LPs, LLCs, Ltds and Incs: Tax Consequences of Entity Choice

Tax News You Can Use | For Professional Advisors

February 3, 2025

When starting a new enterprise, one of the first decisions the founders face is what type of entity to form to operate the business. From a state law perspective, there are a variety of options — sole proprietorships, general or limited partnerships (GPs and LPs, respectively)¹ and corporations, as well as limited liability companies (LLCs), and the less common limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs). Factors that influence entity choice include voting rights, liability, control and flexibility. However, the tax consequences that flow from each choice often can be the deciding factor. In the self-employment tax arena, there are new developments following recent cases decided by the Tax Court that have changed the rules for limited partners in an important way — especially for financial sponsors, family offices, investment companies and other businesses operated as LPs.

Income Tax Differences Among Entity Alternatives

From an income tax perspective, entities fall into three broad categories. The first is a disregarded entity, which is a proprietorship or a single member LLC (other than an LLC electing to be taxed as a corporation) where the existence of the entity is ignored for tax purposes. In these situations, items of income and deduction are reported directly on the owner’s tax return and the tax is paid by the owner. This is generally only available where there is a single taxpayer that owns the business — although in some limited circumstance a married couple can own the entity and pay tax for the disregarded entity.

The second is a passthrough entity, whether that is a GP, an LP, an LLC electing to be taxed as a partnership or a corporation electing to be taxed as an S corporation. Entities in this category file an information return, but the items of income and deduction are passed through proportionately to the owners on a form K-1 and the owners report the income and pay the tax. The advantage of passthrough taxation is that income earned by the entity is not taxed twice — in other words, the same income is not taxed to the entity and then taxed again at the shareholder level when distributions are made. Income from some passthroughs qualifies for the section 199A deduction on the owner’s return, which lowers the effective tax rate, bringing it closer to the rate paid by corporations.

The third entity type for income tax purposes is a corporation, which includes C corporations or LLCs electing to be taxed as corporations. Corporations report income and deductions and pay tax at the entity level. When a shareholder or member receives distributions from the entity as dividends, the shareholder reports them as income and pays tax again. Distributions from the corporation for other purposes, such as salaries or expenses, may be deductible at the corporate level and avoid double taxation. It is also possible for a C corporation to elect to be taxed as an S corporation — after a period of time, it can then make certain distributions to shareholders without a second level of income tax. C corporations currently pay tax at a rate of 21%, which can be an advantage over passthrough taxation if the company is not making significant distributions to shareholders that would be double taxed. C corporation shares are also eligible for Qualified Small Business Stock (QSBS) treatment that reduces capital gains tax — an important advantage, particularly for start-up companies and their founders.

Self-employment Taxes

Payroll taxes (covering Social Security and Medicare) are allocated into two parts — one part is paid by the employee through withholding taxes and the other is paid by the employer. Those who earn their living through business activities pursued outside of third-party employment pay self-employment taxes in lieu of those payroll taxes. In 2025, the self-employment tax consists of 12.9% Social Security tax applicable to the first $176,100 of net self-employment income and 2.9% Medicare tax applicable to all net self-employment income.

When Congress enacted the self-employment tax, many taxpayers were eager for it to apply to their income from a profession operated through a partnership or other entity because that led to eligibility and accrual of benefits for Social Security. Now, when there are more options for retirement planning, more taxpayers focus on the tax cost. For this reason, business owners often look to structure their business entities to minimize the self-employment tax due on distributions.

Self-Employment Tax and Choice of Entity

Sole proprietors and general partners pay self-employment tax on their net business income. Shareholders of corporations do not, even if they are also employees, because the corporation itself is the third-party employer. The lines are blurrier for passthroughs. Previously, tax experts advised that limited partners had less exposure to self-employment tax than LLC members did. There is a statutory provision² that excludes from self-employment tax income earned by a limited partner “as a limited partner,” other than guaranteed payments for services rendered that are compensation for those services. This tax advantage favored using LPs over LLCs for businesses making significant distributions of income.

Three recent Tax Court decisions established a new test to determine the application of self-employment tax to distributions limited partners receive from LPs beyond guaranteed payments. These include the 2023 case, Soroban Capital Partners v. Commissioner,³ and the 2024 cases, Denham Capital Management LP v. Commissioner⁴ and Sirius Solutions LLLP v. Commissioner.⁵ The test asks what function or role the limited partner plays in the partnership business to determine whether the distribution was attributable to the limited partner acting as a passive investor or as an active manager, with self-employment tax applicable to anything other than income as a passive investor. Beginning in 2011, a similar function test has applied to members of LLCs⁶ and limited partners in professional services companies and LLLPs.⁷ Until 2023, however, most believed that this test did not apply to entities formed as state law limited partnerships due to the express provision in the Tax Code excluding distributions to limited partners from the application of the tax.

This is a big issue for financial sponsors and investment entities operating in LP form. The Soroban case illustrates this. In Soroban, a hedge fund manager created as a LP under applicable state law, had limited partners who each contributed two thousand hours of personal services per year in exchange for guaranteed payments. These guaranteed payments were reported as subject to self-employment tax. However, distributions of ordinary business income earned by the partnership and distributed to limited partners was not. The Tax Court held that Congressional intent in adopting the exception was to exclude from self-employment tax distributions received by limited partners who were passive investors. It held that whether or not the distributions are income from self-employment subject to tax depends on what functions the limited partner performed, and it held that all the distributions made to the limited partners of Soroban were subject to self-employment tax. A similar result was reached in Denham, which reaffirmed the Tax Court’s position in Soroban. Another Tax Court case that reached the same outcome is Sirius Solutions, which is currently on appeal to the United States Court of Appeals for the Fifth Circuit.

The upshot of these cases, in the LP area as well as for similar passthrough entities, is that to exclude distributions from the self-employment tax, an owner must show that that the distribution is not based on or derived from the activities of the limited partner in the business. The more it looks like compensation, the more likely it is income from self-employment subject to the tax. The implication for choice of entity is that there is no longer a tax advantage to using an LP when it comes to minimizing self-employment tax — all types of passthrough entities appear to be getting the same treatment under this series of cases.

How Does this Impact Choice of Entity?

LLCs offer more flexibility than partnerships do in some ways, both in terms of state law structure and available tax options. However, for certain types of businesses making significant distributions to owners, LPs have been the preferred entity type due in part to the self-employment tax exception. As we wait and see how the appellate court will rule, those faced with a choice of entity decision may want to take this line of cases from the Tax Court into account and consider whether there are other benefits that would make being an LLC advantageous if the self-employment tax treatment is the same. We may see more companies electing to operate as LLCs or even S corporations in lieu of limited partnerships.

We may also see investment partnerships restructure to fit into the tests outlined in the Tax Court cases so that distributions to at least some limited partners are not subject to self-employment tax. Businesses may change their compensation structures if it is clear that all partnership distributions for certain partners will be subject to self-employment tax that they did not originally anticipate. In addition, there may be changes to the tax law that would put additional pressure to switch from partnerships to corporations, including the new administration’s proposals to reduce the corporate income tax rate further (from 21% to as low as 15%, or even 13%) and the potential sunset of the 199A deduction.