Appeals courts reject hedge fund managers' limited-partner tax strategy

Treasury Secretary Bessent settled his own use of the strategy

Two federal appeals courts have backed the Internal Revenue Service in a long-running dispute over whether hedge fund managers who take limited-partner titles can avoid paying the 3.8% Medicare portion of the federal self-employment tax.

The 2nd U.S. Circuit Court of Appeals — whose jurisdiction includes New York, home to many large hedge funds — ruled in September that limited partners who run, manage, or control their businesses must pay the self-employment tax, regardless of their formal titles. The 5th Circuit reached the same conclusion in August, reversing an earlier panel decision that had sided with fund managers.

“The limited partner gambit,” said University of Baltimore law professor Walter Schwidetzky, “is dead.”

The rulings may still be appealed, but the consequences are already rippling through investment firms. Some with pending IRS cases — including New York Mets owner Steve Cohen — will likely have to pay more to the government for past years, according to the Journal. His firm, Point72, declined to comment. Others will likely begin adjusting their future payments.

The 2nd Circuit’s ruling against Soroban Capital Partners determined that the firm’s three main partners must pay more taxes on their $141.5 million in earnings from 2016 and 2017. Multiplied across many tax years and the hedge-fund and private-equity industries, government revenue could add up. “Hedge funds, PE structures, there’s a significant amount of earnings,” said Dianne Mehany of accounting firm EY, who advises high-net-worth clients. “And if you then classify them as net earnings from self-employment, even roughly 4% is quite a large amount for some people.”

Treasury Secretary Scott Bessent, who ran Key Square Group before joining the government, is among the fund managers who previously used the strategy. During his 2025 confirmation hearing, Bessent indicated he had used it while disputing Senate Democrats’ contention that he saved more than $900,000.

Bessent said then that he was keeping money in a reserve fund for potential tax liabilities and would respect the outcome of the court cases, which didn’t involve him or his firm. Senate Democrats pressed him in a recent letter, arguing that his wait-and-see approach had run its course because of the court rulings and asking him whether he has paid. Bessent settled the issue with the federal government this summer, according to a person familiar with the matter.

“You could think of it as a tax increase on the richest taxpayers in the country,” Schwidetzky said. “The IRS gets to book this one as a success. No question here.”

The settlements come during Bessent’s tenure overseeing the IRS, even as the government has continued to litigate against other fund managers in court.

An eight-year IRS campaign

The IRS announced its campaign against the tax-avoidance strategy in 2018, an effort that persisted across both Trump and Biden administrations. The Tax Court ruled for the IRS in the Soroban case in 2023. The 5th Circuit initially sided with fund managers earlier in 2026 before reversing itself in August. The 2nd Circuit’s decision followed in September. Another case is pending in the 1st Circuit, but lawyers do not expect that court to favor the funds, according to the Journal.

The dispute centers on a 1977 law that excludes limited partners from self-employment taxes. The rule was originally designed to prevent limited partners from paying into Social Security just to qualify for maximum benefits. But Congress’s 1993 decision to uncap the Medicare portion of the tax — which tops out at 3.8% and has no earnings ceiling, unlike the 12.4% Social Security portion that ends at $184,500 — made limited-partner avoidance substantially more valuable for high earners.

A possible opening for law and accounting firm partners

The appellate rulings could open a new avenue of tax planning for partners in law and accounting firms. Under the opinions, self-employment tax liability turns on whether a partner manages, runs, or controls a business — not on title or on whether the partner is technically active or passive.

Law firm partners who do not hold management roles and currently pay self-employment taxes may now argue they fall outside the new standard. Attorneys expect future disputes over what it means to run, manage, and control a business.

“We’re in no man’s land now,” Mehany said. “We have a standard that hasn’t been defined.”

Attorneys said arguments about a particular partner’s role are less likely to work in the typical hedge fund structure, where the firm is run by one or a few partners. Those people won’t have much recourse after the recent rulings.

“These were easy cases that came up and they were the principals running the business,” said Karen Burke, a tax law professor at the University of Florida.

Avoidance of the 3.8% self-employment tax has long been a cornerstone of high-income tax planning, though it has drawn less notice than carried interest, the practice by which fund managers pay capital-gains rates on performance fees.

S corporations and parallel investment-income tax

Wage-earners and self-employed people pay the Medicare tax, and a parallel 3.8% tax applies to investment income in high-income households, according to the Journal. Certain active business income can still escape both taxes. Some people — including former President Joe Biden and former House Speaker Newt Gingrich — use closely held S corporations to avoid the tax on some of their income.