Fifth Circuit Limits Tax Court’s Authority to Recharacterize State-Law Limited Partners for Self-Employment Tax Purposes

The U.S. Court of Appeals for the Fifth Circuit ruled that state-law limited partners are exempt from self-employment taxes on their distributive shares of partnership income without being subjected to a fact-intensive inquiry into whether they function as passive investors. Vacating and remanding a contrary decision of the U.S. Tax Court, the Fifth Circuit held that the Tax Court applied an unduly restrictive standard when it increased the taxable net earnings from self-employment of the partners of Sirius Solutions LLLP, a Houston-based management consulting firm.  

The Fifth Circuit rejected the Tax Court's fact-intensive conclusion that a limited partner is one who is truly a passive investor. The majority explained that the proper inquiry for taxpayers within the Fifth Circuit is whether an individual is a limited partner under applicable state law, not whether the partner meets a judicially created standard of passivity. The court concluded that a “limited partner” is best understood as a partner who enjoys limited liability under state partnership law. Because Sirius’s partners were designated as limited partners under state law, the Tax Court should have relied on that classification rather than substituting its own functional test.

The court emphasized that this interpretation aligns more closely with the statutory text and congressional intent. The majority also noted that dictionary definitions support reading “limited partner, as such” to mean a partner in a limited partnership who has limited liability. In the court’s view, nothing in the statute authorizes courts to impose an additional requirement that such partners must also be passive investors to qualify for the exemption.

Although the ruling is binding only within the Fifth Circuit, it has broad implications for limited partners, and more importantly for limited liability company members, as almost every member of a limited liability company has no personal liability for company debts. 

The decision also comes against the backdrop of other pending self-employment tax disputes involving investment management partnerships, including Denham Capital Management LP v. Commissioner and Soroban Capital Partners LP v. Commissioner, which are currently on appeal in the First and Second Circuits. Those cases raise similar questions about the scope of the Section 1402(a)(13) exemption and could ultimately produce divergent interpretations among the circuits.

One judge dissented, taking the position that Congress intended the limited partner exemption to apply only to passive investors. In his view, the record demonstrated that the Sirius partners were “limited” in name only and actively participated in the business, making them ineligible for the exemption. The dissent underscores the continuing debate over whether the statutory exclusion should turn on formal legal status or economic reality.

On remand, the Tax Court must reconsider the Sirius partners’ self-employment tax liability in a manner consistent with the Fifth Circuit’s opinion. For now, the decision provides welcome clarity for state-law limited partners within the Fifth Circuit and may prompt partnerships to reexamine how state-law classifications interact with federal self-employment tax exposure. If you have questions about this update, please contact Liskow attorneys Leon Rittenberg III, John Rouchell, Caroline Lafourcade, and Kevin Naccari and visit our Tax practice page.