Fifth Circuit Gives Big Win to Taxpayers on SE taxes
The Fifth Circuit overturned the Tax Court on SE for limited partners
In a significant ruling for the professional services industry and partnership taxation, the United States Court of Appeals for the Fifth Circuit has overturned a Tax Court decision in Sirius Solutions, L.L.L.P. v. Commissioner of Internal Revenue. The court held that the term “limited partner” for self-employment tax purposes refers to any partner in a limited partnership who has limited liability under state law, rejecting the IRS’s attempt to restrict the definition to mere “passive investors”.
The Core Dispute: Defining “Limited Partner”
The case centered on Code Section 1402(a)(13), a provision of the Tax Code that excludes the distributive share of partnership income for a “limited partner, as such” from self-employment taxes. For decades, many active participants in professional limited partnerships utilized this exception to shield a portion of their income from Social Security and Medicare taxes.
Sirius Solutions, a business consulting firm organized as a Delaware limited liability limited partnership (LLLP), had followed this practice. From 2014 to 2016, the firm reported $0 in net earnings from self-employment, allocating its multi-million-dollar business income to individual partners who held limited partnership interests. The IRS audited these returns and adjusted the self-employment income upward, arguing that because these partners were active in the business (delivering services, supervising staff, and managing engagements) they were “limited partners in name only” and did not qualify for the tax exclusion.
The Shift to “Functional Analysis”
The Tax Court originally sided with the IRS, relying on its recent precedent in Soroban Capital Partners LP v. Commissioner. In that case, the Tax Court adopted a “functional analysis” test, concluding that Congress intended the exception only for “passive investors”. Under this view, if a partner performed more than minimal services for the partnership, they lost their status as a “limited partner” for tax purposes.
The Fifth Circuit’s Reversal
Circuit Judge Andrew S. Oldham, writing for the majority, disagreed with the Tax Court’s interpretation. The court focused on three primary areas to determine the “single, best meaning” of the statute:
Plain Text and Ordinary Meaning: The court consulted dictionaries from the 1970s, when the statute was enacted. It found that the defining characteristic of a “limited partner” was limited liability, not a lack of participation in business affairs.
Agency Consistency: For over 40 years, the IRS’s own form instructions (Form 1065) defined a limited partner based on limited liability. Similarly, the Social Security Administration (SSA) maintains a regulation stating that a person is a limited partner if their financial liability is limited to their investment. The court noted that it was only in 2022 that the IRS began suggesting a different, narrower view. Although the IRS had issued proposed regulations in 1997 that would have made this income subject to SE tax, they were never finalized.
Statutory Structure: The court pointed out that the statute already contains a “guaranteed payments” clause, which taxes limited partners on payments received for “services actually rendered”. If a limited partner were required to be purely passive, this clause would be largely unnecessary.
The court further criticized the IRS’s “functional analysis” as creating massive uncertainty, noting that under such a test, thousands of partners would need “an army of lawyers” to determine their tax liability.
Dissenting Opinion
Judge James E. Graves, Jr. dissented, arguing that the phrase “limited partner, as such” was intended by Congress to distinguish between a partner’s role as an investor and their role as an active worker. Citing legislative history, the dissent argued the exclusion was designed to prevent investors who perform “no services” from obtaining Social Security coverage through mere investment, and that active partners should remain subject to self-employment tax.
Conclusion and Impact
By vacating the Tax Court’s decision, the Fifth Circuit has provided a major victory for partners in state-law limited partnerships. The ruling reinforces a formalistic, state-law-based definition of “limited partner,” providing greater tax certainty for professional firms—at least within the Fifth Circuit’s jurisdiction—until Congress chooses to amend the statute.
It must be noted that the Fifth Circuit (Texas, Louisiana and Mississippi) is likely the most conservative and taxpayer friendly circuit in the country. With the Social Security System facing a liquidity crisis in a few years, Congress will need to get very active in making this more certain than is true today.
But for now, those taxpayers in the Fifth Circuit who are strictly a limited partner in a limited partnership (LLC’s may or may not qualify) will not owe SE tax on this limited partner earnings.
Finally, a definition for "as such". As such.
Can those of us NOT in the 5th circuit rely on this ruling?