Fifth Circuit rejects passive-investor test for self-employment tax exception

Executive Summary

On Jan. 16, 2026, the U.S. Court of Appeals for the Fifth Circuit issued a significant ruling in Sirius Solutions, L.L.L.P. v. Commissioner, holding that the term ‘limited partner’ in section 1402(a)(13) means a partner in a state-law limited partnership who possesses limited liability—not a ‘passive investor.’ Under this reading of section 1402(a)(13), a distribution to an active partner who is a limited partner in a limited partnership is not subject to self-employment tax (SECA). The decision vacates the Tax Court’s earlier ruling and rejects the IRS activity-based functional analysis.

Background

Sirius Solutions is a Delaware limited liability limited partnership. For the years in dispute, it allocated ordinary business income to its limited partners and excluded those amounts from net earnings from self-employment under section 1402(a)(13). The IRS reclassified the income as subject to SECA. The Tax Court upheld the adjustments using a passive-investor test. Sirius appealed to the Fifth Circuit.

Fifth Circuit’s analysis

The Court held that statutory text controls: a ‘limited partner’ is one who holds limited liability in a state-law limited partnership. The Court rejected the IRS and Tax Court’s view that level of activity is relevant. The opinion emphasizes that concerns about management participation are addressed independently through the guaranteed payment rules—not through the definition of a ‘limited partner.’ Guaranteed payments are subject to SECA even for limited partners in limited partnerships.

What this means for taxpayers

Taxpayers operating as limited partnerships in the Fifth Circuit now have strong authority supporting exclusion of distributive shares from self-employment income when partners have limited liability. Partnerships outside the circuit should monitor developments, as this ruling diverges from the Tax Court’s functional analysis in Soroban and Denham. The IRS is likely to continue to pursue self-employment tax exceptions for limited partners, so entity form, liability protections and treatment of guaranteed payments remain critical.

Soroban and Denham are on appeal, one with the Second Circuit and one with the First Circuit Court of Appeals. Thus, while the Fifth Circuit’s opinion is critical to the limited partner exception landscape and will likely influence the cases on appeal, it will not end the limited partner self-employment tax exemption debate.