For limited partnerships that are headquartered in the Second Circuit or Fifth Circuit and that allocate significant income to limited partners who work in roles other than senior management, the interpretations in the two appellate decisions may present opportunities. Other taxpayers may wish to await potential further proceedings in the Second Circuit case and the outcome of a third appeal currently pending on the same issue.
Section 1402(a)(13) of the Internal Revenue Code, enacted by the US Congress in 1977, provides that “the distributive share of any item of income or loss of a limited partner, as such,” other than certain guaranteed payments for services, is not subject to self-employment tax. As described in our earlier LawFlash, however, the US Tax Court in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), adopted a very narrow interpretation of that exception, holding that only pure passive investors in a limited partnership could be “limited partner[s].” The Tax Court applied the same interpretation in Sirius Solutions, L.L.L.P. v. Commissioner, No. 11587-20 (T.C. Feb. 20, 2024), vacated sub nom. K Alain, L.L.L.P. v. Commissioner, 184 F.4th 766 (5th Cir. 2026), without explaining in either case why—if Congress had intended the term “limited partner” to be limited to pure passive investors—it was necessary to carve out from the exception guaranteed payments for services provided by a limited partner.
Before the Second Circuit’s decision in Soroban, an appeal by the taxpayer in Sirius Solutions produced two opinions by the same Fifth Circuit panel, each rejecting the Tax Court’s passive investor test, vacating its decision, and remanding for further proceedings. The opinions in Sirius Solutions left unclear the level of managerial activity by a limited partner that would be necessary to take the partner outside the scope of the self-employment tax exception.
The opinion issued by the Second Circuit in Soroban, 2026 WL 2751819, aff’g T.C. Memo. 2025-52 & 161 T.C. 310 (2023) adds to the uncertainty. Unlike the Fifth Circuit in Sirius Solutions, the Second Circuit affirmed the Tax Court’s decision. The court held that the extensive exercise of managerial control by the three partners whose status was at issue in Soroban made them ineligible for the limited partner exception, even though they were limited partners under the applicable state law. And although the Second Circuit’s opinion at one point suggests that the court is applying the same test applied by the Fifth Circuit, the opinion also contains 17 references to “passive investors” or “passive investments,” the standard applied by the Tax Court and explicitly rejected by the Fifth Circuit. The opinion therefore increases the likelihood that—pending further appellate guidance—the Tax Court will continue to interpret the limited partner exception very narrowly.
BACKGROUND
In general, a partner in a partnership that operates a trade or business is entitled to treat the partner’s distributive share of income from the partnership’s trade or business as the partner’s own self-employment income for the purpose of computing Social Security benefits. Correspondingly, such a partner needs to pay self-employment tax[1] on its distributive share of income or loss from the partnership business in the same manner as if the partner had carried on the business directly.
There is an exception from that rule for limited partners. Section 1402(a)(13) provides that the self-employment tax base does not include “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … for services actually rendered” for the partnership that are “established to be in the nature of remuneration for those services.” The Social Security Act excludes the same amounts from the net earnings from self-employment credited in computing a partner’s Social Security benefits. See 42 USC 411(a)(12).
Summary of Decisions
In a series of opinions issued from 2023 through 2025, the Tax Court applied a functional analysis test to determine that the limited partners in a hedge fund investment advisor (see Soroban), a management consulting firm (see Sirius Solutions), and a private equity fund manager[2] did not qualify for the limited partner exception from self-employment tax. The Tax Court looked in each case to the limited partners’ roles and responsibilities in generating partnership income and the relationship between their distributive shares and any capital contributions they had made. The court’s purpose in this functional analysis was to determine whether a limited partner was earning income from the business purely as a passive investor or instead played an active role in the operation of the business. According to the Tax Court, limited partners playing an active role in the business could not qualify for the limited partner exception.
In Soroban, for instance, the Tax Court found that the three limited partners were active participants in the partnership’s business of managing hedge fund investments: the partners devoted their time and skills to the business, participated in employment decisions, and negotiated and executed documents and agreements to conduct the business. The Tax Court also found that the limited partners’ distributive shares did not constitute returns on capital investments. Of the three limited partners in question, only one made a capital contribution, and the distributive share he received was disproportionate to the contribution.
The decisions in Denham Capital, Soroban, and Sirius Solutions were appealable, respectively, to the US Courts of Appeals for the First Circuit, Second Circuit, and Fifth Circuit. Two courts of appeals have now weighed in on the Tax Court’s approach, with mixed results.
As noted above and in our prior LawFlash, the Fifth Circuit was the first appellate court to reach a decision, and it rejected the Tax Court’s passive investor test. In its initial opinion, a Fifth Circuit panel held that the term “limited partner” in Section 1402(a)(13) means no more or less than a partner in a limited partnership who has limited liability under state law. The court referred to dictionary definitions of the term and to the longstanding practice of both the Internal Revenue Service (IRS) and the Social Security Administration.
Several months later, the Fifth Circuit panel granted a petition for rehearing, withdrew its initial opinion, and substituted a revised opinion. The revised opinion accepts the premise that status as a “limited partner” may turn in part on a partner’s activities in connection with the partnership business but again rejects the Tax Court’s passive investor test. After reviewing dictionary definitions and treatises, the opinion holds that the “ordinary public meaning” of the term “limited partner” at the time Section 1402(a)(13) was enacted was “a partner who plays no significant role in managing or running a business.” The opinion makes clear that although managerial activities may prevent a limited partner from qualifying for the self-employment tax exception, non-managerial activities will not. Because the Tax Court had not distinguished between managerial activities and non-managerial participation in the partnership business, the Fifth Circuit vacated the Tax Court’s decision in Sirius Solutions and remanded for further proceedings.
The Second Circuit, by contrast, affirmed the Tax Court’s decision in Soroban. To determine the “ordinary meaning” of the term “limited partner” when Section 1402(a)(13) was enacted, the court looked to sources of authority similar to those considered by the Fifth Circuit in Sirius Solutions (dictionary definitions, contemporary treatises, and state law limited partnership statutes). The initial conclusion the court drew as to that the meaning was also similar to the Fifth Circuit’s holding: “a limited partner was understood in 1977 to have two features: limited liability and lack of managerial control over the partnership.” The court went on, however, to frame the relevant distinction as that between “passive investment” and “actively running a business.” And after reviewing the legislative history of the 1977 Social Security Amendments, the court indicated that to qualify for the exception limited partners must “generally act[] as passive investors and … not partake in management of the partnership.” The court concluded by acknowledging that a limited partner may “provide some services to the partnership” and still qualify for the self-employment tax exception, “[s]o long as the activities in question do not constitute controlling, managing, or running the business.”
While the tests applied by the two courts of appeals differ in at least one discernible particular (the Second Circuit would treat any control or management activities as disqualifying, while the Fifth Circuit treats only a significant role in managing or running the business as defeating “limited partner” status), neither court’s opinion draws a particularly bright line. The decisions will leave many taxpayers uncertain as to the self-employment tax treatment of state law limited partners, particularly those who work in the partnership business in a role other than senior management.
UNADDRESSED ARGUMENTS
The Second Circuit and the Fifth Circuit both proceeded on the premise that meaning of the term “limited partner” in 1977 could be discerned by reference to the types of activities that were understood at that time to cause a nominal limited partner to become liable as a general partner. Neither court acknowledged the possibility that, given the inconsistency and active evolution of the law on that issue in 1977, there was not a single, generally accepted understanding of what activities could trigger such liability. Consider the following contemporaneous developments, among others:
- Under the Delaware Limited Partnership Act enacted in 1973, a limited partner could become liable as a general partner only with respect to those persons who transacted with a partnership reasonably believing that the limited partner was a general partner.
- The Revised Uniform Limited Partnership Act of 1985 incorporated a standard similar to the requirement in the 1973 Delaware law, under which limited partners were treated as general partners only with respect to creditors who relied on assertions that the limited partners in question were general partners.
- State supreme courts were, in the 1970s, actively considering whether limited partners should be treated as general partners in circumstances where corporations served as the general partners of the relevant limited partnerships and limited partners were also shareholders in those corporations. See, e.g., Delaney v. Fidelity Lease Ltd., 526 SW2d 543 (Tex. 1975), rev’g 517 SW2d 420 (Tex. App. 1974); Frigidaire Sales Corp. v. Union Properties, Inc., 544 P.2d 781 (Wash. App. 1975), aff’d, 562 P.2d 244 (Wash. 1977).
Given the uncertainty as to what activities would—and the contentiousness about what activities should—defeat the limitations on the liability of a limited partner in 1977, it is understandable that neither court of appeals was able to distill a precise functional definition of “limited partner” from the contemporary authorities. Moreover, even assuming (as both courts did) that Congress intended to define “limited partner” functionally rather than literally, the evolving status of the law in 1977 makes it unlikely that Congress sought to enshrine any particular one of the many state law tests circulating and developing at that time. It is more plausible that Congress would have intended any functional definition of “limited partner” to focus on the activities that would defeat limited liability under the state law applicable to the partnership in question during the relevant taxable year.
WHAT COMES NEXT?
Denham Capital is currently pending on appeal before the First Circuit Court of Appeals. The case was argued on February 5, 2026, and on March 13, 2026, the court ordered supplemental briefing on a jurisdictional issue. Depending on the resolution of that issue, the First Circuit may or may not address the interpretation of Section 1402(a)(13).
The parties in Soroban have until November 1, 2026 to petition for a rehearing by the panel or en banc and, in the absence of a petition for rehearing, the taxpayer has until December 16, 2026 to petition the Supreme Court for a writ of certiorari.
Sirius Solutions is once again before the Tax Court on remand from the Fifth Circuit. The parties had previously stipulated that under the Tax Court’s Soroban test, the taxpayer’s limited partners would not qualify for the self-employment tax exception. It is unclear whether the parties will reach agreement as to whether each limited partner did or did not play a significant role in managing the business.
In other cases appealable to the Fifth Circuit (covering Louisiana, Mississippi, and Texas), the Tax Court will attempt to interpret and apply the Fifth Circuit’s test looking to a limited partner’s significant managerial activities. In cases appealable to courts of appeals other than the Second and Fifth Circuits, the Tax Court ordinarily will follow its own precedent (i.e., Soroban), although taxpayers may seek to convince the court to change course and may cite Sirius Solutions and Soroban as persuasive authority in that regard. Finally, in cases appealable to the Second Circuit (covering Connecticut, New York, and Vermont), it is unclear whether or to what extent the Tax Court will view the court of appeals opinion in Soroban as articulating a different test than the Tax Court itself applied.
It is also unclear how the IRS will respond to the Second Circuit and Fifth Circuit decisions. As discussed above, the two opinions are not entirely clear as to what activities are treated as “managerial” (and therefore may prevent a limited partner from qualifying for the exception) or, in the case of Sirius Solutions, what quantum of managerial activities is disqualifying. As a matter of litigation strategy, the IRS will need to decide whether to treat these decisions as a clear “win” for its position (strengthening its resolve not to settle limited partner cases) or as a partial win that clarifies the law sufficiently to allow the IRS to compromise cases.
IMPLICATIONS FOR TAXPAYERS
The decisions in Soroban and Sirius Solutions present a challenge for state law limited partners at a senior management level, such as the lead principals of investment management firms. These taxpayers may wish to await further guidance, potentially from a First Circuit decision in Denham or further proceedings in Soroban.
As to the filing position for future periods, taxpayers should consider exposure to potential penalties and consult their tax preparers as to the range of reporting positions that a given preparer will accept.
Taxpayers with pending audits or ongoing appeals or litigation involving significant distributive share allocations to limited partners who worked in the business but did not direct and control it may seek to press their cases forward, relying on Sirius Solutions and the language in Soroban rationalizing the Second Circuit’s approach to that of the Fifth Circuit. However, given the Tax Court’s approach to circuit court precedent, taxpayers in this position outside the Second and Fifth Circuits may have limited recourse, and in any event taxpayers’ arguments will continue to evolve with the case law.
Investment firms, particularly those located in the Fifth Circuit, should review their management structures and consider whether to make changes that limit the extent to which their limited partners play active roles in directing the business.
