The U.S. Court of Appeals for the Fifth Circuit ruled that the meaning of “limited partner” under Section 1402(a)(13) of the Internal Revenue Code of 1986, as amended (the “Code”), is determined under state law. This ruling, Sirius Solutions LLP v. Commissioner, overturned a recent Tax Court decision, Soroban Capital Partners LP v. Commissioner.

The Fifth Circuit held that a “limited partner” is defined by limited liability under state law, not by the partner’s level of activity in the partnership. This holding rejects the functional analysis used by the Tax Court in Soroban, which permitted only passive investors (regardless of their status under state law) to qualify for an exclusion from self-employment tax.

Key Takeaways

  • Section 1402(a)(13). Generally, self-employment income includes a partner’s distributive share from a trade or business carried on by a partnership. Section 1402(a)(13) provides that, “there 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.”
  • Previous Decision Reversed. In Soroban, the Tax Court ruled that whether a limited partner met the exclusion under Section 1402(a)(13) depended on a functional analysis based on the partner’s level of participation rather than a classification under state law.
  • Holding From Sirius Solutions. The Fifth Circuit’s holding in Sirius Solutions is consistent with the view, based on a plain reading of the Code, that self-employment tax does not apply to a limited partner in a limited partnership as a matter of law, regardless of the extent of that limited partner’s participation in the activities of the partnership.
  • Historical Context. The Fifth Circuit emphasized that when Section 1402(a)(13) was enacted in 1977, the defining feature of a limited partner was limited liability. The majority relied on contemporaneous dictionary definitions and longstanding IRS and Social Security Administration guidance, which consistently treated limited liability as the key factor in the analysis.
  • Interpretation of “Limited Partner, as such.” The Fifth Circuit stated that the phrase “limited partner, as such” in Section 1402(a)(13) refers to the ordinary meaning of the term—a partner with limited liability. The Tax Court relied on this language to support its functional analysis position, reasoning that it narrowed the scope of the exception to a “limited partner who is functioning as a limited partner.”

Why It Matters

The functional analysis from Soroban raised major concerns and uncertainty as to whether a state-law limited partner would be subject to self-employment tax. This decision from the Fifth Circuit reinstates a bright-line rule that should provide clarity for taxpayers.

Partnerships and their advisors should review their structures and tax positions in light of this important development, particularly if they have paid self-employment tax while a limited partner under state law and may be eligible for a refund. There are other cases pending on the same issue in the First Circuit and Second Circuit, which raises the possibility of a circuit split on the issue.

Contacts:

Trip Dyer I 214.745.5297 I pdyer@winstead.com

John Laughlin I 214.745.5776 I jlaughlin@winstead.com

Burke McDavid  I  214.745.5490  I  bmcdavid@winstead.com

Andrew Rosell  I  817.420.8261  I  arosell@winstead.com