Fifth Circuit Reverses Tax Court; Rejects Self-Employment Tax "Passive Investor" Rule

(Parker Tax Publishing January 2026)

The Fifth Circuit reversed the Tax Court and held that the term "limited partner" as used in Code Sec. 1402(a)(13), which excludes from net earnings from self-employment the distributive share of income or loss of a "limited partner, as such," refers to a partner in a limited partnership that has limited liability. In so holding, it rejected the IRS's "passive investor" rule that requires a functional analysis of a limited partner's role in the partnership, and which the Tax Court previously approved in Soroban Capital Partners LP v. Comm'r, 161 T.C. No. 12 (2023). Sirius Solutions, L.L.L.P. v. Comm'r, 2026 PTC 7 (5th Cir. 2026).

Background

Sirius Solutions, L.L.L.P. (Sirius) is a Delaware limited liability limited partnership which operates a business-consulting firm. In 2014, Sirius was owned by nine limited partners and one general partner. Sirius GP. Four limited partners sold their partnership interests in 2014, so in 2015 and 2016, there were five limited partners and one general partner.

Under Code Sec. 1401, social security and Medicare tax is imposed on an individual's earnings, including self-employment income. Code Sec. 1402(a) defines "net earnings from self-employment" as the gross income derived from any trade or business carried on by the individual, less deductions, plus the individual's distributive share (whether or not distributed) of income or loss from a partnership. However, Code Sec. 1402(a)(13) provides an exception under which a limited partner's distributive share does not include the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Code Sec. 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.

Sirius reported ordinary business income of $5,829,402 in 2014, $7,242,984 in 2015, and $490,291 in 2016 and allocated all that income to its limited partners. Based on the limited partnership tax exception in Code Sec. 1402(a)(13), Sirius excluded the limited partners' distributive shares of partnership income (or loss) from its calculation of net earnings from self-employment during those years and reported $0 of net earnings from self-employment.

After auditing Sirius's 2014, 2015 and 2016 tax returns, the IRS determined that the distributive share exception in Code Sec. 1402(a)(13) did not apply because none of Sirius's limited partners were "limited partners" for purposes of the exception. Sirius filed petitions with the Tax Court seeking readjustments of the IRS's adjustments to its 2014-2016 tax returns.

The Tax Court rejected Sirius's challenges and upheld the adjustments. In reaching its decision, the Tax Court relied on its decision in Soroban Capital Partners LP v. Comm'r, 161 T.C. No. 12 (2023), in which it applied a functional analysis test designed to determine whether a limited partner's economic relationship is generally one of passive investment. In Soroban, the Tax Court held that for purposes of the Code Sec. 1402(a)(13) exception, the term "limited partners" only refers to passive investors and not investors actively participating in the business. Sirius appealed to the Fifth Circuit.

Analysis

The Fifth Circuit reversed the Tax Court and held that the term "limited partner" in Code Sec. 1402(a)(13) refers to a partner in a state-law limited partnership that is afforded limited liability. The court rejected what it called the IRS's "newly adopted passive investor rule," approved by the Tax Court in Soroban.

In reaching its decision, the court began by looking at the ordinary meaning of the text in Code Sec. 1402(a)(13) and found that, at the time of Code Sec. 1402(a)(13)'s enactment, dictionaries defined a "limited partner" as a partner with limited liability in a limited partnership. In each contemporaneous dictionary, the court observed, the term "limited partner" had one and only one characteristic in common: limited liability.

Moreover, the court said, for well over 40 years the IRS's instructions for Form 1065, U.S. Return of Partnership Income, made clear that the term "limited partner" in Code Sec. 1402(a)(13) did not have some hidden, narrower meaning from the rest of the Tax Code. It was not until 2022, the court observed, that the IRS issued instructions that added a vague possible caveat: "However, whether a partner qualifies as a limited partner for purposes of self-employment tax depends upon whether the partner meets the definition of a limited partner under section 1402(a)(13)."

The court disagreed with the IRS's arguments that fundamental tax principles undermined the court's interpretation and bolstered its newly adopted interpretation of a limited partner. The determination of what constitutes a limited partner, the court said, depends on what the term "limited partner" meant at the time of enactment.

Further, the court observed that the Social Security Administration's contemporaneous and longstanding interpretation of "limited partner" in the Social Security Amendments of 1977 matches the one provided by the Internal Revenue Code. The court found this quite relevant as the limited partner tax exception was enacted in Section 313(b) of the Social Security Amendments of 1977 and Section 313(a) adopted a virtually identical exception for Social Security benefits. The court thus concluded that the benchmark of a "limited partner" in 1977 was limited liability.

With respect to the Tax Court and IRS interpretations of a limited partner as being a mere passive investor, the Fifth Circuit said their interpretations failed for three reasons. First, Code Sec. 1402(a)(13) provides that all of a limited partner's distributive share of partnership income (or loss) is excluded from taxation, other than guaranteed payments described in Code Sec. 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services. The text of the exception itself, the court observed, contemplates that "limited partners" would provide actual services to the partnership and participate in partnership affairs. Thus, a strict passive-investor interpretation that defines "limited partner" in a way that prohibits such investor from providing any services to the partnership would make the "guaranteed payments" clause entirely superfluous. Second, the court said, if Congress wished to only exclude passive investors from the tax, it could have easily written the exception to do so. Third, the court pointed to the consequences of the IRS's passive-investor interpretation on a limited partner's ability to discern his tax liability and plan his affairs accordingly. The court reasoned that under the passive investor rule, a limited partner would have to balance an infinite number of factors -- a task the limited partner could do only "with the help of an army of lawyers and accountants - and a whole lot of luck."

The Fifth Circuit also rejected the Tax Court's position that by using the term "limited partner, as such" in Code Sec. 1402(a)(13), Congress made clear that the limited partner exception applies only to a limited partner who is functioning as a limited partner. The Fifth Circuit said that for the Tax Court's conclusion to follow, a limited partner must be defined as a passive investor, which the court already established was not true.

Observation: In a dissenting opinion, Judge Graves said he would have affirmed the Tax Court's decision as he found the text and structure of Code Sec. 1402(a)(13) to be clear that its tax exemption for limited partners applies only to those functioning as passive investors. Judge Graves also pointed out that the majority offered only select portions of various definitions to form an oversimplified definition of "limited partner" to support its result.

For a discussion of partnership income and self-employment taxes, see Parker Tax ¶20,590. For a discussion of self-employment taxes on a limited liability company taxed as a partnership or a limited liability partnership, see Parker Tax ¶13,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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