Hedge-fund managers are facing the end of a long-used strategy to avoid a 3.8% federal self-employment tax after recent court decisions upheld the Internal Revenue Service’s interpretation of the tax law. This development follows an eight-year effort by the IRS to broaden the application of the tax to investment fund partners who are actively involved in managing their businesses.

Traditionally, fund managers cited a 1977 law that exempted limited partners from self-employment taxes, including the Medicare surtax portion. Those classified as limited partners were not required to pay the 3.8% tax, a significant saving for individuals earning tens of millions annually. However, recent rulings from the U.S. Courts of Appeals for the Second and Fifth Circuits have rejected this narrow interpretation. Both courts determined that partners who run, manage, or control their partnerships’ operations are subject to the self-employment tax, regardless of their formal titles.

The Second Circuit’s September ruling is particularly notable because it covers New York, home to many hedge funds. This decision ruled that limited partners actively involved in their firms’ management must pay the tax. University of Baltimore law professor Walter Schwidetzky summed up the impact by saying the limited-partner exemption strategy “is dead.”

The implications of these rulings are already reverberating across the investment management industry. Several hedge-fund firms with ongoing IRS disputes, including Point72, owned by New York Mets proprietor Steve Cohen, may face additional tax bills for prior years. Cohen’s firm declined to comment. Going forward, many fund managers are expected to adjust their tax approaches to comply with the court decisions.

Among those affected is Treasury Secretary Scott Bessent, who managed Key Square Group prior to joining the government. During his 2025 confirmation hearing, Bessent acknowledged having used the limited-partner strategy, while stating he was reserving funds for any potential tax liabilities and would abide by court outcomes. Following recent court decisions, Senate Democrats pressed Bessent for clarification on his tax status. According to an individual familiar with the matter, Bessent settled outstanding issues with the government earlier this year.

Throughout Bessent’s tenure, the IRS continued its legal challenges against hedge-fund tax avoidance. For example, the Second Circuit ruled against Soroban Capital Partners, requiring its key partners to pay taxes on $141.5 million of earnings from 2016 and 2017.

Tax experts note that expanding the self-employment tax to a broader set of investment income could generate substantial government revenue given the size of earnings in hedge funds and private equity. Dianne Mehany, an accountant with EY who advises wealthy clients, said even about 4% tax on large earnings is significant.

Interestingly, the court opinions may create new nuances for other professional partnerships, such as law and accounting firms. The rulings emphasize actual management and control over formal titles in determining tax liability. This could open the door for certain partners without managerial roles to argue for exemption from self-employment taxes, a departure from current practice.

Legal analysts anticipate ongoing debate over what constitutes “managing, running or controlling” a business, though for hedge funds, where a handful of partners usually oversee operations, these arguments may yield limited relief.

While less publicly debated than carried interest tax issues, this self-employment tax avoidance had been a key pillar of high-income tax planning among investment managers. Unlike the Social Security tax, which caps at $184,500 in earnings, the Medicare surtax is uncapped. Wage earners and self-employed individuals pay the Medicare tax, and investment income in affluent households is also subject to a related 3.8% tax. However, certain active business income has escaped these levies, and some taxpayers have used structures like closely held S corporations to minimize exposure.

The recent court decisions mark a significant shift in the tax treatment of hedge-fund partners, signaling increased government scrutiny and potential revenue gains from one of the financial industry’s longstanding tax strategies.