Will First Circuit Case Denham Further Muddy the NESE Tax Waters?

Partners in investment funds and other partnerships won a key court victory in the Fifth Circuit Court of Appeals when they were exempted from being required to pay self-employment taxes under the limited partner exception under §1402(a)(13). Sirius Solutions LLLP v. Commissioner (2026); now known as K Alain LLLP v. Commissioner, Case No. 24-60240, Document 122-1 (5th Cir.). A circuit split, however, may emerge on the preliminary jurisdictional issue on whether the qualification for the limited partnership exception should be determined in a partnership-level proceeding under the Tax Equity and Fiscal Responsibility Act of 1982, or TEFRA, Pub. L. No. 97-248. In a critical juncture in the ongoing litigation, the First Circuit Court of Appeals seemed to focus its questioning during oral arguments on the jurisdictional issue and requested supplementary briefs from the parties on the issue in Denham Capital Management LP v. Commissioner. Case No. 25-1349, Document 00118416829. Although TEFRA was repealed by the Bipartisan Budget Act of 2015, or BBA, Pub. L. No. 114-74, it applied to partnership tax years ending on or before Dec. 31, 2017, which included the years at issue in Denham.

NESE Tax, Limited Partner Exception

Section 1401(a) imposes a tax on an individual’s net earnings from self-employment, or NESE. Section 1402(a) provides the general rule that NESE include a partner’s distributive share of partnership income or loss from a trade or business carried on by the partnership. The limited partner exception provides an exception to the general rule: "[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 §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.”

There is a disagreement between taxpayers and the IRS regarding the determination of whether a partner in a state law limited partnership qualifies for the limited partner exception. In a previous article, I discussed what is the proper standard to qualify for the limited partner exception:

• State law standard. Taxpayers argue that being a bona fide limited partner of a state law limited partnership qualifies one for the exception, the “state law standard.”Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12 (2023); Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114; K Alain LLLP v. Commissioner, 165 F.4th 374 (5th Cir. 2026).
  
  The Fifth Circuit Court of Appeals recently overruled the Tax Court in K Alain LLLP v. Commissioner, 165 F.4th 374 (5th Cir. 2026), rejecting the passive investor standard, stating “We hold that a ‘limited partner’ in §1402(a)(13) is a limited partner in a state-law limited partnership that is afforded limited liability. And we reject the IRS’s newly adopted passive investor rule.” 165 F.4th at 377-8 (5th Cir. 2026).
  
• Passive investor standard. The government argues, and the Tax Court has agreed, that a functional analysis of the roles and responsibilities of the partner is necessary to determine if one is akin to a passive investor, or the “passive investor standard,” to qualify as a limited partner for purposes of the limited partner exception. Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12 (2023); Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114; K Alain LLLP v. Commissioner, 165 F.4th 374 (5th Cir. 2026).

The passive investor standard for partners in a state law limited partnership was first set out by the Tax Court in Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12 (2023). Taxpayers in that case have appealed to the Second Circuit Court of Appeals and oral arguments are pending. Similarly, the Tax Court following its opinion in Soroban held in Denham Capital Management LP v. Commissioner that the passive investor standard applies and that the partners of Denham Capital Management didn’t qualify for the limited partner exception.

Jurisdictional Issue

TEFRA and partnership items. TEFRA, which was enacted in 1982, established procedural rules for partnership audits and adjustments for partnerships with more than 10 partners and required that the tax treatment of all partnership items be determined at the entity level for these partnerships.

Under TEFRA, a determination is made for an issue at the partnership level if it’s a “partnership item.” Section 6231(a)(3)defined a partnership item as “any item required to be taken into account for the partnership’s taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that, for purposes of this subtitle, such item is more appropriately determined at the partnership level than at the partner level.”

Therefore, a partnership item is an item that is required to be taken into account for the partnership’s taxable year under subtitle A, and that regulations provide is more appropriately determined at the partnership level. Treas. Reg. §301.6231(a)(3)-1(a) provides a list of these items. NESE isn’t on that list. However, the government argued that Treas. Reg. §301.6231(a)(3)-1(b) brings NESE into Treas. Reg. §301.6231(a)(3)-1(a). Treas. Reg. §301.6231(a)(3)-1(b) provides:

“Factors that affect the determination of partnership items. The term ‘partnership item’ includes the accounting practices and the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.”

The jurisdictional issue was not contested by K Alain on its appeal to the Fifth Circuit. During oral arguments at the First Circuit in Denham, the taxpayer argued that NESE is not a partnership item and thus the Tax Court did not have jurisdiction to adjudicate the issue in a partnership-level proceeding. Conversely, the government argued that NESE is a partnership item and thus the Tax Court did have jurisdiction. The First Circuit subsequently ordered the parties to file supplementary briefs on the issue. The parties in Soroban have taken the same positions as Denham before the Second Circuit.

BBA and partnership related items. TEFRA was repealed and replaced for tax years beginning after Dec. 31, 2017 by the BBA. None of the cases that have reached a circuit court of appeals involves a tax year for which the BBA applies. The BBA determines the jurisdictional issue based on “partnership related items,” or PRI, as opposed to TEFRA’s “partnership items,” and PRI are defined differently than partnership items. A detailed examination of how the jurisdictional issue might be decided for a BBA partnership is beyond the scope of this article. The two terms are defined differently and different jurisdictional results might occur.

Golsen Rule

In Golsen v. Commissioner, the Tax Court set out what has become known as the Golsen Rule, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), cert. denied, 404 U.S. 940 (1972), where the court must follow the precedent on an issue, if one has been established, by the circuit court to which the taxpayer would appeal an adverse decision. For example, assume circuit court A holds that taxpayer X qualifies for a certain exception and circuit court B holds taxpayer Y, who is identically situated to taxpayer X, doesn’t qualify for the same exception. Taxpayer Z is also identically situated to taxpayers X and Y. If taxpayer Z resides in a state that falls within circuit court A’s jurisdiction, the Tax Court must hold that Z qualifies for the exception. If taxpayer Z resides in a state that falls within circuit court B’s jurisdiction, the Tax Court must hold that Z doesn’t qualify for the exception.

Takeaways

Because of the Golsen Rule, there could be both different substantive standards and different jurisdictional rules with respect to the limited partner exception issue in the Tax Court. As noted above, there are currently two substantive standards. The state law standard is the law in the Fifth Circuit. Currently, for taxpayers that reside outside of the Fifth Circuit, the Tax Court will likely continue to follow its precedent that the passive investor standard determines the applicability of the limited partner exception.

Also, due to the Golsen Rule, if the First Circuit holds that NESE isn’t a partnership item, then, for taxpayers that are located within the First Circuit, the IRS wouldn’t be able to adjust NESE in a TEFRA partnership-level proceeding, and the state law position versus the passive investor standard debate will rage on between the IRS and those taxpayers within the First Circuit’s boundaries. Further, NESE for TEFRA years would have to be determined in partner-level proceedings in the First Circuit and the jurisdictional issue will remain an open question elsewhere.

If the Second Circuit affirms the Tax Court in Soroban, upholding the passive investor standard, or promulgates a new standard, the disparity in the qualifying standard grows as well as at what level—partner or partnership—it’s properly determined under TEFRA. Additionally, once BBA partnerships begin working their way through the courts, the fragmentation of the rules regarding resolution of the limited partner exception could continue to grow because of the different terminology and definitions of partnership item under TEFRA versus PRI under the BBA. Absent Congressional intervention or the issue finding its way to the Supreme Court, it seems further disparity and unclarity on the limited partner exception isn’t just a distinct possibility, but rather the likeliest scenario.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Joseph Vetting is a Managing Director in the Deloitte Tax LLP Washington National Tax Passthroughs Group. Copyright © 2026 Deloitte Development LLC.

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