Overview
On January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit (Fifth Circuit) delivered a highly anticipated opinion on the limited partner exception from self-employment tax under Section 1402(a)(13).[1] In the first ruling from an appellate court to address the issue, the Fifth Circuit concluded that the term “limited partner” for purposes of the self-employment tax exception means a limited partner in a state-law limited partnership that is afforded limited liability. In so doing, the Fifth Circuit reversed the Tax Court and rejected the passive investor test asserted by the Internal Revenue Service (IRS).
Background: The “Limited Partner” Exception to Self-Employment Tax
In general, partners in a partnership[2] are subject to self-employment tax on their shares of the partnership’s business income. However, under Section 1402(a)(13), self-employment taxes are not imposed on the distributive share of any item of partnership income “of a limited partner, as such,” other than guaranteed payments described in Section 707(c) to that partner for services rendered.
The term “limited partner” for purposes of Section 1402(a)(13) is not defined in the Code. In 1997, the IRS issued proposed regulations purporting to define “limited partner” for these purposes, but these proposed regulations were never finalized.[3]
More recently, the definition of limited partner has been addressed on an ad hoc basis by the courts. In Renkemeyer v. Commissioner, 136 T.C. 137 (2011) (Renkemeyer), the Tax Court concluded that, in the context of a limited liability partnership, Congress intended for Section 1402(a)(13) to apply only to limited partners who merely invested in a limited partnership, not to partners active in the partnership’s operations (in other words, a functional analysis). In Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023) (Soroban), the Tax Court held that even state law “limited partners” in a state law limited partnership do not automatically qualify for the exception under Section 1402(a)(13). Instead, the Tax Court, echoing Renkemeyer’s functional analysis standard, determined that a limited partner is one that is a mere “passive investor” in the limited partnership.[4]
The Sirius Case
Sirius Solutions, L.L.L.P. (Sirius), a limited liability limited partnership formed under Delaware state law, operates a business consulting firm. During the relevant time period, Sirius allocated all of its ordinary business income to its limited partners, but excluded this income from its calculation of net earnings from self-employment, based on the limited partner tax exception. Upon audit, the IRS determined that the limited partner exception did not apply because none of Sirius’s limited partners counted as “limited partners” for purposes of Section 1402(a)(13). Sirius petitioned the Tax Court seeking readjustment of its returns, but the Tax Court rejected Sirius’s petition based on its holding in Soroban. Sirius appealed the Tax Court’s ruling to the Fifth Circuit.
Fifth Circuit’s Rejection of the Tax Court’s Functional Analysis Standard
In its decision, the Fifth Circuit rejected a functional analysis approach for purposes of determining limited partner status. Instead, the Court concluded that a “limited partner” for purposes of Section 1402(a)(13) means a limited partner in a state-law limited partnership that is afforded limited liability. In reaching its conclusion, the Fifth Circuit pointed to dictionary definitions and the long-standing views of both the IRS, as evidenced by over 40 years of tax form instructions, and the Social Security Administration.
Turning to the IRS’s more recent “passive investor” standard, the Fifth Circuit rejected it outright, for three reasons. First, the Fifth Circuit concluded that the passive investor interpretation makes little sense in light of the “guaranteed payments” clause of Section 1402(a)(13). Because this clause contemplates that limited partners may provide services, the Fifth Circuit concluded that a strict passive investor interpretation would render the clause superfluous, and that it would be “strange” for Congress to include a rule under which “some participation is permissible, but just not too much.” Second, the Fifth Circuit stated that “if Congress wished to only exclude passive investors from the tax, it could have easily written the exception to do so.” Finally, the Fifth Circuit noted that the IRS’s passive investor interpretation would result in confusion that would make it difficult for limited partners to determine ex ante what their tax liability would be.
The Fifth Circuit also addressed the argument in Soroban that the exception in Section 1402(a)(13) refers not just to a limited partner, but to a “limited partner, as such.” The Tax Court in Soroban concluded, based on this, that “the limited partner exception applies only to a limited partner who is functioning as a limited partner” and that to function as a limited partner means to act as a passive investor. The Fifth Circuit rejected this reasoning, and concluded that the term “as such” was not meant to restrict or narrow the class of limited partners, but instead to clarify how individuals who serve as both a limited and general partner are to be taxed.
Implications
Asset managers and fund sponsors who structure their management companies as limited partnerships often claim the limited partner exception from self-employment taxes. The Tax Court’s opinions in Sirius and Soroban, among others, raised concerns as to the scope of this exception. The Fifth Circuit’s decision repudiates the Tax Court’s rulings in this area and provides welcome guidance for taxpayers.
However, the Sirius decision does not technically bind the IRS or courts outside of the Fifth Circuit. In addition, the taxpayers in Soroban and Denham are currently appealing those decisions to the Second Circuit and First Circuit, respectively. Thus, future developments relating to the limited partner exception are expected.
Moreover, the Fifth Circuit did not discuss the application of the limited partner exception to members of other entities, such as LLPs or LLCs, not formed as state-law limited partnerships (although the Sirius case involves a limited liability limited partnership). Members of such entities may continue to face some uncertainty as to the scope of the limited partner exception.
If you have any questions about this article, please contact Tom Geraghty (tgeraghty@vedder.com), Matthew Larvick (mlarvick@vedder.com), or any other Vedder tax attorney with whom you have worked.
[2] Except as noted, references to “partnership” include LLCs or other entities that are classified as such for federal income tax purposes, and references to “partners” include members of such entities.
[3] The proposed regulations would have precluded a partner from claiming “limited partner” status if the partner (i) had personal liability for partnership debts, (ii) had authority to contract on behalf of the partnership or (iii) participated in the partnership’s trade or business for more than 500 hours in the partnership’s taxable year.
[4] The Tax Court applied a similar analysis in Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114 (Denham), a case also involving a state law limited partnership.
