The U.S. Court of Appeals for the Fifth Circuit ruled January 16 that limited partners in state-law limited partnerships qualify for a self-employment tax exemption based solely on their limited liability status, rejecting the IRS’s requirement that partners must be passive investors. The decision in Sirius Solutions LLLP v. Commissioner creates a direct split with recent Tax Court rulings and provides immediate tax relief for fund managers and business owners in Texas, Louisiana, and Mississippi.
The ruling potentially saves qualifying limited partners 15.3 percent in self-employment taxes on their distributive shares, plus an additional 0.9 percent Medicare tax for high earners. For Sirius Solutions, a Houston-based consulting firm, the decision resolved a dispute over more than $5 million in income the IRS attempted to reclassify as taxable self-employment earnings.
The Statutory Interpretation Dispute
Section 1402(a)(13) of the tax code, enacted in 1977, contains what practitioners call the “limited partner exception” to self-employment tax. The provision excludes certain partnership income allocated to limited partners from the Self-Employment Contributions Act tax.
For over 40 years, both the IRS and Social Security Administration interpreted this provision to mean that any partner with limited liability under state law qualified for the exemption. That changed in 2022, when the IRS began arguing that only passive limited partners who don’t materially participate in partnership business can claim the exception.
The Fifth Circuit flatly rejected this new interpretation. “A ‘limited partner’ is a partner in a limited partnership that has limited liability,” Judge Oldham wrote for the majority. The court emphasized that dictionaries from 1977 defined “limited partner” based on liability rather than activity levels.
The court pointed to a critical flaw in the IRS’s reasoning. The statute already imposes self-employment tax on “guaranteed payments” that limited partners receive for services. If Congress intended to exclude all active limited partners from the exemption, this guaranteed payments clause would be unnecessary.
“The text of the exception itself contemplates that ‘limited partners’ would provide actual services to the partnership and thus participate in partnership affairs,” the court wrote. “So a strict passive-investor interpretation would make the ‘guaranteed payments’ clause entirely superfluous.”
Tax Court Precedent Overturned
The Fifth Circuit’s decision directly contradicts two recent Tax Court rulings that sided with the IRS.
In Soroban Capital Partners LP v. Commissioner, decided in 2023, the Tax Court adopted a “functional analysis” test requiring courts to examine whether limited partners actually participated in partnership activities. The Tax Court followed this approach in late 2024 with Denham Capital Management LP, again ruling that active limited partners cannot claim the exemption.
The Fifth Circuit dismantled this functional test on multiple grounds. The court noted that modern limited partnership laws allow limited partners to participate in control without losing liability protection, and this doesn’t change their federal tax status under the plain statutory language.
The court also highlighted the IRS’s own historical interpretation. From the 1970s until 2022, the agency consistently applied the limited partner exception without requiring passivity as a condition.
What This Means for Taxpayers
For taxpayers in the Fifth Circuit currently facing self-employment tax audits or settlement negotiations, the IRS’s leverage has been significantly undermined. Limited partners can now claim the exemption based solely on their state-law limited liability status.
However, several important limitations apply. Guaranteed payments for services remain subject to self-employment tax, as do distributions related to general partner interests. The decision specifically addressed limited liability limited partnerships and does not extend to members of LLCs or limited liability partnerships.
State-law nomenclature alone won’t suffice. Partners must maintain actual limited liability under state law. If a limited partner loses limited liability status for specific state law reasons, the self-employment tax exclusion could be lost as well.
For taxpayers who have already entered into final closing agreements or settlements with the IRS regarding self-employment taxes, the Sirius decision generally does not provide grounds to reopen those agreements and seek refunds.
Taxpayers outside the Fifth Circuit face continued uncertainty. Under the “Golsen rule,” the Tax Court is not bound by the Fifth Circuit’s decision for taxpayers in other jurisdictions. Those in New York, Connecticut, and Massachusetts may still face the more restrictive “passive investor” test until their respective appellate courts weigh in.
Appeals Pending in Other Circuits
The Denham case is currently on appeal to the First Circuit, with oral arguments scheduled for February 5. The Soroban case is under appeal to the Second Circuit. If these circuits uphold the Tax Court’s functional analysis approach, a clear circuit split will emerge.
Such a split could prompt Supreme Court intervention to resolve the conflicting interpretations. The IRS has until March 3 to petition for a rehearing en banc in the Fifth Circuit, though legal observers don’t expect the court to grant one.
For business owners and fund managers, the decision creates immediate planning opportunities in the Fifth Circuit while leaving substantial uncertainty elsewhere. Those structuring new management businesses should consider using state-law limited partnerships to align with the Sirius facts.
Existing LLCs or limited liability partnerships may want to evaluate whether converting to a limited partnership makes sense. Legal advisors recommend meaningfully changing operational aspects of any new limited partnership compared to the predecessor entity to further support the “limited partner” position post-restructuring.
Taxpayers who previously paid self-employment tax on limited partner distributions should promptly determine how much time remains to claim a refund from the IRS, then evaluate whether the Sirius decision supports a refund claim in their particular circumstances.
The February 5 oral arguments in Denham will provide the next major indicator of whether other circuits will follow the Fifth Circuit’s lead. Depending on the materiality of their self-employment tax position and ongoing developments in the Denham and Soroban appeals, some taxpayers may want to file returns under the current landscape before additional cases are decided.