Fifth Circuit Tax Ruling Could Mean Thousands in Refunds for California Limited Partners: What You Need to Know

If you’re a California resident managing partnership income—whether you’re a fund manager, consulting partner, or professional in a limited partnership structure—a recent federal court decision could significantly impact your tax obligations and potentially put thousands of dollars back in your pocket.

What Happened? Court Overturns IRS Position on Self-Employment Tax

The U.S. Court of Appeals for the Fifth Circuit recently reversed a Tax Court decision in Sirius Solutions, L.L.L.P. v. Commissioner, establishing that true limited partners under state law are exempt from self-employment taxes on their partnership income. While this ruling directly applies to Texas, Louisiana, and Mississippi, it has significant implications for California taxpayers as similar cases work their way through other federal circuits.

Who Is This Ruling For?

This decision particularly matters if you are:

A California resident operating as a limited partner in a partnership structure

Managing partnership income through private equity firms, consulting practices, or professional service partnerships

Someone who has been paying self-employment taxes on partnership distributions

A fund manager, law firm partner, or professional with limited liability status under state law

Why Does This Matter for California Families and Business Owners?

For years, the IRS has applied a “functional test” to determine whether partners owe self-employment tax—essentially looking at how active someone is in the business rather than their formal legal status. The Fifth Circuit rejected this approach entirely.

Financial expert Michael Ryan explains: “The court basically told the IRS, ‘No, you can’t just look at how active someone is in the business and decide whether they owe self-employment tax. If someone’s a true limited partner under state law (meaning they actually have limited liability), their share of partnership income doesn’t get hit with SE tax. Period.'”

For California taxpayers managing significant partnership income, this could translate to substantial annual savings—potentially thousands of dollars each year.

What the Court Actually Said

The Fifth Circuit’s ruling provides clear guidance:

A “limited partner” means a partner in a limited partnership who has limited liability under state law

Limited liability status exempts these partners from self-employment taxes on their partnership income

When a partner holds multiple roles, the limited partner exception applies only to income earned in their capacity as a limited partner

Can California Residents Benefit From This Ruling?

While the Fifth Circuit ruling directly applies only to Texas, Louisiana, and Mississippi, California taxpayers should pay close attention because:

Similar cases are currently pending in the First Circuit (Massachusetts) and Second Circuit (New York)

How these cases are decided could create precedent affecting California taxpayers

The IRS may adjust its national enforcement approach based on multiple appellate decisions

California limited partners can file protective claims to preserve their rights while litigation continues in other circuits

How to Claim a Potential Tax Refund: Amended Return Deadlines

If you believe you’ve been overpaying self-employment taxes on limited partnership income, here’s what you need to know about filing an amended tax return:

Use IRS Form 1040-X to file your amended return

You generally have three years from the date you filed your original return, or two years from when you paid the tax—whichever is later

For a 2022 return filed in April 2022, the deadline would be April 2025 (which has now passed), so focus on more recent tax years

Gather comprehensive documentation proving your limited partner status under state law

What Legal Experts Are Saying

Alex Beene, a financial literacy instructor for the University of Tennessee at Martin, notes: “This ruling clarifies who qualifies as a ‘limited partner’ for the self-employment tax exception under federal tax law. The court rejected the IRS’s use of a functional ‘passive investor’ test and instead held that if someone is a limited partner under state law, that status generally controls for the tax exemption.”

Practical Steps for California Limited Partners

If you’re a California resident with limited partnership income, consider these action steps:

Document your partnership structure: Ensure you have clear evidence of your limited partner status under California law

Review past tax returns: Identify years where you may have overpaid self-employment taxes

File protective claims: Consider filing protective refund claims to preserve your statute of limitations while circuit court cases develop

Clarify your roles: If you hold multiple roles in a partnership, clearly document which income comes from your limited partner capacity versus other roles

Consult with tax and estate planning professionals: Partnership structures often intersect with estate planning, and proper structuring can protect both your current tax position and your family’s future financial security

How This Connects to Your Estate Planning

For many California families, partnership interests represent significant assets that need careful consideration in estate plans. Whether you’re managing partnership income today or planning to transfer partnership interests to the next generation, the tax treatment of these assets matters enormously.

Proper estate planning ensures that:

Your partnership interests are structured to maximize tax benefits for both you and your heirs

Your family understands and can properly manage these assets after you’re gone

Your estate plan coordinates with your business structure to avoid unnecessary probate complications

Your beneficiaries are protected from potential tax disputes with the IRS

What Happens Next? Circuit Split Could Force Supreme Court Resolution

The IRS will continue fighting this issue in other federal circuits. Cases pending in the First and Second Circuits could create a “circuit split”—when different federal appellate courts reach opposite conclusions on the same legal question.

If multiple circuits reach conflicting decisions, the U.S. Supreme Court may eventually need to resolve the issue, providing nationwide clarity on limited partner tax treatment.

Get Expert Guidance on Partnership Structures and Estate Planning

California Probate and Trust, PC helps California residents navigate the complex intersection of business structures, tax planning, and estate protection. Whether you’re managing partnership income today or planning to transfer business interests to your family, we provide comprehensive guidance tailored to your specific situation.

Our experienced attorneys offer:

Review of partnership structures and their tax implications

Coordination between business planning and estate planning

Guidance on amended tax returns and protective claims

Comprehensive estate plans that protect your business assets and your family’s future

Trust administration that ensures smooth transitions of partnership interests

Schedule your free consultation today to discuss how recent tax developments affect your partnership income and what steps you can take to protect your assets and your family. Call (866)-674-1130 or visit cpt.law to get started.

Legal Disclaimer

This article is provided for informational purposes only and does not constitute legal or tax advice. The Fifth Circuit ruling discussed applies directly only to taxpayers in Texas, Louisiana, and Mississippi. California taxpayers should consult with qualified tax and legal professionals before filing amended returns or making changes to their tax reporting. Tax law is complex and highly fact-specific. California Probate and Trust, PC does not provide tax preparation services but can coordinate with your tax professionals as part of comprehensive estate planning. Each person’s situation is unique, and outcomes will vary based on individual circumstances.

Source: Newsweek – Court Ruling Means Tax Refund for Thousands in 3 States