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The Hedge Fund Medicare Tax Gap: Active Limited Partners, SE Tax, and NIIT

September 18, 2026 | By: Robert A. Green, CPA

Originally published Nov. 17, 2025; last updated Sept. 18, 2026.

Update Sept. 18, 2026: Second Circuit Upholds SE Tax on Active Limited Partners

In Soroban Capital Partners LP v. Commissioner, No. 25-2079 (2d Cir. Sept. 17, 2026), the Second Circuit Court of Appeals affirmed the Tax Court, holding that the limited-partner exception from self-employment tax under IRC §1402(a)(13) depends on the partner’s actual management role, not merely the partner’s classification as a limited partner under state law.

The court concluded that a limited partner must have both limited liability and limited involvement in managing or controlling the partnership’s business. A partner may perform some services and still qualify for the exception, but significant management or control is inconsistent with limited-partner treatment for purposes of §1402(a)(13).

The decision is particularly important for the hedge-fund industry because the Second Circuit covers New York, Connecticut, and Vermont. Soroban involved principals of an investment management business who worked full-time and exercised substantial management authority. The decision therefore strengthens the IRS position that active owners of hedge-fund and investment-management companies cannot avoid SE tax on their distributive shares merely by holding state-law limited-partner interests.

The Second Circuit’s approach is also substantially consistent with the Fifth Circuit’s revised Aug. 12, 2026 decision in K Alain, L.L.L.P. v. Commissioner. The Fifth Circuit withdrew its earlier January 2026 taxpayer-friendly opinion, which had focused on state-law limited liability, and replaced it with a decision holding that the §1402(a)(13) exception applies to a limited partner who plays no significant role in managing or running the business. Although the two circuits articulate their standards somewhat differently, both focus on the partner’s management role rather than treating the state-law limited-partner label as controlling.

Planning Implications

These appellate decisions significantly strengthen the IRS position on active limited partners. For hedge-fund and private-equity management companies, state-law limited-partner status alone is not sufficient protection against SE tax when owners actively manage or control the business.

This development reinforces the entity-planning approach discussed in this article: we generally favor a dual-entity structure consisting of a trading fund LP and a separate S-Corporation management company, rather than attempting to use limited-partner status in the management company to avoid SE tax. The S-Corp pays reasonable officer compensation subject to payroll taxes, while remaining S-Corp profits are generally not subject to Social Security and Medicare payroll taxes.

Editor’s note: Since this article was first published, appellate decisions from the Second and Fifth Circuits have significantly clarified the limited-partner exception to self-employment tax under IRC §1402(a)(13). Both courts now focus on a partner’s role in managing or running the partnership rather than treating a state-law limited-partner designation as controlling. The dated updates below trace the evolving case law.

Core point: A partner who significantly manages or controls an investment-management business should not assume that a state-law limited-partner designation excludes the partner’s distributive share from self-employment tax under §1402(a)(13). This is particularly important for active owners of hedge funds, private equity firms, and other investment management companies.

Update Aug. 17, 2026: Fifth Circuit Withdraws January Opinion And Narrows The Limited-Partner SE Tax Exception

On Aug. 12, 2026, the Fifth Circuit withdrew its January 2026 opinion in Sirius Solutions L.L.L.P. v. Commissioner and issued a substitute opinion under the caption K Alain LLLP v. Commissioner. Although the court denied the government’s petition for rehearing en banc, it abandoned the broad state-law test described in our Jan. 25 update below.

The January opinion held that limited liability under state law was sufficient for a partner to qualify for the self-employment tax exclusion under IRC §1402(a)(13). The substitute opinion instead defines a limited partner as “a partner who plays no significant role in managing or running a business.” Therefore, state-law limited-partner status alone is no longer sufficient in the Fifth Circuit; courts must examine the partner’s actual role in the business.

However, the Fifth Circuit did not fully adopt the Tax Court’s passive-investor test in Soroban. The court concluded that a limited partner may participate in some non-managerial business activities without losing the exclusion. Its new dividing line is managerial versus non-managerial activity—not simply active versus passive participation or material versus non-material participation under the passive-activity rules.

This flip-flop substantially narrows the taxpayer-friendly January decision and creates a new factual question: When does a partner’s involvement become a “significant” role in managing or running the business? Active partners who manage a hedge fund, private equity firm, registered investment adviser (RIA), or professional services management company should not assume that their state-law LP designation protects their distributive share from SE tax. Partners engaged only in non-managerial activities may have a stronger argument for the exclusion, although the extent of that protection remains uncertain.

Under the Tax Court’s Golsen rule, the substitute decision directly governs Tax Court cases appealable to the Fifth Circuit, which covers Texas, Louisiana, and Mississippi. Appeals involving Denham Capital Management and Soroban Capital Partners remain pending in the First and Second Circuits, respectively. Until the appellate courts, Congress, or Treasury provide greater clarity, relying on limited-partner status to avoid both SE tax and NIIT remains uncertain and potentially risky. An S-corporation management-company structure continues to offer a more established approach to managing payroll and Medicare taxes, subject to reasonable-compensation requirements.

The Jan. 25, 2026 update below is retained as a historical record of the Fifth Circuit’s original ruling. That opinion was withdrawn and replaced on Aug. 12, 2026, as explained in the update above. It is no longer controlling law.

Update Jan. 25, 2026: Fifth Circuit Rejects IRS Functional Test—Limited Impact Outside Three Southern States

In Sirius Solutions L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. Jan. 16, 2026), the Fifth Circuit Court of Appeals vacated a Tax Court decision involving the limited-partner exception to self-employment tax under IRC §1402(a)(13). The court held that qualification for the exception turned on limited liability under state law—not on whether the partner was a passive investor or materially participated in the business.

In doing so, the Fifth Circuit rejected the functional, passive-investor test applied by the IRS and the Tax Court in Soroban Capital Partners and Denham Capital Management. Instead, the court relied on the statutory text and the historical meaning of “limited partner.” In a footnote, the court expressly reserved the question of how—or whether—its reasoning would apply to interests in other entities, such as LLPs and LLCs.

The Fifth Circuit covers Texas, Louisiana, and Mississippi. Under the Tax Court’s Golsen rule, the Tax Court would have been required to follow Sirius in cases appealable to that circuit. Outside the Fifth Circuit, the Tax Court could continue applying the functional, substance-over-label analysis reflected in Soroban, Denham, and Castigliola.

This geographic limitation was important because many hedge-fund management companies operate outside the Fifth Circuit, particularly in the Second Circuit, which includes New York and Connecticut; the Ninth Circuit, which includes California; and the Third Circuit, which includes Delaware. Consequently, the original Sirius decision did not alter the enforcement environment for most hedge-fund managers, who remained exposed to IRS challenges and unfavorable Tax Court precedent when relying on limited-partner status to avoid SE tax.

Even under the original Sirius ruling, planning based solely on limited-partner classification remained uncertain outside the Fifth Circuit. For management companies seeking a more durable approach to Medicare tax exposure, an S-corporation management structure continued to offer a more established and defensible solution without depending on unresolved statutory gaps in IRC §§1402 and 1411.

Original Blog post on Nov. 17, 2025: Executive Summary

The IRS has recently cracked down on hedge-fund, private-equity, and professional-service management companies that tried to use limited partner status to avoid the 3.8% Medicare-related tax on management-company profits. In several high-profile cases—including Soroban, Denham, and Castigliola—the Tax Court held that partners who actively manage the business are not “true” limited partners under §1402(a)(13) and therefore cannot use LP status to sidestep self-employment (SE) tax.

This white paper explains the structural gap in the tax code that created this issue, why management-company partners fall into the gray zone between SE tax and the Net Investment Income Tax (NIIT), and how the courts and IRS now apply a functional test that looks at what partners actually do, not what their partnership interest is called.

For fund managers, RIAs, and active partners in management companies, the takeaway is clear:
LP status alone does not shield active partners from SE tax, carried interest remains NIIT income, and S-Corporations are the only reliable structure for reducing Medicare taxes.

The paper also clarifies how these rules affect TTS traders, Section 475 income, and investor-level LPs.

White paper: In recent years, several hedge-fund, private equity, and professional service management companies attempted to use limited partner classifications to reduce or avoid the 3.8% Medicare-related tax on management company income. The IRS challenged these positions, and the Tax Court repeatedly ruled that active service partners were not “true” limited partners for purposes of the §1402(a)(13) self-employment (SE) tax exclusion.

This article explains how the statutory gap arose, why management company partners fall into it, how recent cases have resolved these disputes, and what today’s fund managers and traders should understand when structuring their entities.

Partnership tax rules can produce unexpected results when older definitions collide with modern fund structures. The idea of an “active limited partner” highlights this problem. Under IRC §1402(a)(13), a limited partner’s distributive share is generally not subject to self-employment (SE) tax.

At the same time, income from a business in which a taxpayer materially participates is not subject to the Net Investment Income Tax (NIIT) under IRC §1411. When a partner is legally designated as a limited partner but actively participates in the management company, these two rules conflict with the management company’s ordinary income being treated neither as SE income nor NIIT income.

Who This Affects

This issue directly applies to partners in management companies—hedge fund managers, RIAs, private equity sponsors, and professional service partnerships.
It applies less to sole-proprietor traders with TTS and Section 475, whose trading income is not SE income under long-standing IRS guidance. Trading gains are subject to NIIT.
Investors in hedge funds and private equity funds can benefit from this content, too.

Key Lessons

Active managers cannot rely on LP status to avoid SE tax.
Carried interest is always NIIT income—never SE income.
TTS/475 traders avoid SE tax but still owe NIIT.
S-Corporations are the only well-established way to reduce Medicare taxes.
IRS and Tax Court apply a substance-over-label “functional test.”

Primer on Self-Employment (SE) Tax

SE tax includes Social Security (12.4%) up to an inflation-adjusted wage base ($176,100 for 2025), and uncapped Medicare (2.9%) taxes, totaling 15.3% on net earnings from self-employment. For employees, there are similar payroll taxes: employees pay half of the Social Security and Medicare taxes, and employers pay the other half.

Two Paths for the 3.8% “Medicare” Tax

The 2010 Affordable Care Act (ACA) created two parallel mechanisms for imposing a 3.8 percent Medicare-related tax on investment income of high-income taxpayers:

The Self-Employment Medicare Tax (2.9% base + 0.9% Additional Medicare Tax = 3.8%) applies to net earnings from self-employment — active trade-or-business income under IRC § 1402.
The Net Investment Income Tax (NIIT) (3.8%) applies to unearned or passive income such as capital gains, Section 475 ordinary income for traders, interest, dividends, rents, and Schedule K-1 investment profits under IRC § 1411. NIIT also applies to passive activity income and loss from pass-through entities and investment and trading companies.
The NIIT is calculated on the lesser of net investment income (NII) or the amount your MAGI exceeds thresholds: $200,000 for singles, $250,000 for married filing jointly. These thresholds are not indexed for inflation.
Example: a single filer with $500,000 of net trading gains (NII) and MAGI of $600,000. The NIIT threshold for a single filer is $200,000.

Calculation: MAGI $600,000, NII $500,000, Threshold (Single): $200,000

Amount MAGI exceeds threshold: $600,000 − $200,000 = $400,000

The NIIT is owed on the lesser of:

•NII: $500,000, MAGI excess: $400,000

So, the taxable amount for NIIT is $400,000.

NIIT owed: $400,000 × 3.8% = $15,200.

Congress intended that no income should escape both Medicare taxes — a principle reflected in the legislative history of §§ 1402(a), 1411, and ACA regulations. In practice, however, the statutory definitions sometimes leave a gap for active limited partners.

Earned income should be subject to SE tax, and unearned income should be subject to NIIT. Understanding how Congress drew the line between earned and unearned income helps explain why the limited-partner exception exists.

The Limited-Partner Exception

IRC § 1402(a)(13) excludes a limited partner’s distributive share of partnership income (other than guaranteed payments for services) from net earnings from self-employment.

This rule — dating to the 1954 Code — was designed for passive investors in state-law limited partnerships. It assumes such partners do not materially participate in operations and therefore should not owe self-employment tax. The ACA’s NIIT was not started until 2013.

The “Active Limited Partner”

Modern hedge-fund and private-equity management companies, as well as law firms, blur this distinction. Many managers hold limited-partner (LP) interests for liability protection yet actively manage the business daily.

Partners who materially participate in the partnership’s business but hold only limited-partner interests under state law fall into a statutory gray area:

Under § 1402(a)(13), their distributive share is excluded from SE income because limited partners are not considered to earn SE income unless they receive guaranteed payments for services.
Under § 1411(b) and Treas. Reg. § 1.1411-4(g)(7)(i), non-passive participation income is excluded from NIIT, which was set up to catch passive activity pass-through and investment income.

This overlap can leave ordinary business income neither SE income nor passive activity NIIT income. I next discuss how hedge fund and private equity firms deal with this issue, as these were the types of companies that recently lost in tax court over it.

Management Company LP vs. Fund LP: Why the Distinction Matters

In all major cases involving the limited partner exclusion—Soroban, Denham, and Castigliola—the individuals claiming §1402(a)(13) exclusion were owners of the management company (Castigliola is a law firm), not passive investors in a hedge fund or private equity fund LP.

The management company is the entity that provides investment advisory, trading, or portfolio management. Its income—management fees, incentive allocations, and operational revenue (for the law firm)—derives from the partners’ active services.

By contrast, investor fund LPs hold pooled capital and generate investment returns, including capital gains, Section 475 trading income, dividends, interest, and Section 1256 gains.

These investor LPs are the intended beneficiaries of §1402(a)(13), which excludes passive investment income from SE tax. However, this fund LP income is subject to NIIT for the passive investors.

This distinction is critical: the §1402(a)(13) exclusion was designed for passive investor LPs, not partners in service‑providing management companies.

Courts consistently look to the partner’s functional role, not their state‑law label. When an individual materially participates in generating the partnership’s business income, the limited‑partner exclusion does not apply—even if their interest is titled as a limited‑partner interest under state law.

Treasury and IRS Awareness

The Treasury Department acknowledged this coordination problem in the preamble to the Final NIIT Regulations (T.D. 9644, 2013), promising future guidance to reconcile §§ 1402 and 1411. Over a decade later, no such guidance has been issued.

Chief Counsel Advice 201436049 and Proposed Reg. § 1.1402(a)-2 (62 Fed. Reg. 1702, January 13, 1997) both indicate that the term “limited partner” in §1402(a)(13) should be interpreted more narrowly than its state‑law label. These authorities emphasize evaluating what a partner actually does in the business, not just how their interest is titled.

However, neither source definitively resolves how the SE‑tax exclusion applies when a partner is legally a limited partner but materially participates in the partnership’s operations.

Cases such as Castigliola v. Commissioner, T.C. Memo 2017-62, reinforce this functional approach. In Castigliola, law firm partners who were legally designated as limited partners were nevertheless treated as engaged in a trade or business for SE tax purposes because they actively provided services and materially participated in the operations.

The decision makes clear that the substance of a partner’s activities, rather than the state‑law title attached to their interest, governs the application of the SE‑tax rules. Still, the broader issue remains unsettled because the Treasury has not issued comprehensive regulations coordinating §1402(a)(13) with the NIIT rules under §1411.

📊 Management Company vs. Fund LP — Structural Diagram

The management company is a service business. The fund LP is the investment vehicle.

Management Company (LP or LLC)
• Provides investment advisory + management services
• Earns management fees + incentive/performance allocations (carried-interest)
• Partners are service providers
• Income is business income (SE-tax analysis applies)
• Carried-interest in capital gains, Section 475 trading income, and portfolio income are subject to NIIT, not SE tax

⬇️ Manages ⬇️

Fund LP / Master Fund / Feeder Fund
• Pools investor capital
• Generates investment income (capital gains, interest, dividends)
• LPs are passive investors
• Income is investment income (NIIT applies)

📘 Case-Law Spotlight: How Courts Treat “Active Limited Partners” in Fund Managers

🟦 Soroban Capital Partners LP v. Commissioner (2024)

Soroban Capital Partners LP is the management company/RIA, not the hedge‑fund investment vehicle. It earns management fees and incentive allocations and manages multiple fund entities.
Individuals classified as limited partners of the management company were full-time investment professionals responsible for generating the firm’s advisory and management‑company income.
They claimed the §1402(a)(13) limited partner exclusion to avoid SE tax on their box one ordinary business income.
Tax Court held they were not limited partners “as such” under §1402(a)(13) because they were active service partners in the management company.
Their distributive shares of ordinary business income were subject to self-employment tax.
See “Sec. 1402(a)(13) and limited partnerships,” The Tax Adviser, March 1, 2024 (Beavers emphasizes a functional test—partners who are “limited in name only” do not qualify for the §1402(a)(13) exclusion).

🟦 Denham Capital Management LP v. Commissioner (2024)

Denham Capital Management LP is the management company, not the private‑equity fund vehicle. It serves as the General Partner (GP) and investment adviser to a family of sector-focused investment funds.
Partners labeled as limited partners were actively engaged in investment advisory, due diligence, portfolio management, and operational oversight.
IRS challenged the use of §1402(a)(13), arguing these partners were materially participating in a financial‑services business.
Tax Court applied Soroban, concluding these individuals were not limited partners “as such” because they were service partners in the management company.
Result: their distributive shares of management‑company ordinary income were included in net earnings from self-employment, even though the entity was organized as a Limited Partnership (LP).

Key Principle from Both Cases

A partner’s functional role and actual services, not their state‑law title, determine whether the §1402(a)(13) limited‑partner exclusion applies.

📘 Call-Out: “Limited in Name Only” — Functional Test Explained

Beavers (The Tax Adviser, March 2024) emphasizes that §1402(a)(13) must be applied using a functional test. A partner qualifies as a “limited partner” only if they are genuinely passive in the partnership’s operations.

If the partner provides services, manages operations, or materially participates in generating revenue, they are “limited in name only,” and the §1402(a)(13) exclusion does not apply. This principle aligns with the holdings in Soroban, Denham, and Castigliola, which all rejected limited partner labeling when the partners were active service providers.

📘 Call-Out: When a Fund Management Company Has Box One Income — TTS and Section 475 Only

Most hedge funds do not qualify for Trader Tax Status (TTS) because their trading activity does not rise to the level of an active trading business. Without TTS and a Section 475 election, gains remain capital gains reported in K-1 boxes 8–13, not box one ordinary business income/loss.

A hedge fund investment vehicle reports box one ordinary business income only if it:

Qualifies for TTS, and
Elects Section 475(f) mark-to-market (MTM) accounting. When a hedge fund uses Section 475 MTM accounting, its trading gains are ordinary income.

Section 475 trading gains are not earned income subject to SE tax; instead, they are unearned income subject to NIIT.

TTS trading business expenses in box 1 reduce SE income for purposes of SE tax. It’s quirky: TTS business expenses are treated as SEI, and Section 475 ordinary income and capital gains are NII.

IRS Tax Topic 429 states, “gains and losses from selling securities as a trader aren’t subject to self-employment tax.” Traders are not considered to be in the trade or business of providing services. Expert treatises make clear that traders with trader tax status, even when reporting ordinary income under Section 475 MTM, do not pay SE tax on that income, distinguishing them from dealers and other service businesses.

Section 475 ordinary income is subject to NIIT under §1411. A Section 475(f) election is available only to traders who qualify for TTS, and TTS, by definition, requires self-directed, active trading.

Even though TTS traders conduct an active business, the NIIT law explicitly treats trading in financial instruments as investment activity for NIIT purposes. Regardless of the taxpayer’s material participation in a TTS fund LP, TTS/475 income remains NIIT income.

In short, TTS/Section 475 income is always NIIT income because NIIT classifies trading in financial instruments as investment activity—even when the taxpayer is conducting an active trading business.

Carried Interest and the NIIT

Carried interest is a profit interest that allocates a portion of the fund’s investment gains to the managing partner. It is categorically different from:

Management company box one ordinary business income (the management fee), and

Carried interest income retains its underlying character at the fund level and is reported in K-1 boxes 8–13. These items include:

Long‑ and short-term capital gains,
Qualified dividends,
Interest income, and
Section 1256 contract gains or losses,

Under IRC §1411(c)(1)(A)(iii) and Treas. Reg. §1.1411‑4(a)(1)(iii), these categories of income are always included in net investment income (NII). This rule applies regardless of whether the partner is:

A limited partner or general partner,
Active or passive,
Involved in investment management or not.

Because carried interest flows from investment activity and not services, it is:

Always subject to the 3.8% NIIT, and
Never subject to SE tax.
It doesn’t work to claim an “active limited partnership”; it’s NII either way.

In the classic “2 and 20” compensation structure, the management company charges a 2% management fee. It receives a 20% incentive allocation (carried interest) of the fund’s investment income (usually based on new-high-net profits).

The IRS has periodically challenged carried interest as a disguised incentive fee, and some members of Congress have frequently proposed legislation to repeal or further limit carried-interest treatment. Understanding these dynamics is essential when analyzing how carried interest interacts with NIIT and SE tax.

The OBBBA did not change or extend the carried-interest rules created under the TCJA. The three-year holding period under IRC §1061 remains in place, and none of the proposed tightening measures made it into the final bill. As a result, carried interest continues to receive long-term capital gains treatment under the TCJA rules, and OBBBA leaves the existing regime unchanged for private-equity and fund managers.

Even active fund managers pay NIIT on carried interest. The only income potentially affected by the “active limited partner” issue is ordinary business income from the management company or General Partner entity.

Choice of Entity for Traders and Hedge Funds

Entity selection determines how a hedge fund manager’s compensation flows through the tax system.

Many hedge funds adopt a classic structure:

A fund LP or LLC that holds investor capital and generates portfolio gains; and
A GP/management company responsible for investment management and business operations.

Managers commonly participate in the fund in two separate capacities:

Through the GP entity, receiving management‑company income and performance allocations; and
Sometimes, as personal investors holding a limited‑partner interest in the LP. Many managers invest personal capital to demonstrate commitment to investors, although the amounts vary widely, and some managers do not invest personally at all.

When managers do invest personally, they may receive a separate investor K-1 reporting only investment results—capital gains, dividends, interest, and Section 1256 gains—never management fee income or carried interest allocations.

Separately, the GP/management company—whether an LLC taxed as a partnership or an S‑Corporation—issues its own K-1 to the manager for GP-level business income. This K-1 is distinct from and unrelated to any investor-level K-1.

(As always, legal entity selection involves governance and liability considerations. Managers should seek counsel experienced in fund law in their state of residence.)

📘 Call-Out: GP / S‑Corporation Election for Payroll‑Tax Optimization

Electing S‑Corporation status at the GP/management‑company level enables managers to:

Pay themselves reasonable compensation, subject to payroll taxes, and
Receive remaining S‑Corp profits free from Social Security and Medicare taxes.

For S-Corp management businesses, many practitioners use a 25–50% benchmark when evaluating reasonable compensation, but the IRS requires pay to reflect fair market value for services performed.

Remaining profits distributed as S‑Corp dividends are not subject to payroll tax, offering substantial savings compared to partnerships, where active limited partners face increasing scrutiny and SE tax exposure.

This widely accepted planning strategy allows owners to reduce Medicare taxes by receiving income in the form a distributions rather than wages. This method offers a clear, established, and IRS-tested approach to managing payroll‑tax exposure.

It’s a different matter for trading S-Corps eligible for TTS; they don’t have underlying earned income and therefore don’t need reasonable compensation. They use officer compensation to unlock health and retirement plan deductions.

The Bottom Line

Partner Type	SE Tax	NIIT	Notes
Passive limited partner	❌	✅	Investor LP portfolio income and capital gains are subject to NIIT
Active general partner	✅	❌	Business income is subject to SE tax
Active limited partner (stat. gap)	✅*	❌	*Disputed position under current law

See CCA 201436049 and T.D. 9644 (2013) for IRS and Treasury recognition of unresolved issues. Congressional or regulatory guidance is pending.

Guaranteed payments for services remain subject to SE tax regardless of partner status or participation level.

Outlook

Until Treasury finalizes regulations harmonizing §§ 1402 and 1411, high-income partners who actively manage funds yet hold limited-partner interests occupy a legally ambiguous zone. Practitioners should carefully evaluate both state-law entity status and material participation, as future guidance may reclassify such income for SE or NIIT purposes.

For hedge-fund managers, traders, and their advisors, the safest approach is to treat active management-company income as SE income. Using limited-partner status to avoid SE and NIIT remains risky under the current law.

Disclaimer:
This article is for educational discussion only and not individualized tax advice. It summarizes federal tax law as of 2025 and provides no assurance of outcome in any particular case. Consult your tax advisor about your own entity classification, self-employment exposure, and NIIT obligations.

Sources and Citations

1. Denham Capital Management LP v. Commissioner (T.C. Memo 2024-114)
Full opinion (PDF): https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2024/12/tc-memo-2024-114.pdf
KPMG summary: https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2025/01/tnf-kpmg-report-denham-january-2025.pdf

2. Soroban Capital Partners LP v. Commissioner (161 T.C. 310 (2023))
EisnerAmper overview: https://www.eisneramper.com/insights/tax/soroban-capital-case-1402-a-13-exclusion-1223/
Gibson Dunn analysis: https://www.gibsondunn.com/tax-court-determines-that-limited-partners-are-not-necessarily-exempt-from-self-employment-tax-limits-of-limited-partner-exception/

3. Castigliola v. Commissioner (T.C. Memo 2017-62)
Case summary (Current Federal Tax Developments): https://www.currentfederaltaxdevelopments.com/blog/2017/4/10/tax-court-rejects-limited-partner-claim-in-professional-service-firm

4. NIIT Final Regulations (T.D. 9644, 2013)
Federal Register summary: https://www.federalregister.gov/documents/2013/12/02/2013-28409/net-investment-income-tax

5. IRS Chief Counsel Advice 201436049
Primary source (IRS PDF): https://www.irs.gov/pub/irs-wd/201436049.pdf
Tax Adviser summary: https://www.thetaxadviser.com/issues/2015/jan/tax-clinic-08-jan-2015/

Traders: Good And Troubling News In Poppe Ruling

November 6, 2015 | By: Robert A. Green, CPA

Click to read Green’s post on Forbes

In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.

There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.

The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.

In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.

Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?

The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.

Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.

One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.

Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).

Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.

A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.

Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)

Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.

An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.

An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.

Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.

Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.

Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.

Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.

Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).

The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.

Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.

Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.

Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.

But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.

Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.

Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”

Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.

On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.

Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)

Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.

Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.

Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.

I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.

If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.

The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.

Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.

Bottom line
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.

For more information, check out T.C. Memo. 2015-205.

Darren Neuschwander CPA contributed to this blog post.

The Tax Court Was Right To Deny Endicott Trader Tax Status (Recording)

October 7, 2014 | By: Robert A. Green, CPA

Join CPAs Robert A. Green and Darren Neuschwander, Managing Members of Green NFH, LLC

Click here to read the related blog dated Aug. 30, 2013.

Description: In this Webinar, we review a Word file containing the actual tax court case. We read important sentences highlighted in yellow, and discuss several comments added by Green. All options traders and other traders who manage their investments and want to claim trader tax status need to watch this recording. We added this Word file as a PDF to Green’s Trader Tax Guide.