Sirius Victory for Limited Partners

On January 16, 2026, in Sirius Solutions v. Commissioner, the U.S. Court of Appeals for the Fifth Circuit held that limited partners in a partnership may qualify for an exemption from self-employment tax on their distributive share of partnership income, regardless of whether the partner is a “passive” investor or not.  The Fifth Circuit thus became the first federal appellate court to squarely reject a “functional analysis” test and interpret the limited partner exception to self-employment tax based on state-law limited liability status.

The court held that a partner in a state-law limited partnership qualifies for the exception if the partner possesses limited liability, regardless of the extent of his or her participation in the business.  This decision vacated a prior Tax Court ruling and establishes an important precedent for asset managers, private equity professionals, and real estate investors in the Fifth Circuit with the potential to influence decisions in other circuits too.

The conflict centers on Internal Revenue Code §1402(a)(13), which generally excludes a limited partner’s distributive share of partnership income (other than guaranteed payments for services) from the 15.3 percent self-employment tax used to fund Social Security and Medicare.  For years, the IRS and the Tax Court relied on a line of cases culminating in Soroban Capital Partners v. Commissioner, which reaffirmed and extended a functional analysis asserting that “limited partners” refers only to passive investors.  Under this approach, courts conducted a factual inquiry into a partner’s day-to-day activities to determine whether his or her income was essentially investment in nature, with active partners treated like general partners for self-employment tax purposes.

The Fifth Circuit rejected this functional test and instead focused on the plain text of the statute.  The court emphasized that statutory language must be given its ordinary meaning at the time of enactment.  Consulting contemporaneous dictionaries from 1977, the court concluded that the touchstone of a “limited partner” at that time was limited liability, not the degree of operational involvement.  Accordingly, “a ‘limited partner’ is a partner in a limited partnership that has limited liability.”  The court criticized the IRS’s subjective approach as one that forces taxpayers to seek “the help of an army of lawyers and accountants” and rely on “a whole lot of luck.”

The decision is binding only within the Fifth Circuit (Texas, Louisiana, and Mississippi).  It has no precedential effect in the Second Circuit (New York) or the Third Circuit (New Jersey).  As a result, the Soroban standard remains controlling in those jurisdictions.  Nevertheless, Sirius is highly persuasive and provides a clear roadmap for how other appellate courts may ultimately resolve the issue.