The IRS wants to argue that the more involved a limited partners is in the day-to-day operations of a business, the more likely they should be subject to self-employment tax.
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What is a limited partner? That’s exactly the question tackled by the Fifth Circuit in a recent tax dispute. While the case looked like a routine partnership-level tax matter, the opinion dove into the definition of a limited partner, treating it as a question of legal status, not day-to-day activity.
There has long been disagreement over how far the “limited partner” exception to self-employment tax in the tax code actually goes. The statute draws a clear line: a limited partner’s share of partnership income is generally excluded from self-employment tax, except for guaranteed payments. But the IRS has argued that what matters is what partners actually do, including how involved they are in the business, how much control they have over operations, and whether they really look like investors.
Background
Sirius Solutions is a business consulting firm organized as a limited liability limited partnership (LLLP) in Delaware with an office in Houston, Texas. Like many partnerships, it has a general partner (GP), with individual partners holding limited partner (LP) interests.
Under state law, those limited partners enjoyed limited liability, which means they were not personally responsible for the partnership’s debts beyond their capital contributions. That’s exactly why these entities are organized this way.
For the tax years at issue (2014 through 2016), Sirius reported ordinary business income and allocated it to its partners in the usual way. That income showed up on the partners’ Schedules K-1. The partnership took the position that limited partners’ shares of partnership income were excluded from net earnings from self-employment and not subject to self-employment tax. (An exception applies to any payments qualified as guaranteed payments for service.) This meant that Sirius reported zero net earnings from self-employment in each year.
The IRS disagreed with this approach and issued Final Partnership Administrative Adjustments (FPAAs), the partnership equivalent of a notice of deficiency. The FPAAs claimed that the partners were not “limited partners” for purposes of section 1402(a)(13), despite their status under state law. The problem, according to the IRS, was not liability, but activity—the partners were too involved in the business to qualify for the exception. In other words, the IRS took the position that the limited partner exception applies only to passive investors, not to partners who meaningfully participate in the business.
In a decision issued in February 2024, the Tax Court sided with the IRS, finding that, under the statute, a limited partner is a partner who resembles the passive investors Congress had in mind in 1977 when the statute was drafted. The Tax Court felt that Sirius’s partners did not fit that description, relying heavily on its earlier decision in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), which focused on participation rather than formal legal status.
As expected, Sirius appealed.
GP v. LP v. LLP v. LLLP
The key distinction among partnership forms tends to be liability, not participation. In a general partnership (GP), every partner is personally liable for the business’s debts, meaning each partner’s personal assets are at risk. The partners also share in management decisions.
A limited partnership (LP) divides partners into two groups: a general partner who manages the business and has unlimited liability, and limited partners who have limited liability (risk is typically limited to their investment). While limited partners used to not be allowed to participate in management decisions, modern-day partnership statutes tend to allow limited partners to be active without giving up liability protection.
LLPs and LLLPs are further variations on a theme. An LLP is a general partnership that has elected to have its partners enjoy statutory limited liability, while an LLLP is a limited partnership that extends limited liability protection to the general partner. In both cases, state law separates liability exposure from day-to-day involvement in the business. That matters because it is contrary to the IRS’s assumption that “limited partner” is shorthand for passive activity rather than a description of legal status and liability.
Fifth Circuit’s Holding
Sirius’ matter eventually landed at the Fifth Circuit, which hears federal appeals from Texas, Louisiana, and Mississippi. There, it got a win, with the Fifth Circuit holding that a limited partner is a partner in a limited partnership who has limited liability—full stop.
The Fifth Circuit squarely rejected the IRS’s position that “limited partner” should be read as a proxy for “passive investor.” It also rejected the Tax Court’s attempt to add a participation-based limit that does not appear in the statute.
The rest followed easily. The Sirius partners were partners. The entity was a limited partnership under state law. The partners had limited liability. That placed them within section 1402(a)(13), subject only to the exception for guaranteed payments for services.
With that, on January 16, 2026, the Fifth Circuit vacated the Tax Court’s decision and remanded the case (meaning that it returned it to the lower court).
How the Fifth Circuit Got There
The Fifth Circuit relied heavily on the text of the statute. Specifically, section 1402(a)(13) excludes a limited partner’s share of income from self-employment tax, except for guaranteed payments. The statute does not qualify or further limit the term “limited partner.” It does not say “passive limited partner” or “limited partner who does not materially participate.” The court treated that silence as deliberate.
From there, the court considered what Congress intended for “limited partner” to mean when it enacted the provision in 1977. In the Fifth Circuit’s view, it was a term borrowed from state partnership law, not a description of how a partner behaves. That means that a limited partner is defined by liability (specifically, by protection from personal responsibility for partnership debts).
The Fifth Circuit also pointed to the structure of section 1402(a)(13) itself. Congress did not write a participation-based test. Instead, it created an exclusion with a narrow exception for guaranteed payments. It could have included other qualifiers or exclusions, but it didn’t.
The Court also wasn’t moved by a reference to the IRS’s 1997 proposed regulations, which sought to categorize limited partners based on their authority and participation. Those regulations were never finalized, and Congress didn’t adopt anything similar. If anything, the court suggested that the long delay meant that Congress had not embraced the IRS’s position.
What Remains Open on Remand
When a matter comes back down to a lower court, the parties cannot relitigate the same issues that were decided by the appellate court. They also can’t bring up new arguments that they abandoned.
But they can raise issues that might have been left open by an appellate court, or not addressed by the court even though they might have been raised in the lower court (or issues that couldn’t have reasonably been raised earlier).
So what does that mean?
For now, guaranteed payments remain subject to self-employment tax. On remand, the IRS could try to argue that distributions were really guaranteed payments for services, particularly if they were fixed or tied to services rather than profits.
The IRS could also try to revisit state-law partner status, though the Fifth Circuit’s analysis doesn’t leave a lot of room for that argument. Activity alone isn’t enough–the question is whether the partners actually lacked limited liability.
Since ordinary partnership tax principles still apply, the IRS could try to challenge the specific allocations or characterizations on the partnership return. What it cannot do (at least in the Fifth Circuit) is revive the theory that active participation by itself disqualifies a partner from the limited partner exception.
What’s Next
For now, at least in the Fifth Circuit, the takeaway is simple: a limited partner does not stop being a limited partner just because they work in the business. But as partnerships evolve under state law, don’t expect this to be the last word.
The case is Sirius Solutions v. Commissioner of Internal Revenue, No. 24-60240 (5th Cir. 2026).
Source: https://www.forbes.com/sites/kellyphillipserb/2026/01/20/fifth-circuit-pushes-back-on-irs-attempt-to-redefine-limited-partner/
