having a state law designation. The court held that Congress intended section 1402(a)(13) to apply to partners that are passive investors. The court interpreted this to mean the exception was meant for individuals who are primarily passive investors, not those who are actively engaged in the business, regardless of their state law classification.
Preventing Tax Avoidance: The court’s interpretation of section 1402(a)(13) is designed to prevent individuals from using state law labels to avoid self-employment tax. If the exception applied merely because of a state law designation, it would be easy for partners who function as active participants in a business to avoid paying self-employment taxes simply by calling themselves “limited partners”.
The Legislative Intent of Section 1402(a)(13): The court noted the legislative history of section 1402(a)(13) which states that “the intent of section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations (which was the archetype of limited partners at the time) would not receive credits toward Social Security coverage”. The court concluded that Congress did not intend to exclude partners who performed services for a partnership in their capacity as partners from liability for self-employment taxes.

The Functional Analysis Test: A Deeper Dive

The court’s response to the petitioner’s argument is the application of a “functional analysis test.” This test, which the court first articulated in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), doesn’t just look at a partner’s title but at their actual role and activities within the partnership. The key aspects of the functional analysis are:

Passive Investor vs. Active Participant: The fundamental question the court seeks to answer is whether the partner is functioning more like a passive investor or an active participant in the business. Passive investors, in the traditional sense, put up capital and do not actively engage in the management or day-to-day operations of the business.
Source of Income: The court scrutinizes how the partnership generates income. In Denham Capital Management, the income was generated from management fees earned through the active management of investments, not through passive returns on capital. This indicated that the partners’ efforts were integral to the partnership’s income generation.
Partner’s Role in Generating Income: The court analyzes the partner’s involvement in the activities that generate income. The court found that the partners’ time, skills, and judgment were essential to providing the investment services from which the partnership earned its fees.
Capital Contribution vs. Distributive Share: A crucial element of the analysis is comparing the partner’s capital contributions to their distributive share of partnership income. In Denham Capital Management, most partners made no capital contributions, yet received large distributive shares, which were disproportionate to any investment risk. The court, citing Renkemeyer, held that where a partner’s investment is small compared to the income, the income is not considered a return on investment.
Management and Decision-Making: The court examines the extent of the partner’s participation in the management and decision-making processes of the partnership. In Denham Capital Management, the partners were deeply involved in strategic decisions through their participation in management, valuation, and investment committees.
Time Commitment: The court considers the time the partner dedicates to the partnership. The Denham Capital Management partnership agreement required all partners (except one) to devote substantially all their business time to the partnership, which the court took as an indicator of active involvement.

Precedent for Functional Analysis

The Tax Court has consistently applied the functional analysis test in prior cases:

Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023): The court stated that a functional analysis test should be used to determine the roles and responsibilities of partners to determine their status for tax purposes.
Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011): The court established the functional analysis test, focusing on whether a partner’s role is akin to that of a passive investor or an active participant in the business.
Castigliola v. Commissioner, T.C. Memo. 2017-62: The court used the Renkemeyer analysis to conclude that the members of a professional limited liability company were not limited partners because they were involved in the management of the business.
Hardy v. Commissioner, T.C. Memo. 2017-16: The court found that a surgeon was a limited partner because they had no management responsibilities and their share of income was based on the fees paid for the use of the surgery center.

These cases reinforce the idea that the “limited partner, as such” designation requires more than just a state law label; it requires an examination of the partner’s actual function and role within the partnership.

The Court’s Conclusion in Denham Capital Management

In Denham Capital Management, the court found that the partners were not "limited partners, as such" because they were actively involved in the core business operations, their income was directly related to their efforts and expertise, and their role was integral to the business. The court emphasized the fact that the partners’ roles were so fundamental to the firm’s operation that investors had the right to withdraw their investments early if one or more of the Partners died, became disabled, or could no longer devote substantially all business time to the funds. The court concluded that the partners’ relationships with Denham were more akin to those of employees or self-employed individuals rather than passive investors.

Implications for Tax Professionals

For CPAs, this case underscores that, in the view of the Tax Court, simply labeling a partner as a “limited partner” under state law is insufficient to exclude their distributive share from self-employment tax. The tax implications are determined by a functional analysis of the partner’s role and responsibilities. Tax professionals should carefully evaluate the activities, income sources, and management roles of partners to accurately determine their status for federal tax purposes.

In summary, the Tax Court emphasized “limited partner, as such” because this phrase is not merely a state law designation, but a federal tax concept that requires an evaluation of a partner’s economic relationship to their partnership. The functional analysis test, as detailed above, is used to make this determination. This analysis is necessary to achieve the intent of Section 1402(a)(13) to benefit passive investors and prevent tax avoidance.

Citation: Denham Capital Management LP et al. v. Commissioner, TC Memo 2024-114, December 23, 2024, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/tax-court-adheres-limited-partner-exception-decision/7pgx5

Google’s NotebookLM was used to assist in the analysis of this decision and the drafting of this article.