The US Court of Appeals for the Fifth Circuit has quietly rewritten the rules for who counts as a “limited partner” exempt from self-employment tax, replacing a taxpayer-friendly January opinion with a more restrictive standard that will make the exemption harder to claim for partners who are actively involved in running their businesses.
The case, involving Houston consulting firm Sirius Solutions LLLP, centers on Section 1402(a)(13) of the tax code, which exempts a limited partner’s share of partnership income from the self-employment taxes that fund Social Security and Medicare. Sirius argued that any partner with limited liability under state law should qualify for the exemption, regardless of their actual involvement in the business. The IRS countered that only genuinely passive investors should qualify. The Tax Court sided with the IRS, but a Fifth Circuit panel reversed that decision in January, adopting a bright-line rule that a limited partner is simply “a partner in a limited partnership that has limited liability.” The formalistic test would have let almost any partner claim the exemption based on paperwork alone.
This week, the same panel withdrew that opinion and issued a new one reaching the same result for Sirius but on narrower grounds. Judges Kurt Engelhardt and Andrew Oldham now define a limited partner as “a partner who plays no significant role in managing or running a business,” a functional standard grounded in what the judges called the plain text of the statute. The court did not explain why it revised its earlier reasoning. Judge James Graves Jr., who dissented from both versions, said the new opinion “partially corrected course” but still failed to limit the exemption strictly to passive investors, as he believes the statute requires. The new opinion ties limited partner status to a partner’s actual role in the business, making it tougher for active partners to claim the exemption.
The ruling does not settle the matter nationally. Similar cases are pending in two other federal circuits, and the underlying question, including a related Tax Court case involving Soroban Capital Partners, may eventually reach the Supreme Court. In the meantime, partnerships relying on limited partner status to avoid self-employment tax should review partners’ actual management roles, not just their titles, and watch how this evolving standard develops. For more information about this update, contact Liskow attorneys Leon Rittenberg III, Caroline Lafourcade, and Kevin Naccari, and visit Liskow’s Tax Practice page.