Fifth Circuit Rejects IRS Test for Limited Partners' Self-Employment Tax

The U.S. Court of Appeals for the Fifth Circuit ruled on January 16, 2026, that a partner's status as a limited partner under state law is enough, by itself, to qualify for the self-employment tax exclusion in the tax code, without having to prove to the IRS that the partner was a purely passive investor. The decision, Sirius Solutions, L.L.L.P. v. Commissioner, reverses a Tax Court test the IRS has used against partners in investment, consulting and professional-services firms who also work actively in the business.

What the court decided

Section 1402(a)(13) excludes a limited partner's distributive share of partnership income from self-employment tax, so long as it is not a guaranteed payment for services rendered. In 2023 the Tax Court, in Soroban Capital Partners LP v. Commissioner, read that exclusion narrowly, applying a "functional analysis" under which a partner had to show they actually behaved as a passive investor, regardless of their state-law title, or the exclusion did not apply. Using that test, the Tax Court found that the limited partners at Sirius Solutions, who were allocated roughly $5.8 million to $7.2 million a year between 2014 and 2016, owed self-employment tax because they worked actively in the business. The Fifth Circuit disagreed, holding that the ordinary meaning of "limited partner" when the exclusion was written in 1977 was a partner who holds limited liability under state partnership law. Active involvement in the business does not by itself disqualify someone from the exclusion, the court found, as long as the partner is not paid a guaranteed payment for services and genuinely holds limited liability under the partnership agreement and state law.

Who this affects

The ruling binds courts only within the Fifth Circuit, which covers Texas, Louisiana and Mississippi, and applies to partners in entities organized as limited partnerships under state law, not to members of limited liability companies taxed as partnerships, a related question the opinion does not resolve. It matters most to partners in law firms, private investment funds and consulting practices structured this way who take a distributive share rather than a salary, and who have been paying self-employment tax on that share out of caution or because of an IRS exam. The IRS has pursued the functional test against partners at several other investment firms, so a bright-line state-law standard changes how those partnerships think about allocating income between distributive shares and guaranteed payments.

The after-tax math

Self-employment tax runs 12.4% for Social Security, up to the 2026 taxable wage base of $184,500, plus 2.9% for Medicare with no dollar ceiling. Example: a partner in a Texas-based state-law limited partnership is allocated a $600,000 distributive share with no guaranteed payment. Treated as self-employment income, the Social Security portion would apply only to the first $184,500, producing roughly $22,900, and the Medicare portion would apply to the full $600,000, adding roughly $17,400, for total self-employment tax near $40,300. A partner who genuinely holds limited-partner status under state law owes none of that tax on the distributive share under the Fifth Circuit's standard, though the income remains subject to ordinary income tax, and the net investment income tax can apply separately to investment-type earnings.

Moves to discuss with your advisor

Owners and partners in this position may want a CPA or tax attorney to review the partnership's state-law formation documents, the split between guaranteed payments and distributive shares, and whether the entity is a genuine limited partnership rather than an LLC, since the ruling turns on state-law form rather than the partner's job description. Partners who paid self-employment tax on limited-partner income under the functional test in earlier open years may want to discuss protective refund claims, since amended returns are generally limited to a three-year window from the original filing.

What to watch

Appellate opinions in closely watched tax cases are sometimes the subject of rehearing petitions, and courts occasionally revise or reissue an opinion after it is first released, so the precise boundaries of this standard are worth watching in the months ahead. Outside the Fifth Circuit, the Tax Court's functional test from Soroban remains the operative law until other appeals courts rule, meaning partners in the Second, Ninth or other circuits cannot yet rely on this decision.

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