The United States Court of Appeals for the Fifth Circuit has delivered a significant decision regarding self-employment (SE) tax liability for limited partners, overturning the Tax Court’s reliance on the "functional analysis" test established in Soroban Capital Partners LP v. Commissioner. In Sirius Solutions, L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. 2026), the Fifth Circuit rejected the IRS’s position that the Section 1402(a)(13) exclusion applies only to "passive investors." Instead, the Court held that the statutory term "limited partner" must be interpreted based on its ordinary meaning at the time of enactment: a partner in a limited partnership who possesses limited liability.

This article details the factual background, the arguments presented, and the technical statutory analysis employed by the Fifth Circuit in this pivotal ruling.

Factual Background and Procedural History

The petitioner, Sirius Solutions, L.L.L.P. (Sirius), is a business consulting firm organized as a limited liability limited partnership under Delaware law. For the tax years 2014, 2015, and 2016, the partnership was owned by a general partner, Sirius Solutions GP, L.L.C., and several individual limited partners. During these years, Sirius reported substantial ordinary business income—ranging from approximately $5.8 million to $7.2 million in profitable years—which it allocated to its limited partners.

Relying on the exclusion provided in I.R.C. § 1402(a)(13), Sirius excluded the limited partners’ distributive shares of partnership income from net earnings from self-employment, reporting "$0 of net earnings from self-employment" on its returns. The IRS audited Sirius and issued Notices of Final Partnership Administrative Adjustment (FPAA), reclassifying the distributive shares as net earnings from self-employment. The IRS asserted that "none of Sirius’s limited partners counted as ’limited partners’ for purposes of the statutory exception".

Sirius petitioned the Tax Court for readjustment. On February 20, 2024, the Tax Court upheld the IRS adjustments, citing its own recent precedent in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023). In Soroban, the Tax Court held that the term "limited partner" in Section 1402(a)(13) refers strictly to "passive investors," necessitating a functional inquiry into the partners’ activities. Sirius subsequently appealed to the Fifth Circuit.

The Taxpayer’s Request for Relief and the Issue on Appeal

The sole issue before the Fifth Circuit was the statutory interpretation of "limited partner" within 26 U.S.C. § 1402(a)(13). The code section excludes from SE tax "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".

Sirius argued that the Tax Court erred by ignoring the plain text of the statute and the entity’s state-law classification. The taxpayer contended that because the partners were limited partners in a state-law limited partnership with limited liability, they fell squarely within the statutory exclusion.

The Court’s Analysis: Textualism Over Functionalism

Writing for the majority, Judge Oldham vacated the Tax Court’s decision, holding unequivocally: "A ’limited partner’ is a partner in a limited partnership that has limited liability". The Court explicitly rejected the "passive investor" requirement imposed by the IRS and the Tax Court.

Plain Meaning and Dictionary Definitions

The Court began its analysis with the ordinary meaning of the text at the time of the statute’s enactment in 1977. Reviewing contemporaneous dictionaries, the Court found that the defining characteristic of a limited partner was consistently limited liability, not a lack of participation in the business. The Court noted, "Each contemporaneous dictionary has one and only one characteristic in common: limited liability. The touchstone of a ’limited partner’ in 1977 was limited liability".

While the Court acknowledged that some definitions mentioned that limited partners usually do not manage the business, it concluded those were secondary descriptions rather than the primary definition.

Contemporaneous Agency Interpretations

The Court placed significant weight on the "contemporaneous and longstanding" interpretations by the IRS and the Social Security Administration (SSA).

First, the Court examined IRS instructions for Form 1065 dating back to 1978. For over 40 years, the IRS defined a limited partner as one whose "personal liability for partnership debts is limited to the amount of money... contributed". The Court observed that "no ‘passive investor’ definition of limited partner—or any other definition—was even hinted at in 1978". The Court emphasized that ignoring these instructions would violate fair notice principles, noting, "It is difficult to see how the instructions are not the agency’s interpretation... The lawbooks teem with examples of taxpayers who’ve learned the hard way what happens when they ignore IRS instructions".

Second, the Court looked to SSA regulations. Since the 1977 amendments addressed both Social Security taxes and benefits, the Court found the SSA’s interpretation "triply apt". The SSA regulations explicitly state: "You are a ‘limited partner’ if your financial liability for the obligations of the partnership is limited to the amount of your financial investment in the partnership".

Rejection of the "Passive Investor" and "Functional Analysis" Tests

The Fifth Circuit dismantled the reasoning used in Soroban and by the IRS on three main grounds:

1. The Guaranteed Payments Clause: The Court argued that the "passive investor" interpretation renders the statutory carve-out for guaranteed payments superfluous. Section 1402(a)(13) taxes guaranteed payments for "services actually rendered." The Court reasoned, "The text of the exception itself contemplates that ‘limited partners’ would provide actual services to the partnership and thus participate in partnership affairs. So a strict passive-investor interpretation... would make the ‘guaranteed payments’ clause entirely superfluous".

2. Statutory Silence: The Court noted that Congress has used terms like "passive investor" or "passive income" in other sections of the Tax Code but chose not to do so in Section 1402(a)(13). Furthermore, Congress explicitly excluded partners who "rendered no services" in Section 1402(a)(10), yet did not use that language in subsection (a)(13).

3. The Meaning of "As Such": The Tax Court in Soroban had relied heavily on the phrase "limited partner, as such," arguing that "as such" restricted the exclusion to partners functioning as limited partners (i.e., passively). The Fifth Circuit rejected this, stating the IRS abandoned the argument on appeal "for good reason". The Court explained that "as such" is recursive and clarifies the tax treatment of dual-status partners: "Without the qualification, a dual-status partner might think his entire distributive share is not subject to taxation. So the words ‘as such’ avoid ambiguity by clarifying that when functioning as a limited partner, a taxpayer’s distributive share... is excluded... But when functioning as a general partner, his distributive share is included".

Reconciling State and Federal Law

The IRS argued that federal tax law should not turn on state-law labels. The Court agreed with the principle but distinguished "labels" from substantive rights. The Court explained that while federal law dictates taxation, it relies on state law to create legal interests. "[T]here is a federal definition of ‘limited partner’ in § 1402(a)(13): a partner in a limited partnership that has limited liability. But because the creation of a limited partnership and the grant of limited liability are matters of state law, we must look to state law to determine if those preconditions... are satisfied".

The Court clarified that a mere label is insufficient; if a state labeled a sole proprietor a "limited partner," they would not qualify. The substantive interest required is limited liability.

Application of Law to Facts

Applying the statutory definition to Sirius, the Court found the analysis straightforward. Sirius is a validly formed L.L.L.P. under Delaware law. The IRS’s attempt to apply a functional analysis to the partners’ activities was improper because the statute focuses on the legal nature of the interest held—specifically, limited liability—rather than the level of activity.

The Court dismissed the argument that modern limited partnership laws (which allow limited partners to participate in control without losing liability protection) somehow change the federal tax definition. "[S]uch restrictions on or regulations of limited partners do not affect their status as limited partners". The Court also rejected the argument that the partners were "limited in name only," noting that this argument "cannot be reconciled with longstanding principles of corporate law".

Conclusion

The Fifth Circuit vacated the Tax Court’s decision and remanded the case for further proceedings consistent with its opinion. This ruling creates a distinct split from the Tax Court’s approach in Soroban and Renkemeyer. Within the Fifth Circuit, the functional analysis test is dead letter for state-law limited partnerships. The Court concluded that regarding the legislative history and policy arguments raised by the IRS: "At bottom, in any complex statutory dispute, the best course is to follow the statute’s plain text. When § 1402(a)(13) says ’limited partner,’ it is referring to a limited partner in a state-law limited partnership that has limited liability".

Practitioners should note that the IRS may continue to litigate this issue in other circuits, given the dissent by Judge Graves, who argued that the majority’s interpretation opens a loophole inconsistent with the legislative intent to tax earnings from work. However, for taxpayers in the Fifth Circuit, the possession of limited liability in a state-law limited partnership is now the dispositive factor for the Section 1402(a)(13) exclusion.

Prepared with assistance from NotebookLM.