In January 2026, the U.S. Court of Appeals for the Fifth Circuit issued an important decision in the ongoing battle between taxpayers and the IRS over the application of self-employment tax to limited partners. The Court’s ruling in Sirius Solutions LLLP v. Commissioner could result in significant tax savings for service partnerships, fund managers and professional firms operating through limited partnerships. However, the decision is explicitly limited to these entity types, leaving unanswered questions about LLCs or other entity types taxed as a partnership.
Sirius Solutions, a Delaware limited liability limited partnership (LLLP), is a business consulting firm owned by multiple limited partners and a general partner, which itself is an LLC. Sirius Solutions allocated several million dollars of ordinary business income to its limited partners for the 2014 through 2016 tax years. Section 1402(a) of the tax code defines “net earnings from self-employment” as the gross income derived by an individual from any trade or business carried on by such individual plus the individual’s distributive share of income or loss described in Sec. 702(a)(8) from any trade or business carried on by a partnership of which that individual is a member.
Sec. 1402(a)(13), however, provides an exception for limited partners, stating “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … to that partner for services actually rendered to or on behalf of the partnership.” Consistent with the limited partner exception, Sirius Solutions reported zero net earnings from self-employment tax for those years, excluding the partners’ distributive shares, while continuing to treat guaranteed payments as self-employment income.
The IRS audited the partnership and took an entirely different view. It argued the individual partners were not limited partners because they were actively involved in the business. The Tax Court agreed, relying heavily on its recent decision in Soroban Capital Partners LP v. Commissioner. In that decision, the Court applied a functional analysis, meaning it evaluated partner activity level in the partnership rather than their state law status.
The heart of the case, at least in the minds of the Fifth Circuit, comes down to one rather simple question: How should the term “limited partner” be interpreted for purposes of the self-employment tax exception under Sec. 1402(a)(13)?
There were two contrasting interpretations:
The Court of Appeals for the Fifth Circuit overturned the previous Tax Court decision, holding that the “limited partner” exception to the self-employment tax applies to a partner in a limited partnership who has limited liability under state law.
The Court of Appeals’ reasoning was grounded in a straightforward but powerful premise: Congress meant what it said when it used the term limited partner. Because the statute does not define limited partner, the Court looked to how the term was understood when Congress enacted Sec. 1402(a)(13) in 1977. Across dictionaries, state limited partnership statutes and IRS guidance at the time stated a limited partner was consistently defined by the presence of limited liability, not by a partner’s activity level. Further, Sec. 1402(a)(13) explicitly includes guaranteed payments in self-employment income — the category used to compensate partners for services. The Court reasoned this carveout only makes sense if Congress contemplated that limited partners can, in fact, perform services. If Congress had meant to exclude all active partners, this provision would be unnecessary. Further, the Court established if Congress had intended to adopt a passive-investor standard for the exception, it could have done so, as it did both before and after the enactment of Sec. 1402(a)(13). Based on definitions, the Social Security Act definition and form instructions at the time stated the term Limited Partner was a partner limited by liability. Finally, the Court noted a function analysis test was too fact intensive and subjective, stating it should not require “an army of lawyers and accountants — and a whole lot of luck” to determine if partners are subject to the limited partner exception.
The Fifth Circuit viewed the Tax Court’s approach as adding words to the statute. Nothing in the text or legislative history suggested Congress intended an activity based inquiry. In the Court’s view, by imposing one, the Tax Court effectively rewrote Sec. 1402.
In November 2023 and again in May 2025, the Tax Court held in Soroban Capital Partners LP v. Commissioner that in determining a partner’s exclusion from self-employment tax, a functional analysis is required, meaning a limited partner who actively participates in the business is not exempt from self-employment tax. This decision is now at the Court of Appeals in the Second Circuit, with another decision in Denham Capital Management L.P. v. Commission on Appeal at the First Circuit. The Tax Court in both cases, so far, has sided with the Commissioner, establishing a functional test in determining limited partner for purposes of Sec. 1402(a).
It is worth noting that proposed regulations on this topic were issued in 1997, which would have not allowed partners to be considered limited partners for the purposes of Sec. 1402(a) if they:
These proposed regulations would have looked at the functionality of a partner to determine self-employment tax implications, not only state law liability status. However, these proposed regulations were issued a temporary moratorium by Congress in 1997, preventing Treasury or the IRS from issuing regulations defining a limited partner under Sec. 1402(a). Congress’ concern with the proposed regulations in 1997 align with the Fifth Circuit’s reasoning in its decision in Sirius. Treasury was overriding the legal definition of limited partner, which Treasury does not have the authority to do. The 1997 proposed regulations have never been finalized.
As to how this decision impacts other entity types taxed as partnerships, such as LLCs, a footnote of the Sirius decision states “we do not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception.”
With two more cases before two separate Circuits in Denham and Soroban, further clarity (or more questions) on this issue is coming. However, the Sirius Solutions decision is a monumental shift away from the IRS’ long advocated functional analysis approach. By restoring the plain text meaning of Sec. 1402(a)(13), the Fifth Circuit has offered taxpayers a simpler, more predictable framework. For now, limited partnerships should carefully consider how this case affects their current self-employment tax posture and future planning.
Contact David Charles or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.