Fifth Circuit Overrules Tax Court, Providing Major Victory for Limited Partners on Self-Employment Tax

In a significant decision for the investment funds industry, the U.S. Court of Appeals for the Fifth Circuit has officially rejected the Internal Revenue Service (IRS)’s “passive investor” test for the limited partner self-employment tax exception. On January 16, 2026, the court ruled in Sirius Solutions LLLP v. Commissioner that any limited partner in a state-law limited partnership who enjoys limited liability qualifies for the exclusion of their profit shares from self-employment (SECA) taxes. This decision creates a significant split with the U.S. Tax Court’s recent pro-IRS rulings and provides immediate clarity, and potential tax savings, for fund managers and other business owners operating in Texas, Louisiana and Mississippi (the states comprising the Fifth Circuit).

The Controversy: The “LP Exception” and Three Key Cases

For decades, many taxpayers have operated under the understanding that Section 1402(a)(13) of the tax code contains a “limited partner exception” intended to exclude certain partnership income allocated to limited partners from the SECA tax (which is generally imposed on self-employed taxpayers at a rate of 15.3% plus an additional 0.9% tax for high earners). Recently, however, the IRS has aggressively challenged this view, arguing that this exception should only apply to passive limited partners who do not materially participate in the partnership’s business. This debate has been defined by three major cases. In Soroban Capital Partners LP v. Commissioner (2023), the Tax Court sided with the IRS, ruling that a “functional analysis” of a partner’s activities is required to determine if they are passive. The Tax Court followed this in late 2024 with Denham Capital Management LP, reiterating that active limited partners cannot claim the exception. Finally, in Sirius Solutions LLLP, a Houston-based consulting firm challenged this interpretation after the IRS attempted to reclassify over $5 million of its income as taxable self-employment earnings.

The Sirius Holding and the Court’s Rationale

The Fifth Circuit flatly rejected the Tax Court’s approach, ruling that a “limited partner” is simply a partner in a limited partnership who enjoys limited liability. The court’s reasoning focused on the plain meaning of the law when it was written in 1977, noting that dictionaries from that era defined “limited partner” based on liability rather than activity levels. Furthermore, the court pointed out that both the IRS and the Social Security Administration had consistently defined the term “limited partner” this way for over 40 years in their own instructions and regulations. The court noted that the law already imposes SECA tax on “guaranteed payments” for services. If Congress had intended for active limited partners to be excluded from the exception entirely, this “guaranteed payments” clause would be unnecessary.

Practical Consequences, Technical Limits, and the Path Ahead

For taxpayers currently in the middle of a SECA audit or settlement negotiations, the IRS’s leverage has been significantly undermined by the Sirius ruling, especially for taxpayers located in the Fifth Circuit. However, due to the “Golsen rule,” the Tax Court is not yet bound by the Sirius decision for taxpayers outside of the Fifth Circuit’s territory, meaning those located in New York, Connecticut and Massachusetts, for example, may still be subject to the Tax Court’s more restrictive “passive investor” test until their respective appellate courts weigh in. For taxpayers who have already entered into a final closing agreement or settlement with the IRS regarding SECA taxes, including taxpayers located in the Fifth Circuit, the Sirius decision generally does not provide grounds to reopen the agreement and seek a refund.

Even for taxpayers located in the Fifth Circuit, “guaranteed payments” for services and distributions in respect of general partner interests remain subject to SECA tax. Furthermore, simply relying on state-law nomenclature will not suffice. The Sirius decision requires a partner to maintain “limited liability” in order to be respected as a limited partner within the meaning of the SECA rules. If a limited partner loses limited liability status under local law for specific local law reasons, its SECA tax exclusion could be lost as well. Finally, the Sirius case involved a limited liability limited partnership (LLLP). The Fifth Circuit stopped short of extending its holding to members of LLCs or LLPs, so use of such entities may not confer a SECA exemption.

The IRS has not yet announced its next steps. It has until March 3, 2026, to petition for a rehearing en banc in the Fifth Circuit, but we do not expect the Fifth Circuit to grant a rehearing. The IRS may also appeal to the Supreme Court, especially if Denham (under appeal to the First Circuit) or Soroban (under appeal to the Second Circuit) result in conflicting appellate opinions.

Planning Opportunities:

• Evaluate Structure: Consider structuring any new management business as a state-law limited partnership to align with the Sirius facts. If your management business is already structured as another type of legal entity (e.g., an LLC), consider whether it may be feasible to convert the entity to a limited partnership. In such case, it is prudent to also meaningfully change operational aspects of the new limited partnership as compared to the predecessor entity in a manner that further supports the “limited partner” position post-restructuring. Simply inserting a limited partnership on top of an existing limited liability company is less favorable as compared to having the management fees initially flow into a limited partnership.
• Documentation: Managers should be prepared to defend their status as limited partners by documenting their limited liability under state law. If state law removes limited liability under certain circumstances, e.g., where a limited partner exercises too much control, then you should ensure that those circumstances do not exist and keep records to that effect.
• Consult on Refunds: If you have previously paid SECA tax on limited partner distributions, you should promptly establish how much time is left to claim a refund from the IRS, and then evaluate whether the Sirius decision supports a refund claim in your particular circumstances.
• Stay Tuned: The Denham oral arguments on February 5 will be the next major indicator of whether other circuits will follow the Fifth Circuit’s lead. This is particularly relevant to Massachusetts-based managers. Depending on the materiality of your SECA tax position and ongoing indications from the Denham and Soroban processes, it may be prudent to file tax returns under the current landscape before additional cases are decided.