The 5th U.S. Circuit Court of Appeals has withdrawn its January 2026 decision broadly construing the term “limited partner” for purposes of an exclusion from self-employment tax. (K Alain LLLP v. Commissioner of Internal Revenue, 2026 WL 2333930, 8/12/2026; substituting for Sirius Solutions LLLP v. Commissioner of Internal Revenue, 165 F.4th 374)
Dispute over meaning of ‘limited partner’
The Tax Code imposes a tax on self-employed individuals’ net earnings from self-employment, with the proceeds used to fund Social Security and Medicare. However, under IRC § 1402(a)(13) individual limited partners may exclude their distributive share of income from a partnership from their net earnings from self-employment.
The exclusion was put into place to prevent taxpayers from passively investing in partnerships to gain access to Social Security coverage. But recent litigation over § 1402(a)(13) has centered on whether individual partners are evading self-employment tax by relying on state “limited partner” designations — despite these taxpayers’ active role in a partnership.
In the now-withdrawn decision in Sirius Solutions, the 5th Circuit held that a “limited partner” is simply a partner in a limited partnership that possesses limited liability. The circuit court had rejected the Tax Court’s position, first set forth in Soroban Capital Partners LP, 161 T.C. 310, that the tax exception under IRC § 1402(a)(13) applies only for passive investors. The 5th Circuit also failed to take up the Tax Court’s “functional analysis test” to determine whether a partner had an active role or acted as a limited partner.
The government filed a petition for en banc review of the January decision, arguing that the 5th Circuit had improperly expanded the exclusion — threatening Social Security and Medicare funding and “upsetting Congress’s design.”
Meanwhile, cases involving the limited partner exclusion are pending in the 1st and 2nd circuits (Denham Capital Management v. Bessent, No. 25-1349; Soroban Capital Partners v. Commissioner, Nos. 25-2027, 25-2250), with oral arguments held earlier this year.
5th Circuit revisits limited partner definition
In an August 12 decision, the 5th Circuit denied the government’s petition for rehearing en banc. However, it also withdrew its January decision and issued a substitute decision narrowing the definition of limited partner, for purposes of § 1402(a)(13), to “a partner who plays no significant role in managing or running a business.”
The majority in the 2-1 decision, however, rejected the Tax Court’s even narrower definition in Soroban: that a limited partner under § 1402(a)(13) is a passive investor. “An informed reader of the English language in 1977 would have understood that a ‘limited partner’ could not manage the partnership … but perhaps could participate in certain non-managerial aspects of the business,” the 5th Circuit explained.
The court ruled that the “managerial/non-managerial distinction” is key when looking to legal sources that existed when Congress adopted the § 1402(a)(13) exception in the 1970s.
In addition, said the 5th Circuit, “the Soroban decision cannot be squared with decades of IRS-approved guidance insisting that what mattered was limited liability alone.”
Judge James Graves, who dissented in the January decision, once again disagreed with the majority. “‘[F]ederal courts’ have long defined a limited partner as a ‘passive investor,’ and that is consistent with the functional analysis test,” Graves wrote.
He characterized the majority decision as “improperly attempting to define ‘passive investor’ and taking issue with the application of a functional analysis test, while simultaneously essentially arguing that a functional analysis test allows for some level of participation.”
In Graves’ view, the majority’s decision provides “little clarity” and creates “an indefensible, illogical, and illegal loophole.”
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