Fifth Circuit Ruling Clarifies Limited Partner Self-Employment Tax Exclusion

The U.S. Court of Appeals for the Fifth Circuit ruled that the meaning of “limited partner” under Section 1402(a)(13) of the Internal Revenue Code of 1986, as amended (the “Code”), is determined under state law. This ruling, Sirius Solutions LLP v. Commissioner, overturned a recent Tax Court decision, Soroban Capital Partners LP v. Commissioner.

The Fifth Circuit held that a “limited partner” is defined by limited liability under state law, not by the partner’s level of activity in the partnership. This holding rejects the functional analysis used by the Tax Court in Soroban, which permitted only passive investors (regardless of their status under state law) to qualify for an exclusion from self-employment tax.

Key Takeaways

Section 1402(a)(13). Generally, self-employment income includes a partner’s distributive share from a trade or business carried on by a partnership. Section 1402(a)(13) provides that, “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.”

Previous Decision Reversed. In Soroban, the Tax Court ruled that whether a limited partner met the exclusion under Section 1402(a)(13) depended on a functional analysis based on the partner’s level of participation rather than a classification under state law.

Holding From Sirius Solutions. The Fifth Circuit’s holding in Sirius Solutions is consistent with the view, based on a plain reading of the Code, that self-employment tax does not apply to a limited partner in a limited partnership as a matter of law, regardless of the extent of that limited partner’s participation in the activities of the partnership.

Historical Context. The Fifth Circuit emphasized that when Section 1402(a)(13) was enacted in 1977, the defining feature of a limited partner was limited liability. The majority relied on contemporaneous dictionary definitions and longstanding IRS and Social Security Administration guidance, which consistently treated limited liability as the key factor in the analysis.

Interpretation of “Limited Partner, as such.” The Fifth Circuit stated that the phrase “limited partner, as such” in Section 1402(a)(13) refers to the ordinary meaning of the term—a partner with limited liability. The Tax Court relied on this language to support its functional analysis position, reasoning that it narrowed the scope of the exception to a “limited partner who is functioning as a limited partner.”

Why It Matters

The functional analysis from Soroban raised major concerns and uncertainty as to whether a state-law limited partner would be subject to self-employment tax. This decision from the Fifth Circuit reinstates a bright-line rule that should provide clarity for taxpayers.

Partnerships and their advisors should review their structures and tax positions in light of this important development, particularly if they have paid self-employment tax while a limited partner under state law and may be eligible for a refund. There are other cases pending on the same issue in the First Circuit and Second Circuit, which raises the possibility of a circuit split on the issue.

Fifth Circuit Ruling on Limited Partner Self-Employment Tax: What California Business Owners Need to Know

If you’re a California resident who owns or invests in a partnership—whether you’re managing real estate holdings, investment funds, or a family business—a recent federal court decision could significantly impact your self-employment tax obligations and potentially entitle you to refunds.

What Happened? Understanding the Fifth Circuit’s Decision

The U.S. Court of Appeals for the Fifth Circuit recently issued a landmark ruling in Sirius Solutions LLP v. Commissioner that clarifies how “limited partner” status is determined for self-employment tax purposes. The court ruled that limited partner status is based on state law—specifically, whether you have limited liability under your state’s partnership laws—not on how actively you participate in the business.

This decision directly overturned a Tax Court ruling in Soroban Capital Partners LP v. Commissioner, which had created uncertainty by suggesting that only passive investors could qualify for the self-employment tax exclusion, regardless of their legal status.

Why Does This Matter for California Partnerships?

Under Section 1402(a)(13) of the Internal Revenue Code, limited partners are generally excluded from paying self-employment tax on their distributive share of partnership income (with some exceptions for guaranteed payments).

The Tax Court’s previous approach created confusion by requiring a “functional analysis” based on participation levels rather than legal classification.This meant that even if you were legally classified as a limited partner under California law, you might still face self-employment tax if you were actively involved in the business.

The Fifth Circuit rejected this approach entirely, reinstating a clear, bright-line rule: if you’re a limited partner under state law with limited liability, you’re excluded from self-employment tax—period.

Key Takeaways for California Business Owners and Investors

State law controls: Your limited partner status is determined by California partnership law, not by the IRS’s interpretation of your business activities

Limited liability is the key factor: When Section 1402(a)(13) was enacted in 1977, limited liability was the defining characteristic of a limited partner, and the Fifth Circuit emphasized this historical context

Activity level doesn’t matter: You can be actively involved in partnership decisions and still qualify for the self-employment tax exclusion as long as you maintain limited partner status under state law

Potential refund opportunities: If you’ve been paying self-employment tax as a state-law limited partner, you may be eligible for refunds

What Should You Do Next?

The Fifth Circuit’s decision provides important clarity, but it also creates potential circuit splits as similar cases are pending in the First and Second Circuits.Here’s what California partnership owners and investors should consider:

Review your partnership structure and tax positions with qualified legal counsel

Determine whether you’ve been classified as a limited partner under California law

Assess whether you’ve paid self-employment tax that may now be refundable

Ensure your partnership agreements clearly establish limited partner status where appropriate

Stay informed about developments in other circuits that could affect your tax position

How California Probate and Trust Can Help

At California Probate and Trust, PC, we understand that partnership structures often intersect with estate planning and asset protection strategies. Whether you’re structuring a family limited partnership, managing investment holdings, or planning for generational wealth transfer, our experienced attorneys can help you navigate complex tax and legal issues.

We offer a comprehensive approach that addresses both the legal structure of your partnerships and the broader estate planning implications. Our team has represented thousands of California clients in developing strategies that protect their assets while minimizing tax burdens.

Schedule Your Free Consultation

If you’re a California partnership owner or investor concerned about self-employment tax obligations, or if you’re looking to structure your business interests for optimal tax efficiency and family protection, contact California Probate and Trust, PC today for a free consultation.

Source: The National Law Review – Fifth Circuit Rejects Tax Court’s Definition of Limited Partner for Self-Employment Tax Purposes

Legal Disclaimer

This article is provided for informational purposes only and does not constitute legal or tax advice. The information contained herein is based on a Fifth Circuit decision that may not be binding in all jurisdictions, including California, which is within the Ninth Circuit. Tax law is complex and subject to change, and the application of these principles depends on individual circumstances. Readers should not act upon this information without seeking professional counsel from qualified attorneys and tax advisors familiar with their specific situations. California Probate and Trust, PC does not guarantee any particular outcome and makes no warranties regarding the accuracy or completeness of this information. Attorney advertising.