The U.S. Court of Appeals for the Fifth Circuit ruled that limited partners may qualify for an exception from self employment taxes based on their legal status as limited partners with limited liability, rejecting an IRS interpretation that tied the exception to whether a partner was a passive investor. The decision in Sirius Solutions, L.L.L.P. v. Commissioner addresses how Section 1402(a)(13) applies to partners in limited partnerships and reverses a Tax Court approach that used a functional test focused on day to day involvement.
At issue was whether a limited partner can exclude a distributive share of partnership income from self employment tax under Section 1402(a)(13). The IRS argued that only partners who function as passive investors qualify. The Fifth Circuit said the statute does not impose that requirement.
Judge Andrew Oldham, writing for the majority, said a limited partner is defined by limited liability under state law, citing dictionary definitions from the time Congress adopted the current provision in 1977.
What The Case Involved
Sirius Solutions is a business consulting firm organized as a limited liability limited partnership under Delaware law. For tax years 2014 through 2016, the partnership reported between $5.8 million and $7.2 million in ordinary business income, which it allocated to individual limited partners.
Sirius excluded those allocations from self employment tax and reported zero net earnings from self employment based on the Section 1402(a)(13) exclusion for limited partners. After an audit, the IRS issued notices treating the distributive shares as self employment income subject to Social Security and Medicare taxes at a combined 15.3% rate. Based on the income levels described in the record, the disputed tax was estimated at more than $900,000 per partner over the three year period.
The Tax Court ruled for the IRS in February 2024, relying on its decision in Soroban Capital Partners LP v. Commissioner. That case applied a functional analysis that focused on whether partners operated as passive investors rather than relying on state law limited partner status.
The Court’s Rejection Of Functional Analysis
The Fifth Circuit said the Tax Court’s approach was not supported by statutory text. The court reviewed dictionary definitions contemporaneous with the 1977 enactment and said those sources described limited partners primarily by limited liability for partnership debts rather than by a requirement to be passive.
The court also cited historical IRS guidance, including Form 1065 instructions dating to 1978 that described a limited partner as a person whose personal liability for partnership debts is limited to the amount contributed. The court said the instructions did not include an activity based test.
The panel also reviewed Social Security Administration regulations, noting the 1977 amendments addressed both employment taxes and benefits. The court cited SSA language stating a person is a limited partner if financial liability for partnership obligations is limited to the amount of the investment.
The Fifth Circuit said the IRS’s recent position differed from prior agency materials and that the shift supported its conclusion that the statute does not require passivity.
Statutory Text And The Meaning Of Section 1402(a)(13)
The court identified several points in the statute that it said were inconsistent with a passivity requirement.
First, Section 1402(a)(13) excludes a limited partner’s distributive share from self employment tax but does not exclude guaranteed payments for services described in Section 707(c). The court said that language indicates Congress anticipated that limited partners could provide services and still be treated as limited partners for purposes of the exclusion, with guaranteed payments remaining taxable.
Second, the court noted that Congress used explicit passivity concepts elsewhere in the Internal Revenue Code, including provisions addressing passive activity rules, but did not use similar language in Section 1402(a)(13).
Third, the court addressed the phrase “limited partner, as such,” which the Tax Court had used to support the functional analysis approach. The Fifth Circuit said the phrase clarifies treatment in situations where a person may have more than one role, and it does not create a separate requirement that a partner be passive.
The IRS argued that federal tax outcomes should not depend on state law labels. The Fifth Circuit said state law labels alone are not controlling, but it treated limited liability as a substantive legal characteristic that state law determines.
Impact On Partnerships And Pending Appeals
The Fifth Circuit has jurisdiction over Texas, Louisiana, and Mississippi. The ruling applies within those states unless modified by further appellate review.
Two related cases are pending in other circuits. The Second Circuit is considering the Soroban dispute, and the First Circuit is reviewing Denham Capital Management v. Commissioner. Both involve challenges to Tax Court decisions applying the functional analysis framework. Different outcomes could create a split among federal appeals courts.
The case record and commentary in the article noted that partnership income is concentrated in sectors including financial services and real estate. The article cited IRS Statistics of Income figures indicating partnerships reported $1.1 trillion in ordinary income in 2016 and that limited partners claimed about $300 billion in self employment exclusions. The article also cited that financial services and real estate account for about 60% of pass through business income, and that real estate partnerships represent about 25% of partnership returns.
Self Employment Tax Rates And Guaranteed Payments
Self employment taxes apply to Social Security and Medicare, including a combined 15.3% rate described as 12.4% for Social Security up to $176,100 in 2025 and 2.9% for Medicare, with an additional 0.9% Medicare tax for certain higher income taxpayers. The Fifth Circuit decision addressed the distributive share exclusion for limited partners. Guaranteed payments for services remain subject to self employment tax under the statute.
Next Procedural Steps In The Case
The Fifth Circuit remanded the case to the Tax Court for further proceedings consistent with its opinion.
A dissent by Judge James Graves said the majority’s reading would allow partners to avoid employment taxes on earnings from work. The majority’s decision and the dissent’s position were cited in the article as part of the ongoing debate that could continue in other circuits.
The IRS had not publicly announced whether it would seek further review or change enforcement practices in Fifth Circuit states at the time of the article.