Self-emploiyment taxes are an additional tax over and above any income tax that may be due. The amount can be significant—these Social Security and Medicare taxes can add up to 15.3% on top of ordinary income tax rates. For smaller businesses, it is often a very large part of the overall tax due.
How this tax applies for businesses that are organized as partnerships and limited liability entities has been in question for several decades. Business owners often organize their companies as partnerships or limited liability entities to protect personal assets from business liabilities. These same owners typically work actively in their businesses, providing services, managing operations, and generating the income that flows through to their personal tax returns.
In doing this, it raises the question about whether the limited partner exception under Section 1402(a)(13) of the tax code exempts the partner from self-employment tax. This provision excludes a limited partner’s distributive share of partnership income from self-employment taxes. For decades, the IRS and tax court have taken the position that this exception applies only to passive investors who don’t actively participate in the partnership’s business. Active partners who work in the business have been required to pay self-employment taxes on their share of partnership income, regardless of their formal designation under state law.
But what if a partner is formally designated as a “limited partner” under state partnership law, enjoys limited liability protection, yet actively works in and manages the business? Does the limited partner exception depend on the partner’s formal legal status, or does it turn on whether the partner functions as a passive investor?
The case of Sirius Solutions, L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. Jan. 16, 2026), provides an opportunity to consider this question about the scope of the limited partner exception.
Contents
Facts & Procedural History
The limited partnership in this case, Sirus, operated a business consulting firm based in Houston, Texas. The company was organized as a limited liability limited partnership under Delaware law. Sirius Solutions GP, L.L.C. served as the general partner, holding less than one percent of the partnership interest.
During the 2014 tax year, Sirius had nine individual limited partners in addition to its general partner. Four of the limited partners sold their interests during 2014, leaving five individual limited partners for the 2015 and 2016 tax years.
The individual partners each had specific titles and roles within the business. They worked exclusively for Sirius, devoted substantial time to the firm’s operations, delivered services on client engagements, developed business, supervised staff, billed hours, selected staff for engagements, negotiated with clients, and participated in hiring and termination decisions.
Sirius reported ordinary business income of over $5 million in 2014, $7 million in 2015, and a loss of $400,000 in 2016. The partnership allocated all of this income to the individual limited partners rather than to the general partner. Based on the limited partner exception in Section 1402(a)(13), Sirius excluded the limited partners’ distributive shares from the calculation of net earnings from self-employment. Sirius reported zero dollars in net earnings from self-employment for all three years.
The IRS pulled Sirius’s 2014 return for audit. In June 2020, the IRS issued a Notice of Final Partnership Administrative Adjustment (“FPAA”) determining that the individual partners were not “limited partners” within the meaning of Section 1402(a)(13). The IRS increased the partnership’s net earnings from self-employment from zero to over $5 million for 2014. Similar adjustments followed for the 2015 and 2016 tax years.
Sirius petitioned the U.S. Tax Court for readjustment of these determinations. The tax court ruled in favor of the IRS and the case was appealed to the Fifth Circuit Court of Appeals.
Self-Employment Tax and Net Earnings from Self-Employment
Self-employment tax represents the partner’s contribution to Social Security and Medicare. Employees pay these taxes through payroll withholding, with the employer paying a matching amount. Self-employed individuals pay both the employee and employer portions themselves. The taxes fund Social Security retirement benefits and Medicare coverage that the taxpayer will receive in later years.
Social Security and Medicare taxes are imposed on two categories of income: wages paid to employees and self-employment income earned by business owners and independent contractors. This is an additional tax over and above the income tax that imposed on what is largely the same income.
For 2014 through 2016, the self-employment tax rate was 15.3% on income up to the Social Security wage base (approximately $117,000 to $127,200 during those years) and 2.9% on income above that threshold. So the taxpayer would pay this amount, plus income tax at the prevailing income tax rates.
So what exactly is self-employment income? Self-employment income is defined as “the net earnings from self-employment derived by an individual” during the taxable year. This income is reduced by a few subtractions. Specifically, the tax code defines “net earnings from self-employment” to include an individual’s distributive share of income or loss from any trade or business carried on by a partnership of which the person is a member.
This broad rule means that when a business operates as a partnership for tax purposes, each partner generally must pay self-employment tax on their share of the partnership’s business income. This applies whether or not the partnership actually distributes cash to the partners. The tax is calculated on the partner’s allocable share of income, not on distributions received.
The Limited Partner Exception
Congress enacted Section 1402(a)(13) as part of the Social Security Amendments of 1977. This provision creates an exception to the general rule that partnership income is subject to self-employment tax. The statute provides:
[T]here 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.
The same legislation also adopted a parallel exception for Social Security benefits calculations. A limited partner’s distributive share does not count toward the earnings record used to calculate future Social Security retirement benefits. The amount of Social Security benefits a person receives depends on their earnings history. By excluding limited partner income from self-employment earnings, Congress also excluded it from the benefit calculation. This created symmetry between the taxes paid and the benefits received.
Congress enacted these provisions in response to concerns about investors who were obtaining Social Security coverage by making passive investments in limited partnerships. These investors would invest relatively small amounts of capital, receive modest investment returns, pay minimal self-employment taxes on those returns, and thereby obtain Social Security coverage and credits toward future benefits. Congress viewed this as inconsistent with Social Security’s fundamental purpose of replacing lost earnings from work.
The House Report accompanying the legislation explained that Congress intended to exclude “earnings which are basically of an investment nature” from Social Security coverage. H.R. Rep. No. 95-702, pt. 1, at 40-41 (1977). The report noted that certain business organizations were soliciting investments in limited partnerships as a means for investors to become insured for Social Security benefits, and stated that this situation was “inconsistent with the basic principle of the social security program that benefits are designed to partially replace lost earnings from work.”
Limited Partners as Passive Investors
Prior to the Fifth Circuit’s decision in Sirius Solutions, the U.S. Tax Court had developed a well-established interpretation of the limited partner exception through a series of decisions dating back to 2011. This line of cases adopted what courts and commentators call a “functional analysis test.” Under this approach, the determination of whether someone qualifies as a limited partner depends not on their formal designation under state law, but on whether they function as a passive investor in the partnership.
The tax court first articulated this approach in Renkemeyer, Campbell & Weaver v. Commissioner, 136 T.C. 137 (2011). That case involved a law firm organized as a limited liability partnership under Kansas law. All of the partners were licensed attorneys who practiced law as part of the firm. The IRS determined that their distributive shares of partnership income were subject to self-employment tax. The partners argued they qualified for the limited partner exception because Kansas law provided them with limited liability protection.
The tax court rejected this argument and held that the partners did not qualify for the exception. The court explained that the intent of section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations (which was the archetype of limited partners at the time) would not receive credits toward Social Security coverage. The court found that the partners’ distributive shares arose from legal services they performed on behalf of the firm, not from passive investment returns. Therefore, they were subject to self-employment taxes.
The tax court applied similar reasoning in later case. We covered several of these, including this one involving a medical practice and this one involving a management company. These cases established that determining limited partner status requires examining the functions and roles of the partners in the partnership’s business. Labels assigned under state law are not dispositive. A partner who actively participates in managing and operating the business cannot claim the exception merely by organizing under a state law form that provides limited liability or includes “limited” in its name.
The Plain Text and Limited Liability
The Fifth Circuit reversed the tax court in Sirius Solutions. The majority opinion held that the tax court had misinterpreted Section 1402(a)(13). According to the Fifth Circuit, a “limited partner” is simply a partner in a state law limited partnership who has limited liability. The court rejected the functional analysis test requiring passive investor status.
The court began its analysis with dictionary definitions of “limited partner” from the time Congress enacted Section 1402(a)(13) in 1977. Webster’s Third New International Dictionary defined “limited partner” as “a partner whose liability to creditors of the partnership is usu[ally] limited to the amount of capital he has contributed to the partnership providing he has not held himself out to the public as a general partner and has complied with other requirements of law.” Black’s Law Dictionary’s 1979 edition defined “limited partner” as “a partner whose liability to third party creditors of the partnership is limited to the amount invested by such partner in the partnership.”
The court found that every contemporaneous dictionary focused on limited liability as the defining characteristic of a limited partner. The court concluded that the term’s ‘single, best meaning is a partner in a limited partnership that has limited liability. The court found no support in the ordinary meaning of “limited partner” for imposing an additional requirement that the partner be a passive investor.
The Fifth Circuit also relied heavily on guidance issued by the IRS and Social Security Administration shortly after Section 1402(a)(13) was enacted. In 1978, the IRS issued partnership tax return instructions defining “Limited Partner” as “one whose potential personal liability for partnership debts is limited to the amount of money or other property that the partner contributed or is required to contribute to the partnership.” This definition remained consistent in IRS instructions from 1978 through 2016, covering the tax years at issue in Sirius Solutions.
The Social Security Administration issued regulations in 1980 that similarly defined limited partner based on limited liability. The regulation stated: “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.” This regulation remains in effect today.
The Fifth Circuit found these contemporaneous and longstanding agency interpretations “especially useful” in determining the statute’s meaning. The court noted that the IRS’s instructions explain the requirements of the tax code to the public and help taxpayers comply with the law. When an agency maintains a consistent interpretation for more than 40 years and then suddenly changes course, courts should be skeptical of the new position.
What About LLCs and LLPs?
This ruling does not fully explain whether the holding applies to LLCs and LLPs.
Most modern businesses organize as limited liability companies rather than limited partnerships. LLC members enjoy limited liability just as limited partners do. If the Fifth Circuit’s test focuses solely on limited liability, it would seem to follow that LLC members should also qualify for the exception.
The Fifth Circuit’s opinion explicitly limits its holding to partners in state law limited partnerships who have limited liability. In a footnote, the majority stated: “Although we refer only to membership in a limited partnership throughout this opinion, we do not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception.”
This limitation creates significant uncertainty. If the Fifth Circuit is correct that limited liability is the only requirement, the prior tax court decisions would seem to be inconsistent with the statutory text.
The Takeaway
This is an important case for a legal issue that has been debated for decades. If the majority’s interpretation is correct, it would seem that a partner can avoid all self-employment taxes simply by organizing their business as an LLC or limited partnership instead of as a general partnership or sole proprietorship, with no other change in how they operate or the work they perform. This creates a tax planning opportunity—what some may call a loophole, depending on one’s perspective.
This case may not be the end of the matter. We may continue to see litigation on this area if the IRS continues to assert that LLC members and LLP partners who actively participate in their businesses owe self-employment taxes on their shares of income. This may also be the case for taxpayers who would appeal to courts outside the Fifth Circuit–as those courts might not follow Sirius Solutions and may continue applying the functional analysis test. This could create a circuit split and may ultimately require Supreme Court resolution.
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