Fifth Circuit Rejects ‘Passive Investor’ Test for Limited Partner Exception to Self-Employment Tax

On January 16, 2026, the US Court of Appeals for the Fifth Circuit became the first federal appellate court to interpret the “limited partner” exception from self-employment tax under Section 1402(a)(13) of the Internal Revenue Code. In Sirius Solutions L.L.L.P. v. Commissioner, the court held that a partner in a state law limited partnership qualifies for the exception if the partner is legally a limited partner—that is, a partner with limited liability under the state law governing the partnership—regardless of the degree to which the partner participated in the partnership business.

The court’s decision (which vacated a contrary holding of the US Tax Court) is a welcome development for taxpayers that have relied on the limited partner exception, including asset managers and professionals operating in the asset management, financial services, private equity, hedge fund, and real estate industries. 

The Fifth Circuit rejected the approach of the Tax Court in Soroban Capital Partners LP v. Commissioner, on which the Tax Court had relied in deciding Sirius and another intervening case.

The Court of Appeals instead interpreted Section 1402(a)(13) based on the contemporaneous meaning of the phrase “limited partner” when Congress enacted the exception in 1977 as well as how that term had been interpreted by the relevant federal agencies for more than four decades before the Internal Revenue Service adopted the position it advanced in Soroban Capital. The opinion is not only a substantive rejection of the Tax Court’s functional test, but also a reminder that, even after Loper Bright, longstanding administrative practice continues to play a meaningful role in statutory interpretation.

For private funds, asset managers, real estate and investment professionals, and other operating enterprises in limited partnership form, this decision improves clarity and predictability by making the availability of this exception from self-employment tax turn on an objective, ascertainable status—as a limited partner—that has independent legal significance rather than on an assessment of how active a partner is in the partnership’s day-to-day operations that is fact-intensive and may be second-guessed.

The strength of the reasoning in Sirius makes it relevant even outside the Fifth Circuit (where it is precedential). The decision has immediate implications for the formation of private fund sponsor businesses, governance practices, audit strategy, and litigation posture.

BACKGROUND

Section 1402(a)(13) provides that a limited partner’s distributive share of partnership income (except for guaranteed payments received for services to the partnership) is excluded from “net earnings from self-employment.” Historically, many asset management businesses structured as state law limited partnerships have relied on this provision to exclude limited partners’ distributive shares from self-employment tax.

In recent years, however, the IRS had advanced a narrower interpretation of the statute, arguing that the exception applies only to partners who are passive investors. Under this view, whether a partner is a “limited partner” for purposes of Section 1402(a)(13) depends on an analysis of that partner’s roles, responsibilities, and level of participation in the partnership’s business to determine whether the partner is functioning as a limited partner (the so-called “functional analysis” test).

The Tax Court endorsed the functional analysis test in Soroban (which we discussed in a prior Lawflash) and subsequently applied it in Denham Capital Management LP v. Commissioner.[1] Those cases created uncertainty for private funds, investment management companies, and other taxpayers. Assessing a partner’s manner and degree of participation in partnership operations can involve an unlimited range of facts and the relative significance of each of those facts is unclear, leaving a taxpayer’s reporting open to second guessing.

In Sirius, the Fifth Circuit squarely rejected that framework.

THE FIFTH CIRCUIT’S HOLDING

In vacating the Tax Court’s decision, the Fifth Circuit held that, for purposes of Section 1402(a)(13), whether a partner in a state law limited partnership is a “limited partner” depends only on whether that partner has limited liability under the relevant state law, not on the partner’s level of participation in the partnership’s business or a fact-intensive inquiry into the partner’s activities. 

The court explained that the ordinary meaning of “limited partner” in 1977 (when Section 1402(a)(13) was enacted) was a partner whose liability is limited under state law. Contemporary dictionary definitions uniformly tied limited partner status to limited liability and only incidentally made reference to passivity or lack of involvement.

The Fifth Circuit also considered the context in which Section 1402(a)(13) uses the term “limited partner,” emphasizing that the statute says nothing about any functional or activity-based test and that, by providing for the treatment of guaranteed payments received by a limited partner for services provided to the partnership, the statute expressly contemplates that a limited partner may participate in partnership activities.

Finally, the court observed that other tax law provisions focused on passive income (such as the limitation on passive activity losses, PFIC rules, tax on excess passive income of S corporations, and others) explicitly use the term “passive” rather than imparting the concept by implication.

The Court of Appeals noted that in Soroban the Tax Court had advanced only one argument based in the text of Section 1402(a)(13): that the phrase “limited partner, as such” narrows the exception to partners who are passive investors in a partnership. The court found that argument unpersuasive, first, because the words “as such” make no reference to a partner’s level of participation in partnership activities and, second, because there was another, more natural reading of those words. Because the same person can be both a general partner and a limited partner in the same partnership, the words “as such” clarify that the exclusion applies only to the income allocated to such a partner in their capacity as limited partner, as opposed to income allocated to them in their capacity as general partner.

A central feature of the opinion is the Fifth Circuit’s reliance on decades of administrative practice. The court gave significant weight to the fact that for more than 40 years (prior to 2022) the IRS defined “limited partner” in its partnership tax return instructions by reference to limited liability and consistently instructed partnerships to include only guaranteed payments for services in the self-employment income reported to a limited partner.

The court also relied on longstanding Social Security Administration regulations that adopted the same definition in interpreting the parallel exclusion of income allocated to limited partners in the calculation of Social Security benefits, which was enacted in tandem with Section 1402(a)(13). This consistent administrative interpretation reinforced the court’s conclusion that limited liability, not passivity, is the defining characteristic of limited partner status under Section 1402(a)(13).

Finally, the court held that because the Tax Court’s decision rested entirely on an erroneous functional analysis, the decision had to be vacated and the case remanded for further proceedings under the correct legal standard. Under that standard, the relevant inquiry is whether the partners at issue were limited partners under state law and enjoyed limited liability, not whether their activities were more akin to those of passive investors or active service providers.

MOVING FROM A TEST OF CONDUCT TO AN ANALYSIS OF LEGAL STATUS

The court was openly skeptical of an approach that would require “an army of lawyers and accountants—and a whole lot of luck” for limited partners to understand their self-employment tax obligations. By adopting an interpretation focused on the limited liability afforded to a partner under state law rather than on the partner’s role in partnership activities, the court created a more administrable and predictable framework for applying the limited partner exception. The court’s framework does not eliminate the need for analysis of a partner’s status, but it redirects that analysis away from partner activity and toward legal status.

At the same time, the court was equally clear that its interpretation does not turn on mere labels or nomenclature. A person who has unlimited liability or who does not hold an interest in a partnership is not a “limited partner” for purposes of Section 1402(a)(13) simply because state law calls them one, nor does a state’s use of different terminology to refer to a partner with limited liability prevent them from applying the limited partner exception.  

The court also noted that, under its interpretation, a partner whose participation in partnership activities or management was extensive enough that under state law the partner incurred unlimited liability for the partnership’s debts would no longer be a “limited partner.” 

This focus on substance may also have implications beyond traditional limited partnerships.  Many private funds and management businesses operate through entities other than limited partnerships, such as limited liability companies. While the court in Sirius did not address the question of whether another type of entity can qualify as a “limited partnership” under Section 1402(a)(13), its reasoning reinforces the broader principle that federal tax law looks to the substantive rights and protections created under state law, not labels alone.

WHAT’S NEXT?

Because the Tax Court’s decision rested entirely on a legal standard that the Fifth Circuit rejected, the case must now return to the Tax Court for further proceedings under the correct framework, as determined by the Fifth Circuit.[2] On remand, the Tax Court must focus on whether the partners in Sirius were in fact limited partners under applicable state law rather than whether they were sufficiently passive in their activities.

This consideration could include an evaluation of the partnership’s governing documents, the applicable state partnership statute, and how limited liability was structured and preserved in practice. If the partners are determined to have been partners with limited liability under state law, then their distributive shares (other than guaranteed payments for services) would fall within the Section 1402(a)(13) exception.

For other taxpayers with active disputes, the Tax Court is bound to follow the decision in Sirius only if the taxpayer’s residence at the time of filing a Tax Court petition (or in the case of a partnership, its principal place of business) was in the geographic jurisdiction of the Fifth Circuit, which includes Texas, Louisiana, and Mississippi. Cases involving taxpayers outside of those states will continue to be governed by Soroban unless and until either the Tax Court reconsiders that decision or other appellate courts (or Congress) address the scope of the limited partner exception.

KEY TAKEAWAYS AND OBSERVATIONS

Status, Not Conduct, Drives the Analysis

The Sirius decision represents an important step toward clarity and predictability in the administration of the limited partner exception. By anchoring the analysis in state law limited liability rather than partner activity, the court replaced an unstable and unpredictable facts-and-circumstances test with a framework grounded in legal status and entity design. If the Fifth Circuit’s test ultimately prevails, it will restore a measure of certainty to an area that has become increasingly difficult to administer and advise on with confidence.

Procedure and Administration Matter More Than Ever

In the post-Chevron world, the Supreme Court has made clear that courts interpret statutes independently, but historical agency practice remains part of the interpretive toolkit. That principle was on full display in Sirius. The Fifth Circuit relied in part on decades of consistent IRS forms, instructions, and parallel agency guidance as evidence of how Section 1402(a)(13) has been understood and administered in practice.

The decision underscores that tax procedure and administration are not peripheral; how the government has explained and applied a statute over time matters, and courts are prepared to hold agencies to their own history. The decision also signals that longstanding administrative practice constrains how far enforcement positions can shift through litigation alone, absent formal rulemaking or congressional action.

Substantive State Law Rights and Protections Are Central

For private funds and asset managers, the opinion reinforces that careful attention must be paid to the substantive rights, duties, and protections created under the partnership agreement. Under the rule articulated in Sirius, entity form and the preservation of limited liability are the primary drivers of SECA exposure. Governance hygiene matters in practice, and blurring the lines between limited partner and management roles risks undermining limited liability and the associated federal tax protections.

Reshaping, Not Resolution—Yet

While much anticipated and certainly impactful, the decision in Sirius does not settle the debate over limited partner status under Section 1402(a)(3). Final resolution will depend on how other Circuit Courts of Appeals address the issue, how the IRS and possibly the Tax Court respond in light of this decision, and whether Congress ultimately chooses to weigh in. Other circuits may adopt different approaches, and for now forum risk and audit geography will continue to matter.

For industry participants located outside the Fifth Circuit, Sirius does not alter binding law, but it does materially reshape the analytical landscape by providing a credible appellate counterweight to the Tax Court’s functional approach. That shift will have practical consequences, including how the Independent Office of Appeals will evaluate risk and how settlement dynamics will unfold.

Although the issue is not resolved or nationally settled, Sirius makes a structural, procedural, and text-based position far stronger and far more credible than it was before, giving taxpayers and practitioners a materially different starting point for analysis and advocacy.