New IRS Self-Employment Tax Risks for US Investors in Foreign Funds (2025 Update)

According to IRS data, less than 3% of limited partnership investors are subject to self-employment tax, and most US investors in foreign funds remain protected under existing exemptions. A recent Tax Court case (Soroban Capital Partners LP v. Commissioner) has created headlines, but the ruling primarily affects investors who work full-time managing their investment funds, not typical passive investors.

The bottom line: If you’re a passive investor who contributed capital to a foreign hedge fund, private equity partnership, or venture capital fund without taking on management responsibilities, you’re likely still protected from the 15.3% self-employment tax. The new “functional analysis test” looks at what you actually do, which means truly passive investors can breathe easier.

What changed: The May 2025 Soroban decision means US investors can no longer rely solely on the “limited partner” legal label for protection. The IRS now examines your actual role, but this primarily affects active managers, not passive capital contributors.

What Is the Soroban Case and Why Should I Care?

The Soroban Capital Partners LP v. Commissioner case involved hedge fund partners who were “limited partners” on paper but worked full-time managing the fund’s daily operations. These partners made investment decisions, managed client relationships, and were featured prominently in marketing materials as essential to the fund’s success.

The court’s decision: When someone works full-time for an investment fund and generates income through active management rather than passive investment, their distributions should be subject to self-employment tax.

Why this matters for you: The ruling clarifies that the IRS will look beyond legal labels to examine actual activities. However, if you’re genuinely a passive investor who contributed capital and receives returns based on that investment, the decision actually supports your position.

Key relief: The court specifically noted that truly passive investors with substantial capital contributions who don’t participate in management remain protected under the limited partner exemption.

Am I at Risk for Self-Employment Tax on My Foreign Fund Investments?

Most investors in foreign funds are not at risk. The functional analysis test focuses on several key factors:

Higher risk indicators (these describe active managers, not typical investors):

• Working full-time or substantial part-time for the partnership
• Having daily operational management responsibilities
• Making binding investment decisions for the fund
• Being featured in marketing materials as essential personnel
• Receiving compensation primarily through management fees rather than investment returns

Lower risk indicators (these describe typical passive investors):

• Contributing significant capital with a minimal management role
• Participating only in periodic advisory meetings
• Having no authority over daily operations
• Receiving returns that correlate with your capital investment
• Maintaining an arms-length relationship with fund management

The reality check: If you invested money in a foreign hedge fund or private equity partnership and receive quarterly statements showing your investment performance, you’re likely a passive investor who remains protected.

Do I Need to Worry About the Foreign Earned Income Exclusion?

This is where the news gets more complex, but there’s important context to remember. Self-employment tax cannot be reduced by the Foreign Earned Income Exclusion (FEIE), which allows expats to exclude up to $130,000 (2025 tax year) from regular income tax.

Here’s the key point: This limitation only matters if you’re actually subject to self-employment tax in the first place. Since most passive investors aren’t subject to this tax, the FEIE limitation doesn’t affect them.

If you are subject to self-employment tax: You might still owe $0 in regular income tax using FEIE or the Foreign Tax Credit, but you’d owe the 15.3% self-employment tax on the partnership income.

Example for context: A US expat in London with $200,000 in hedge fund distributions (if subject to self-employment tax) could owe $0 in regular income tax but $30,600 in self-employment tax.

What Foreign Fund Structures Are Affected by This Ruling?

The Soroban decision applies to US investors in popular offshore fund structures, but remember that your role matters more than the structure itself.

Commonly affected structures:

• Cayman Islands Exempted Limited Partnerships (most hedge funds)
• Luxembourg SCSp partnerships (private equity)
• British Virgin Islands limited partnerships
• Irish ICAV structures with partnership elements

What you should know: These structures remain perfectly legitimate for passive investors. The issue isn’t the structure itself but whether you’re actively managing the fund.

Practical guidance: If you received offering documents, made an investment, and now receive periodic statements, you’re likely using these structures appropriately as a passive investor.

What Are the Current 2025 Self-Employment Tax Rates?

For investors who are determined to be subject to self-employment tax:

• 12.4% Social Security tax on earnings up to $168,600
• 2.9% Medicare tax on all earnings
• 0.9% Additional Medicare Tax on earnings over $200,000 (individuals)
• Total rate: 15.3% for the most affected investors

What IRS Enforcement Should I Expect?

The IRS Large Business & International division has increased scrutiny of self-employment tax exemption claims, but they’re focusing on clear cases of active management.

What they’re looking for:

• Partnership tax returns showing significant management fees to “limited partners”
• Marketing materials describing limited partners as essential personnel
• Time records showing full-time work for investment partnerships
• Form 8865 filings indicating management roles

What this means for you: If you’re a genuine passive investor, increased IRS scrutiny actually helps clarify the rules in your favor. The enforcement targets active managers who were inappropriately claiming exemptions.

What Compliance Steps Should I Take Right Now?

For passive investors (most readers):

1. Verify your information returns are filed: Ensure Form 8865 and Form 8938 are current
2. Document your passive role: Keep investment agreements and account statements showing capital-based returns
3. Review time commitment: Ensure any fund involvement is limited to appropriate investor oversight

For active participants:

1. Assess your role honestly: Apply the functional analysis factors to your situation
2. Consider estimated tax adjustments: If you determine that self-employment tax applies
3. Evaluate restructuring options: Work with professionals to modify your role if needed

Timeline for action: These aren’t emergency steps. Take 30-60 days to review your situation systematically.

Are There Pending Legal Developments I Should Monitor?

Yes, but the trends are clarifying rather than creating more uncertainty:

• Current appeals: Denham Capital (1st Circuit) and Sirius Solutions (5th Circuit) involve similar issues and may reach the Supreme Court if circuits disagree.
• Expected IRS guidance: The IRS is likely to issue clearer standards for passive investor protections, which should provide more certainty.
• What this means: The legal landscape is moving toward clearer rules that better protect genuinely passive investors while targeting active managers who were gaming the system.

What Advanced Planning Should I Consider?

For most passive investors: Continue your current approach. The Soroban decision supports rather than threatens your position.

For more complex situations:

• Partnership agreement review: Ensure documents reflect your passive status
• Role documentation: Maintain clear records of investment vs. management activities
• Professional consultation: Consider specialized advice for significant investments or unclear situations

Sophisticated strategies like blocker corporations add complexity and should only be considered with comprehensive professional guidance, as they involve Controlled Foreign Corporation rules and extensive reporting requirements.

What Should I Do Next?

Step 1: Assess your situation (most readers will find they’re fine)

• Review your investment documents and account statements
• Consider whether you have any management role or just receive investment returns
• Ensure the required information returns are filed

Step 2: Take appropriate action

• If you’re clearly a passive investor: Continue your current approach and stay informed
• If you’re unsure about your role: Consider professional consultation for peace of mind
• If you’re actively managing: Work with qualified professionals to assess options

Step 3: Stay informed

• Monitor appeals court decisions and IRS guidance
• Review your situation if investment roles change
• Maintain proper documentation of your passive investor status

The bottom line for your peace of mind

The Soroban decision clarifies rules that help rather than hurt genuinely passive investors. If you invested capital in foreign funds and receive returns based on that investment without managing daily operations, you’re likely still protected from self-employment tax.

What you can feel confident about:

• Passive investors remain protected under existing exemptions
• The ruling targets active managers, not capital contributors
• Proper documentation supports your position
• Professional guidance is available for complex situations

Remember: This ruling doesn’t eliminate investment opportunities or create widespread new tax liabilities. It clarifies existing rules to ensure that people who work full-time managing investment funds pay employment taxes, while preserving protections for genuine investors.

If you’re feeling overwhelmed by these developments or want confirmation about your specific situation, qualified professionals can provide the clarity and peace of mind you’re looking for.

Related Resources:

• Foreign Tax Credit Guide for reducing regular income tax
• Form 8865 Requirements for foreign partnership reporting
• Foreign Earned Income Exclusion for expat tax benefits

Have questions about the process or next steps? Contact us, and one of our Customer Champions will happily address all your concerns.

This analysis reflects current law and court decisions as of July 2025. Tax situations vary significantly, so consult with qualified professionals familiar with international partnership taxation for advice specific to your circumstances.