Case on Limited Partners’ Self-Employment Tax Could Be Headed to Supreme Court

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Under an important exception to the IRC §1402 self-employment rules, limited partners are exempt from paying tax on their distributive share of partnership income. Exactly who qualifies as a limited partner, however, is a complex question that just got more contentious–and may be headed to the Supreme Court.

5th Circuit Ruling in Sirius Solutions: A Shift Toward State-Law Classification

In a recent high-profile decision, the 5^th Circuit Court of Appeals ruled in Sirius Solutions, L.L.L.P. v. Commissioner that partners with limited liability under state law qualify for the self-employment tax exception, regardless of whether they are actively involved in the business. The ruling reversed and remanded the lower U.S. Tax Court opinion, rejecting its “functional analysis” test and discrediting the Tax Court’s 2025 Soroban Capital Partners decision in the IRS’s favor. The 5^th Circuit’s ruling can be considered a major victory for limited partnerships, in particular for service partnerships with limited partners.

As the Congressional Research Service notes, the term “limited partner” for purposes of the self-employment tax exception is not defined in the Internal Revenue Code. The IRS and the Tax Court have adopted a “functional analysis” to determine if a limited partner acts as an active manager or as a service provider, rather than as a passive investor. Their analysis depends on the specific facts of a case rather than on the designation of a limited partner under state law.

Under the Sirius Solutions decision, state-law legal status is controlling, at least in the 5^th Circuit–Texas, Louisiana and Mississippi. That means, state-law limited partners who have limited liability may not be subject to federal self-employment taxes even when they actively participate in the business. In other words, a state-law limited partner designation could save them a tax of 15.3% of net earnings.

IRS Response and Potential Rehearing

The IRS and the Trump Administration’s Justice Department are defending the IRS position by opposing the appeals in cases the government won and now by petitioning for a rehearing (as reported by Tax Notes) by the full 5^th Circuit Court in the Sirius Solutions case. An en banc hearing would be before all active judges of the Court instead of just the 3-judge panel. The petition argues that the Sirius decision could cause “serious funding consequences for Social Security and Medicare,” and notes that limited partners would be tax-exempt “…even where they work full-time managing and controlling the business.”

Other important cases have been decided on the application of self-employment taxes to limited partners. With the 5^th Circuit’s decision, there are now active cases in three federal circuits that have reached different conclusions. Here’s the current scorecard:

• 1st Circuit, Denham Capital Management LP, et al v. Bessent

Lower court decision for the IRS, on appeal by taxpayer

• 2nd Circuit, Soroban Capital Partners LP v. Commissioner

Lower court decision for the IRS, on appeal by taxpayer

• 5th Circuit, Sirius Solutions, L.L.L.P. v. Commissioner

Appeals court decision for taxpayer, petition by government for rehearing

In these latest cases, there is a 2-1 split in favor of the government. Now, the First and Second Circuits have to make their decisions. If they rule for the government, it will set up a split in the Circuit Courts, which paves the way for potential Supreme Court review.

What This Means for Limited Partners

These cases should take a while to move through the system and will be closely watched by limited partnerships and their advisors. At this time, only taxpayers in the 5^th Circuit may qualify for refund claims for self-employment taxes paid. And of those, only state-law designated limited partners are covered, not necessarily LLC members or LLPs without an official limited partner designation.

What is clear is that limited partners need to be aware of their state legal status and should continue to document their activities or non-active status to prepare for potential future changes to their self-employment tax liability.

Contributors

Lucia Smeal, Tax Attorney
Lucia Nasuti Smeal is a guest columnist on tax topics for Frazier & Deeter. Smeal is an attorney, a former clinical assistant professor at Georgia State University’s J. Mack Robinson College of Business and adjunct professor at Franklin University. She also was the former editor of Tax Notes Today, published by Tax Analysts. In past years, Smeal worked for the Congressional Research Service and was a member of the U.S. House Periodical Press Corps. She is a frequent speaker and writer on current tax developments.