Fifth Circuit Rejects IRS "Passive Investor" Test for Limited Partners in Self-Employment Tax Case

In a significant win for taxpayers, the Fifth Circuit has reversed the Tax Court’s decision in Sirius Solutions LLLP v. Commissioner and held that a limited partner under state law is exempt from self-employment tax on their distributive share of partnership income, even if they are more than just a passive investor.

The Dispute

Sirius Solutions, a Delaware limited liability limited partnership, allocated all of its operating income to its individual limited partners and reported zero net earnings from self-employment. Like countless other limited partnerships, they relied on the limited partner exception of §1402(a)(13), which says the distributive share of a “limited partner, as such” is excluded from self-employment tax.

The IRS disagreed, arguing that the partners did not qualify for the limited partner exception since they were active in the business. As a basis for this position, the IRS contended that the inclusions of the words “as such” in the statute showed that Congress intended to exempt only those who functioned as passive investors rather that anyone merely classified as limited partners under state law. The Tax Court ruled in favor of the IRS, consistent with its opinions in other recent cases adopting this functional analysis test.

The Fifth Circuit’s Reasoning

In the first appellate review of this functional analysis, the Fifth Circuit rejected the IRS’s approach. The Court held that nothing in the statute requires a limited partner to be passive. To the contrary, §1402(a)(13) expressly contemplates that limited partners may receive guaranteed payments for services, undermining the IRS’s theory that active participation disqualifies them.

The court also relied on decades of agency guidance. Since 1978, IRS Form 1065 instructions had defined “limited partner” solely by reference to limited liability, and Social Security Administration regulations adopted the same understanding. The IRS’s 2022 pivot to a functional test, the court noted, conflicted with over 40 years of consistent interpretation.

Impact

At least two other major cases (Soroban Capital Partners and Denham Capital Management) are pending outside the Fifth Circuit. If another circuit upholds the IRS’s functional test, creating a circuit split, the U.S. Supreme Court may ultimately need to resolve the issue.

Limited partnerships should consult their tax advisors regarding the implications of the Sirius decision and the appropriate reporting of limited partner income while litigation on the issue continues to develop.

If you have any questions regarding this blog post or tax matter, please contact njahansouz@meadowscollier.com.