Hedge fund managers face a significant change to a longstanding tax-planning strategy after recent US appeals court rulings backed the Internal Revenue Service’s position that active limited partners can be liable for the 3.8% federal self-employment tax, according to a report by the Wall Street Journal.

The issue centres on a provision dating back to 1977 that has generally excluded limited partners from self-employment tax. Fund managers have argued that the exemption can apply even when partners play an active role in running their investment businesses, potentially reducing their tax bills by millions of dollars over multiple years.

Two recent federal appeals court decisions have challenged that interpretation. The US Court of Appeals for the Second Circuit ruled in September in the case of Soroban Capital Partners that the self-employment tax can apply to limited partners who actively manage or control their businesses. The decision followed a separate ruling by the Fifth Circuit in August supporting the government's position.

The Second Circuit's decision is particularly relevant to the hedge fund industry because its jurisdiction includes New York, home to a large concentration of alternative investment managers. The court's ruling involved three Soroban partners and more than $141m of earnings from 2016 and 2017.

The decisions could have implications for other fund managers with open disputes or tax years under review. New York Mets owner and Point72 founder Steve Cohen is among those whose firm has faced an IRS case relating to the issue, according to the Wall Street Journal. Point72 reportedly declined to comment.

The developments also have implications for Treasury Secretary Scott Bessent, who previously ran hedge fund Key Square Group. Bessent acknowledged during his 2025 confirmation process that he had used the limited-partner approach while disputing claims about the amount of tax involved. He said at the time that he had set aside money to cover a potential liability and would abide by the outcome of the relevant court cases. Bessent subsequently settled his self-employment tax issue with the federal government this summer, according to a person familiar with the matter.

For hedge fund and private equity executives, the financial impact can be material because the Medicare component of the self-employment tax is not subject to the same earnings cap as the Social Security portion. The tax can therefore apply to substantial amounts of income at the upper end of the earnings scale.

The IRS began a formal campaign challenging the strategy in 2018, with the issue continuing through multiple administrations. The Tax Court ruled in favour of the government in the Soroban case in 2023 before the litigation progressed through the appeals courts. The Fifth Circuit initially ruled against the government's position before reversing course in August, followed by the Second Circuit's September decision. Another case remains pending before the First Circuit.