Fifth Circuit resets the limited partner test under §1402(a)(13)

Tax professionals have been watching the self-employment tax battle over limited partners for years, anticipating a definitive resolution. Now, the Fifth Circuit has stepped in, not just to settle a dispute but to fundamentally change the conversation. In a significant victory for taxpayers and textualism, the court has rejected the IRS and U.S. Tax Court’s functional approach to the limited partner exception. 

In Sirius Solutions, L.L.L.P. v. Commissioner, No. 24-60240 (Fifth Cir. Jan. 16, 2026), the court vacated and remanded a Tax Court decision, rejecting the long-developing “passive investor” test for purposes of the limited partner exception in §1402(a)(13). The Fifth Circuit held that the term “limited partner” means what it says: a partner in a state-law limited partnership who is afforded limited liability. For practitioners, this decision is not just academic; it directly affects how we analyze self-employment tax exposure for partners in limited partnerships and similar entities.

What the dispute was about 

At its core, the dispute is over the meaning of a few words in the Internal Revenue Code. Section 1402(a)(13) excludes from the calculation of net earnings from self-employment (NESE) the distributive share of income or loss of a “limited partner, as such,” other than guaranteed payments under §707(c) for services actually rendered. 

For years, the IRS has argued and the Tax Court has largely agreed in cases like Renkemeyer and the recent, precedential opinion in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023) that the term “limited partner” applies only to individuals who are passive investors. Under this functional test, if a partner holding a limited partner interest was actively involved in the partnership’s business, the IRS contended the exception did not apply. Consequently, their entire distributive share could be subject to self-employment tax, regardless of their formal status under state law.

In Sirius, the taxpayer was a Delaware limited liability limited partnership (LLLP) operating a consulting firm. It allocated income to its limited partners and, relying on the plain language of §1402(a)(13), reported zero NESE. The IRS issued Final Partnership Administrative Adjustments (FPAAs), asserting that the partners were not “limited partners” for federal tax purposes because they were not passive investors, and adjusted NESE by millions. The Tax Court, following its recent decision in Soroban, sided with the IRS. The Fifth Circuit did not. 

The Fifth Circuit’s holding: a return to the text

The Fifth Circuit’s analysis is a masterclass in statutory interpretation. The court focused on the plain text of the statute and the ordinary meaning of “limited partner” at the time the exception was enacted in 1977. After reviewing dictionary definitions from the era, the court concluded that the universal, defining characteristic of a limited partner was limited liability under state law, not passivity. 

The court dismantled the IRS’s functional test for three key reasons:

• Text and history: The court found no basis in the statutory text for a judicially created “passive investor” requirement. It noted that for over 40 years following the statute's enactment, the IRS’s own instructions for Form 1065 and the Social Security Administration’s regulations defined a limited partner based on their limited liability under state law. The court found this contemporaneous and long-standing agency interpretation to be powerful evidence against the IRS’s new litigation position. 
• The guaranteed payment clause: The court emphasized that §1402(a)(13) already carves out guaranteed payments for services from the exclusion. This carve-out, the court reasoned, would be entirely superfluous if limited partners were prohibited from providing any services to begin with. Congress clearly contemplated that a limited partner could provide services, receive guaranteed payments for them (which would be subject to SE tax), and still have their distributive share of income excluded.
• The “As Such” language: The Tax Court in Soroban interpreted the phrase “as such” to mean “functioning as a limited partner,” thereby importing a functional test. The Fifth Circuit rejected this, explaining that the phrase’s purpose is to address dual-capacity partners (individuals who are both a general partner and a limited partner in the same entity). The phrase clarifies that only the income received in the capacity as a limited partner is excluded. 

In short, the Fifth Circuit held that the IRS cannot rewrite §1402(a)(13). If an individual is a partner in a state-law limited partnership and has limited liability, their distributive share is excluded from NESE, with the statutory exception of any guaranteed payments for services. 

What this means for tax professionals

This decision creates a new landscape, but one with important jurisdictional boundaries and remaining risks.

First, location matters. This is a Fifth Circuit decision, binding on taxpayers in Texas, Louisiana and Mississippi. Outside this jurisdiction, the IRS is free to continue litigating its passive-investor theory. We can expect continued audits and litigation, which could lead to a circuit split, potentially teeing up the issue for the Supreme Court. 

Second, entity documentation is critical. The court’s bright-line test elevates the importance of state-law formation and governance. Practitioners must meticulously review: 

1. The partnership agreement to ensure it properly establishes limited partner status.
2. State filings and certificates to confirm the entity is a valid limited partnership (or LLLP). 
3. The rights and obligations of partners to ensure limited liability is maintained under the controlling state law. 

Third, do not ignore guaranteed payments. The Fifth Circuit did not eliminate self-employment tax for active partners. It clarified the correct mechanism: guaranteed payments. Structuring compensation between a partner’s distributive share and guaranteed payments for services is now the central planning point. This requires careful analysis and robust documentation to substantiate the nature of payments. 

Fourth, be cautious with aggressive positions. The dissent in Sirius focused heavily on the facts, noting the partners worked exclusively for the firm and performed significant management functions. While the majority rejected the functional test for the §1402(a)(13) exception itself, substance-over-form doctrines remain a risk. If the facts are egregious enough, the IRS could still challenge a partner’s status under other theories or even argue that a partner’s level of control caused them to lose limited liability under the relevant state law, thus failing the Fifth Circuit’s test on different grounds. 

The bigger picture

At its core, this case determines when a limited partner’s distributive share is excluded from net earnings from self-employment under §1402(a)(13). Sirius Solutions is a powerful reminder that the words in the Internal Revenue Code matter. The Fifth Circuit has pushed back against agency attempts to create policy-driven tests where the statute is clear. For now, it has replaced a vague, facts-and-circumstances inquiry with a clear, bright-line rule based on state-law status. Tax professionals should revisit their assumptions and advise clients based on this pivotal, though geographically limited, development. Expect more guidance, more audits and likely more appeals as this issue continues to unfold nationwide.