With the 5th U.S. Court of Appeals ruling that a federal self-employment tax exception hinges on a partner’s limited liability status under state law, not their limited level of participation, a tax professional shared his takeaways.
Fifth Circuit Overturns Tax Court
On January 16, the 5th Circuit issued a long-awaited decision in Sirius Solutions, L.L.L.P. v. Commissioner (2026 WL 125600, 1/16/2026). The decision overturns the Tax Court and rejects the IRS’ test for determining whether a partner is a “limited partner” for purposes of the exception to self-employment tax under IRC § 1402(a)(13).
The IRS had advanced a functional analysis test that required looking at a partner’s level of participation in the business to determine whether they were a “limited partner.” The agency contended that the § 1402(a)(13) exception only applied where partners are passive investors, regardless of their official designation under state law. The Tax Court, following its own precedent in Soroban Capital Partners LP v. Commissioner (161 T.C. 310 (2023)), sided with the IRS.
But the 5th Circuit, in its recent decision, disagreed. It held that “a ‘limited partner’ is a partner in a limited partnership that has limited liability.”
A ‘Wait and See’ Approach
Grant Thornton’s Joe Pacello said the decision is a win for taxpayers like Sirius Solutions and its partners, but may not have immediate impacts. Pacello, who works with clients in the asset management industry, said he doesn’t expect to see structuring changes just yet.
He noted that appeals of similar Tax Court rulings are pending in the 1st Circuit (Denham Capital, T.C. Memo. 2024-114) and 2nd Circuit (Soroban), and a circuit split is “quite possible.” Until those cases are decided, the area remains “a bit unsettled,” Pacello told Checkpoint.
The IRS is still holding firm on its position, as evidenced by a January 27 letter in Denham Capital. IRS counsel argues that the 5th Circuit decision “misses the mark” and that the court “ignored numerous authorities showing that lack of control was a hallmark of being a limited partner” when § 1402(a)(13) was passed into law. The letter also contends the 5th Circuit ignored Congress’ rationale for the provision – “to address the problem that limited partners, who were passive investors, were using the distributive shares of partnership income to qualify for social security.” Congress intended those benefits for workers providing services, the letter explains.
“I think many in the industry will be in sort of a wait-and-see mode until this all plays out,” said Pacello. That holds true for “fund managers that were contemplating converting into or out of a limited partnership structure,” he explained.
He noted that until the 5th Circuit’s decision, the “momentum” was in the other direction – the Tax Court had sided with the IRS and supported its functional analysis test. For that reason, Pacello said, some fund managers were looking at potentially converting from limited partnership structures to S corporation or other structures.
The 5th Circuit’s decision will likely give fund managers who were considering converting out of limited partnership structures “reason to pause those efforts,” said Pacello. However, he also does not expect that “fund managers are going to be rushing to convert management companies into limited partnership structures.”
Practitioners Weighing Refund Claims
For partnerships within the 5th Circuit’s jurisdiction of Louisiana, Mississippi, and Texas, the ruling provides a basis for excluding limited partner income from self-employment tax, said Pacello. But he noted that even fund managers outside the 5th Circuit may view the decision as “substantial authority” and pursue refund claims.
“We’re now having conversations with our clients about the impacts inside the 5th Circuit and outside as well,” said Pacello. For those outside the 5th Circuit, he said “it’s definitely a little early” to be seeking refunds. He expects it will six months to a year before we see circuit court decisions in Soroban and Denham Capital – and then, if there’s a circuit split, the Supreme Court may weigh in.
But Pacello suggests that given the 5th Circuit’s ruling, “at a minimum, taxpayers and fund managers in other circuits should reassess the strength of their position.”
Pacello also cautioned that seeking refunds can be procedurally complex. If the partnership has already issued a Schedule K-1 treating the income as subject to self-employment tax, an individual limited partner wanting to claim a refund might need to take an “inconsistent position” on their own 1040 tax return. By doing so, they can “expedite” the process, rather than waiting for the partnership to go through the amendment process, he explained.
Ruling’s Scope
The 5th Circuit’s ruling also is narrowly focused on the status of limited partnership members, according to Pacello. He highlighted a footnote in the decision where the court clarifies, “we do not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception.”
The “expectation” is that the ruling applies to limited partnerships, Pacello stressed. “I don’t think the court anticipates that this will go beyond limited partnerships at this stage.” And there’s caselaw addressing other entity types, like LLPs, he added.
But that could still have wide-ranging impacts for his clients. Pacello said that in the asset management industry, “many fund managers form their investment management companies as Delaware limited partnerships.”
Take your tax and accounting research to the next level with Checkpoint Edge and CoCounsel. Get instant access to AI-assisted research, expert-approved answers, and cutting-edge tools like Advisory Maps and State Charts. Try it today and transform the way you work! Subscribe now and discover a smarter way to find answers.
