Narrow Self-Employment Tax Analysis Nixed by Appeals Court (1)

State-law limited partners can qualify for an exemption from self-employment taxes on their distributive shares of income without the Tax Court analyzing case-by-case whether they operate as passive investors, the Fifth Circuit ruled Friday.

Limited partners of Sirius Solutions LLLP, a Houston business management consulting firm, were held to too stringent a standard when the US Tax Court decided to increase the partnership’s taxable net earnings from self-employment, the US Court of Appeals for the Fifth Circuit said. The Tax Court should have used Sirius partners’ designations under state law to decide their tax exemption eligibility, rather than apply its own multi-factor test scrutinizing their activities, the appeals court said in its decision to vacate and remand.

“A ‘limited partner’ is a partner in a partnership that has limited liability,” Judge Andrew S. Oldham wrote for the court, joined by Judge Kurt D. Engelhardt.

The Tax Court is free to still apply its multi-factor test when judging the exemption claims of limited partnerships in other circuit court jurisdictions. But for state-law limited partners operating in the Fifth Circuit, the ruling could open a pathway to significantly reduce the risk of tax exposure.

IRC Section 1402(a)(13) excludes the distributive income share of a “limited partner, as such,” from earnings subject to the Self Employment Contributions Act, which raises funds for Social Security and Medicare. Sirius challenged the Tax Court’s interpretation of “limited partner, as such,” which the law doesn’t define.

The Tax Court and government both took the term “limited partner, as such” to be synonymous with a passive investor, meaning Sirius’s partners could only have their distributions exempt from self-employment tax by passing the court’s test to show that they only invested passively. Sirius challenged that reading, arguing any limited partner designation under state law was enough to qualify for the SECA exemption.

Other investment fund partners could see major income tax benefits because a broader interpretation may mean more partners qualify for a self-employment tax exemption. Other cases involving self-employment tax include Denham Capital Management LP v. CIR and Soroban Capital Partners LP v. CIR, which have been appealed to the First and Second Circuits.

Sirius’s interpretation more closely matches the law as Congress wrote it, the Fifth Circuit ruled.

“Dictionary definitions and the longstanding views of the two agencies tasked with administering the Social Security Amendments of 1977 all point in one direction,” Oldham said. “The term’s ‘single, best meaning’... is a partner in a limited partnership that has limited liability.”

Judge James E. Graves Jr. dissented, saying the law is clear that the tax exemption for limited partners should only apply to passive investors.

“The record here clearly establishes that the individual partners were not merely passive investors but were ‘limited’ in name only,” he said.

The Fifth Circuit remanded the case to the Tax Court for proceedings consistent with the opinion.

Holland & Knight LLP represents Sirius.

The case is Sirius Sols., LLLP v. Commissioner, 5th Cir., No. 24-60240, 1/16/26.