Fifth Circuit Hands IRS Defeat in Limited Partner Self Employment Tax Exclusion Case
Limited partners in state law limited partnerships are governed by a special set of tax rules—and are typically able to exclude their distributive shares of partnership income from self-employment tax. In recent years, the IRS has tried to put a stop to the IRC Section 1402 exclusion and treat limited partners as general partners for self-employment tax purposes. For the first time ever, a federal appeals court has weighed in on the self-employment tax treatment of limited partners in state law limited partnerships. On January 16, 2026, the Fifth Circuit Court of Appeals sided with the limited partners in Sirius Solutions, LLLP v. Commissioner—and, in doing so, vacated last year's Tax Court decision in Soroban and handed the IRS a significant defeat. Clients who are organized as limited partnerships may wish to reevaluate their tax positions in light of Sirius and those who relied on Soroban may wish to consider filing for refunds.
Limited Partners and the Self-Employment Tax: Background
Generally, the IRS imposes taxes on all of a taxpayer's income—whether it's earned as an employee or as a self-employed individual. One significant exception is IRC Section 1402(a)(13), which excludes a limited partner's distributive share of partnership income from Social Security and Medicare taxes (the Self-Employed Contributions Act, or SECA, exclusion). Guaranteed payments received by limited partners in exchange for services provided to the partnership do not qualify for the exclusion.
In recent years, the IRS has attempted to limit the overall exception to passive investors in state law limited partners, applying a functional analysis test to determine whether partners qualified. One pivotal 2025 Tax Court Case was Soroban Capital Partners v. Commissioner.
In Soroban, the Tax Court sided with the IRS and held that all of the limited partners' income was subject to self-employment tax, not just the portion characterized as guaranteed payments. The Tax Court applied the functional analysis test that it adopted in its 2023 ruling on the matter (while the court adopted the functionality test in 2023, it provided little guidance on the analysis necessary to apply the test).
The Tax Court found that the limited partners in question were limited partners in name only, so did not qualify for the SECA exemption. They Tax Court emphasized the fact that the partners were "essential" to the business' operations, responsible for generating income and that the partners were held out to the public as essential and participated in both management and the partnership's decisions. In further applying the test, the court noted that the partners worked full-time, had authority to manage and that their income was not of an investment nature.
Fifth Circuit Sirius Decision
The limited partners in Sirius Solutions had relied on the SECA 1402 exclusion and excluded their limited partners' distributive shares of partnership income when calculating their earnings for self-employment tax purposes. The IRS challenged this position and found that the limited partners did not qualify as
"limited partners" for purposes of IRC Section 1402 because they were not passive investors. Relying on the Soroban precedent, the Tax Court upheld the IRS' position.
The Fifth Circuit disagreed. It vacated the Soroban decision and found instead that the partner's level of participation in the partnership was not relevant. Instead, the relevant inquiry is whether the limited partner has limited liability under state law.
The Fifth Circuit analysis involved an analysis of the relevant text—and the fact that IRC Section 1402(a)(13) does not include any reference to the fact that the partner's level of participation within the business is relevant. The court also emphasized the fact that the IRS has consistently interpreted a "limited partner" as one with limited liability since 1977, when IRC Section 1402(a)(13) was enacted. They also emphasized the fact that Congress could have adopted a passive investor standard if they wished.
Going Forward Post-Sirius
Under the Fifth Circuit's standard, whether a limited partner qualifies for the SECA exception depends on the partner's legal status rather than their activity within the partnership's business.
The Fifth Circuit analysis creates a more predictable and administratively practical standard for limited partners—rather than one that would require intensive factual analysis.
However, it's important for clients to understand that the issue is far from resolved. The Sirius decision only holds precedential value in the Fifth Circuit. Currently, the Soroban case is on appeal in the Second Circuit and a similar case, Denham Capital, is on appeal in the First Circuit. If either of circuit sides with the Tax Court and adopts their functional analysis test, the Supreme Court would likely weigh in to decide the issue.
Clients should also understand that even under Sirius, the Section 1402 exclusion applies only to state law limited partners—not to LLCs and other types of business entities.
Conclusion
To facilitate the Fifth Circuit review, the partners in Sirius stipulated that they would not qualify for the SECA exclusion if the Tax Court's functional analysis test did apply. Clients should pay close attention to additional rulings and IRS action with respect to the SECA exclusion going forward—and those in the Fifth Circuit may wish to file for refunds.