Executive Summary
- What’s new: The Fifth Circuit rejected the IRS’ “passive investor” test for the self-employment tax exception, holding that a “limited partner” is simply a partner in a state-law limited partnership with limited liability.
- Why it matters: The decision overturns previous Tax Court rulings, impacts partnership tax classifications and is binding in the Fifth Circuit, with related appeals pending in the First and Second Circuits and possible Supreme Court review.
- What to do next: Companies should consider reviewing how this decision may affect their partnership structures or self-employment tax positions and monitoring ongoing appeals and potential changes in other jurisdictions.
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On January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit decisively rejected the IRS’ attempt to narrow the definition of “limited partner” for purposes of the self-employment tax exclusion under section 1402(a)(13) of the Internal Revenue Code. In Sirius Solutions, L.L.L.P. v. Commissioner, the court held that a “limited partner” is simply a partner in a state-law limited partnership who enjoys limited liability — flatly rejecting the IRS’ position that only “passive investors” qualify. This is the first appellate decision to reach, and to overturn, a series of Tax Court rulings that had endorsed the IRS’ restrictive interpretation.
Background: Self-Employment Tax and the Limited Partner Exception
The Internal Revenue Code generally imposes self-employment tax on a partner’s distributive share of partnership income. However, section 1402(a)(13) carves out an exception: a “limited partner, as such,” is not subject to self-employment tax on their distributive share — except for guaranteed payments for services actually rendered.
The Sirius Case: IRS Pushes ‘Passive Investor’ Test, Fifth Circuit Pushes Back
Sirius Solutions, a Delaware limited liability limited partnership, allocated all of its ordinary business income (and loss) to its limited partners for 2014, 2015 and 2016. Relying on section 1402(a)(13), Sirius excluded these amounts from self-employment income, reporting zero self-employment earnings for those years.
The IRS audited Sirius and asserted that none of its limited partners qualified for the exception, arguing that only “passive investors” are “limited partners” under the statute. The IRS issued Notices of Final Partnership Administrative Adjustment, increasing Sirius’ net earnings from self-employment to include the limited partners’ distributive shares.
Sirius challenged the adjustments in Tax Court. While the case was pending, the Tax Court decided Soroban Capital Partners LP v. Commissioner, holding that the phrase “as such” in section 1402(a)(13) limits the exception to passive investors. 161 T.C. 310, 320 (2023) (“Soroban I”). Sirius and the IRS stipulated that Soroban I controlled, and the Tax Court ruled for the IRS. Sirius appealed.
Fifth Circuit: ‘Limited Partner’ Means What It Says
The Fifth Circuit reversed, holding that a “limited partner” under section 1402(a)(13) is a partner in a state-law limited partnership with limited liability — period. The court relied on the ordinary meaning of “limited partner” at the time the statute was enacted, as reflected in contemporary dictionaries and longstanding IRS and Social Security Administration guidance. These sources consistently defined a limited partner by limited liability, not by the degree of involvement in the partnership’s business. The court also pointed to the statute’s carve-out for “guaranteed payments” for services, which presumes that limited partners may perform services — undercutting the IRS’ passive investor test. And, while explicitly not deciding the issue, the Fifth Circuit suggested that the Tax Court may have improperly denied section 1402(a)(13)’s self-employment tax exception to owners of other types of limited liability entities (such as LLCs and LLPs) in cases predating Soroban I and Sirius.
The Fifth Circuit vacated the Tax Court’s decision and remanded for further proceedings consistent with its interpretation. The IRS has until March 2, 2026, to seek rehearing in the Fifth Circuit.
What’s Next: Related Appeals and Potential for Circuit Split
The Fifth Circuit’s decision in Sirius is the first appellate ruling among three pending challenges to the Tax Court’s passive investor test. Two other cases — Denham Capital Management LP v. Commissioner (on appeal to the First Circuit) and Soroban Capital Partners LP v. Commissioner (on appeal to the Second Circuit) — raise the same issue. Oral argument in Denham is set for February 5, 2026; briefing in Soroban is ongoing. Several related cases are also pending in the Tax Court.
For now, Sirius is binding only in the Fifth Circuit. The First and Second Circuits could reach different conclusions, setting up a potential circuit split. If that happens, Supreme Court review is likely.
Key Takeaways
- The Fifth Circuit has rejected the IRS’ “passive investor” test for the limited partner exception to self-employment tax.
- Under Sirius, a partner in a state-law limited partnership with limited liability qualifies for the exception, regardless of their level of activity in the partnership.
- The issue is far from settled nationwide, with appeals pending in other circuits and the possibility of Supreme Court involvement if a split emerges.
Please contact us with any questions about how this decision might affect your partnership structures or self-employment tax positions.
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