Client Alert: The Fifth Circuit Clarifies “Limited Partner” for Self-Employment Tax Purposes
Date: February 25, 2026
- The Fifth Circuit held that a “limited partner” for purposes of the self-employment tax means a partner in a state law limited partnership who has limited liability.
- The court rejected the IRS’s “passive investor” interpretation and instead held that generally, a limited partner with limited liability under state law qualifies for the exclusion from the self-employment tax on the partner’s share of partnership income.
- The Fifth Circuit’s decision could lead to a potential circuit split, ultimately setting up the issue for consideration before the Supreme Court.
Generally, the Internal Revenue Code imposes Social Security and Medicare taxes on earnings from self-employment. However, a limited partner’s share of partnership income is not subject to self-employment taxes, with a narrow exception for “guaranteed payments” to a limited partner for services actually rendered to the partnership. The IRS has taken the position that for purposes of the exclusion from self-employment taxes, a “limited partner, as such” means a partner who is merely a passive investor in the partnership. The IRS’s position required a functional analysis of the limited partner’s activities in the partnership. Under the IRS’s interpretation, limited partners under state law who engage in activities beyond that of a passive investor would be subject to self-employment taxes.
Sirius Solutions, L.L.L.P. (“Sirius”), a Delaware limited liability limited partnership, reported its limited partners’ distributive shares of income as not subject to self-employment taxes. The IRS took the position that Sirius’s limited partners were not “limited partners, as such” for purposes of the exception because they operated in a manner beyond that of a mere passive investor. The Tax Court agreed with the IRS and concluded that only “limited partners” who are passive investors in the partnership qualify for exclusion from self-employment taxes.
On appeal before the Fifth Circuit, the IRS argued that the exception for limited partners is only for limited partners who are passive investors and urged a functional or factor-based approach that looks at the partner’s actual activities and level of participation in the business. Sirius contended that Congress used the familiar, ordinary meaning of “limited partner”—that is, a partner with limited liability under state law—when it enacted the self-employment tax exception, and that the IRS’s “passive investor” interpretation conflicted with the statutory text.
On January 16, 2026, the Fifth Circuit reversed the Tax Court’s decision. The court agreed with Sirius and held that the definition of a “limited partner,” for purposes of the self-employment tax exception, is a partner with limited liability. Notably, the court stated that its ruling did not apply to members of other entities such as LLPs or LLCs. Additionally, the court reasoned that Congress made an exception—to the exception for limited partners—by imposing self-employment taxes on any “guaranteed payments” for services actually rendered. The court reasoned that a strict passive-investor interpretation would make this exception to the exception entirely superfluous.
The Fifth Circuit vacated the Tax Court’s decision and remanded the case for further proceedings consistent with its interpretation. The panel’s decision was not unanimous as the dissent would have upheld the IRS’s functional analysis approach and passive investor interpretation. As of now, the ruling is binding within the Fifth Circuit (Texas, Louisiana, and Mississippi). Similar appeals on the same issue are pending in other circuits (notably, Denham Capital Management LP v. Bessent in the First Circuit and Soroban Capital Partners LP v. Commissioner in the Second Circuit), thus raising the possibility of a circuit split and, eventually, petition to the Supreme Court.
Limited partners within the Fifth Circuit now have clearer grounds to exclude their distributive shares from self-employment tax, subject to the statutory rule that guaranteed payments for services remain subject to self-employment taxes. Partnerships should ensure that their organizational documents, partner designations and state filings accurately reflect limited partner status, rights and liabilities, and consult with legal and tax professionals before taking a position. The attorneys at Whiteford are prepared to assist partners and business professionals on this evolving issue. We will continue to provide updates as parallel matters develop in other jurisdictions.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.