The 5th U.S. Circuit Court of Appeals ruled that the definition of “limited partner” for federal self-employment tax exemption purposes is determined by limited liability under state law, rejecting the Tax Court’s interpretation that requires the partner to be a passive investor. (Sirius Solutions, L.L.L.P. , 2026 WL 125600, 1/16/2026)
Self-Employment Tax Exclusion Challenged
The Internal Revenue Code imposes Social Security and Medicare taxes on an individual’s earnings, whether they are employed by another or self-employed. However, the Code excludes from these Self-Employed Contributions Act (SECA) taxes a limited partner’s distributive share of income, other than guaranteed payments made to the partner for services actually rendered to or on behalf of the partnership.
Sirius Solutions, a limited liability limited partnership operating as a business-consulting firm, excluded its limited partners’ distributive shares of partnership income from its calculation of net earnings from self-employment for the 2014, 2015, and 2016 tax years. It relied on the limited partner exception under IRC § 1402(a)(13).
The IRS audited Sirius’ returns and determined that the exception did not apply. It asserted that none of Sirius’ limited partners qualified as “limited partners” for statutory purposes, as they were not passive investors. The Tax Court upheld the IRS’ adjustments, relying on its prior decision in Soroban Capital Partners LP, 161 T.C. 310 (2023).
In Soroban, the Tax Court had held that the term “limited partners” in § 1402(a)(13) refers only to passive investors, and that a functional analysis test was required to determine if a partner functioned as a limited partner. The Tax Court’s reasoning in Soroban was that the “as such” modifier in the statute indicated Congress’ intent to narrow the scope of the exception to those who actually functioned as limited partners and were passive investors.
Fifth Circuit Rejects Tax Court Interpretation of ‘Limited Partner’
However, in a January 16 decision in Sirius Solutions, the 5th Circuit rejected the IRS’ and Tax Court’s interpretation of “limited partner” in IRC § 1402(a)(13). Instead, the appeals court held that a “limited partner” is simply a partner in a limited partnership that possesses limited liability.
According to the 5th Circuit, this interpretation is supported by textual analysis. The ordinary meaning of “limited partner” at the time of the statute’s 1977 enactment consistently referred to limited liability, while dictionaries from that era defined a limited partner primarily by their limited liability for partnership debts.
In addition, both the Social Security Administration (SSA) and the IRS consistently interpreted “limited partner” as a partner with limited liability in their contemporaneous guidance and instructions following the 1977 amendments. And a 1980 SSA regulation explicitly states that a “limited partner” is one whose financial liability for partnership obligations is limited to their investment. IRS Form 1065 instructions from 1978 and subsequent years also defined “limited partner” based on limited liability.
The 5th Circuit also clarified that the phrase “as such” in § 1402(a)(13) does not restrict the class of limited partners to passive investors. Instead, it serves to clarify how individuals who hold both limited and general partner statuses should be taxed, ensuring that their distributive share is excluded when functioning as a limited partner, but included when functioning as a general partner.
The 5th Circuit rejected the lower court’s “passive investor” interpretation, explaining that this would render the “guaranteed payments” clause in § 1402(a)(13) largely superfluous, as it contemplates that limited partners might provide services to the partnership. It also noted that if Congress had intended to exclude only passive investors, it could have used terms like “passive investor” as it did in other sections of the Tax Code. In addition, it concluded that the IRS’ functional analysis test creates uncertainty for taxpayers, requiring an “infinite number of factors” to determine tax liability. And it emphasized that its interpretation is based on substantive interests created under state law.
Implications for Taxpayers
“This decision will have far reaching implications across industries – particularly for partnerships whose structures rely on state law limited partner classifications,” said Holland & Knight’s Lee Meyercord, who along with Mary McNulty, represented Sirius Solutions. “Limited partners in the Fifth Circuit who previously paid self-employment tax should consider potential refund claims if the statute of limitations is open,” Meyercord told Checkpoint.
However, Meyercord noted that cases are pending in two other circuits on the meaning of “limited partner” for purposes of the self-employment tax exemption. That includes an appeal of the Tax Court’s decision in Soroban Capital in the 2nd Circuit and in Denham Capital, T.C. Memo. 2024-114, in the 1st Circuit. “If either of those circuits adopt a passive investor test, there would be a circuit split and the Supreme Court could eventually resolve the question,” said Meyercord.
Those two cases delved more into the “functional test,” Meyercord explained during a January 8 D.C. Bar panel. Sirius Solutions, however, stipulated that if a functional test applies, the partners would not prevail, she added. This stipulation teed up a discrete legal issue, allowing Sirius Solutions to be the first of the three cases to be briefed and argued at the appellate level.
The 5th Circuit’s decision came almost a year after oral arguments – and was accompanied by a lengthy dissent. But Meyercord had said during the D.C. Bar panel that “taxpayers would really like the 5th Circuit to decide before any other circuit.”
However, the NYU Tax Law Center’s Miles Johnson called on other courts to “resist the Fifth Circuit’s interpretation” which he said, “takes an overly formalistic reading of the statute and would effectively allow wealthy taxpayers to elect out of paying employment taxes on labor income.”
In addition, Johnson noted that the 5th Circuit’s decision “hinges on state-law limited partnership status and does not allow members of LLCs and other types of entities to avoid SECA taxes on their distributive share.” For this reason, taxpayers, even within the 5th Circuit, “should not take the Sirius holding too far,” he cautioned.
Johnson added that the Sirius Solutions decision “underscores the need for legislation to clarify the scope of the SECA ‘limited partner’ exception and to resolve other key gaps and inconsistencies in employment taxes on active business income.”
For more information on the rules governing self-employment tax for partners, see Checkpoint’s Federal Tax Coordinator 2d ¶ A-6151.
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