An About-Face?

Earlier this year, the federal Court of Appeals for the Fifth Circuit^[i] ruled that the U.S. Tax Court had misinterpreted the Code’s self-employment tax rules as they apply to individuals who hold limited partnership interests in a state law limited partnership, notwithstanding that such individuals also render services to the partnership of a nature that is integral to the limited partnership’s business.^[ii]

In doing so, the Court relied upon a narrow reading of the following provision of the Code:^[iii]

“The term ‘net earnings from self-employment’ means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed. . . plus his distributive share. . . of income. . . from any trade or business carried on by a partnership of which he is a member. . . “. . . except that in computing. . . such distributive share of partnership ordinary income. . . there shall be excluded the distributive share of any item of income. . . of a limited partner, as such, other than guaranteed payments. . . 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. . .”^[iv]

The Court held that, for purposes of the above-described exclusion (the “Exclusion”) from net earnings from self-employment (“NESE”), a “limited partner” is a partner in a state-law limited partnership who is afforded limited liability protection. Period. In doing so, the Court focused on the statutory label “limited partner” and not on the nature or extent of the activities of the individual partner.

In other words, the Court ignored the fact that a service partner – for example, one who was issued a partnership interest in exchange for rendering services of a non-managerial nature in furtherance of the partnership’s business – does not necessarily lose the limited liability protection afforded to a limited partner.

It also rejected the IRS’s functional analysis – which considers the roles and responsibilities of the partners to determine whether they were bona fide limited partners for purposes of the self-employment tax – stating that the agency effectively equated the status of a limited partner with that of a “passive investor.”

In objecting to the use of the descriptor “passive,” the Circuit Court ignored the all-important context in which the word was used by the Tax Court; otherwise, it would have acknowledged that the Tax Court was comparing the level of activity conducted by an owner whose return from the partnership’s business was tied to the amount of money and other property such owner invested in the business with that of a partner whose return was dependent on his services to the partnership and its business, and not on the value of his capital contribution.

Unfortunately, the Circuit Court also failed to provide the definition of “passive” that informed its decision.

Then Again

Last week, however, the Fifth Circuit withdrew its prior opinion^[v] and, without much explanation for the withdrawal, substituted a new opinion in which it held that the term “limited partner” refers to a partner “who plays no significant role in managing or running a business.”

Does that sound familiar? Echoes of the position espoused by the IRS, accepted by the Tax Court, and previously rejected by the Fifth Circuit in its earlier, now-vacated opinion? Sort of, but not quite, as we’ll see.  

What’s more, the Court did not expressly state it was reversing itself; rather, it explained that it was returning to the “original public meaning” of the term “limited partner” as understood, according to the Court, for purposes of the tax imposed on self-employment income – i.e., “a partner who plays no significant role in managing or running a business.”

Let’s see how the Court explained its sudden “no change” in direction.   

The Earlier Opinion

Back in January of this year, as stated above, the Circuit Court determined that an individual was a “limited partner” for purposes of applying the Exclusion^[vi] if he held a limited partnership interest in a state law limited partnership. The reasoning behind the Court’s decision was as follows:

• self-employment income is defined as NESE, which includes an individual’s distributive share (whether or not distributed) of income from any trade or business carried on by a partnership of which such individual is a member;
• in computing this distributive share for a limited partner, the Code excludes from NESE the distributive share of any item of income of the “limited partner, as such,” other than guaranteed payments 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, in which case the payments are considered as made to one who is not a member of the partnership;
• the foregoing terms are to be given their “ordinary meaning” at the time of enactment;
• a “limited partner” has always been defined as a partner whose liability to creditors of the partnership is limited to the amount of capital he has contributed to the partnership, provided he has not held himself out to the public as a general partner and has complied with other requirements of applicable state law – the term “limited partner” has never been defined to mean a “passive investor”;
• thus, the distributive share of partnership income (as distinguished from a guaranteed payment for services rendered) of a partner in a limited partnership with limited liability (i.e., a limited partner) is exempt from self-employment tax.

The Court of Appeals then dedicated a portion of its opinion to dismissing the “functional analysis” test on the basis of which the IRS and the Tax Court^[vii] had, according to the Court, equated the status of a limited partner with that of a passive investor.

Last week, as stated above, the Court vacated this earlier opinion.

Before reviewing the Court’s “new” opinion, let’s revisit the IRS’s functional analysis approach and the Fifth Circuit’s reaction to its application.

Functional Analysis

A functional analysis considers whether the partners in question – ostensibly limited partners –  are “generally akin’ to passive investors.” In order to exclude a partner’s distributive share of partnership income from NESE, “the surrounding circumstances of the partner’s economic relationship with the partnership must sufficiently indicate that it is generally one of passive investment.”

Thus, the IRS and the Tax Court will analyze a “limited” partner’s roles and responsibilities in the management of the partnership and in the partnership’s business activities. Specifically, they will review, among other things, the sources of the partnership’s income and how it was generated, the partner’s roles in generating that income, whether the partner devoted significant time to the partnership’s business, the authority exercised by the partner, the relationship between the partner’s distributive share of partnership profits and the capital contributions the partner made to the partnership.^[viii]

The foregoing aside – and this is the crux of the matter – the Tax Court stressed that the test of whether a partner functions as a limited partner for purposes of the self-employment tax is not dictated by any set number of factors. Rather, it is a facts and circumstances test that examines all relevant facts and circumstances. The “labels” placed on a partner for state law purposes are the least relevant factors to consider because they may be inconsistent with the economic reality of a partner’s relationship with the partnership. For example, a partner labeled a limited partner who works for the partnership’s business full time, whose work is essential to generating the business’s income, who is held out to the public as essential to the business, and who contributes little or no capital to the partnership, is not functioning as a limited partner for purposes of applying the Exclusion regardless of the label placed on that partner.

Now let’s see whether the IRS’s functional analysis approach played any role in leading the Fifth Circuit to conclude that a “limited partner” is one “who plays no significant role in managing or running a business.”

Newer and Better (?) Opinion

The Court began by stating the statutory parameters: “payments to limited partners for ‘services actually rendered’ to the partnership are subject to Social Security and Medicare taxation [as NESE]. But the pass-through share of partnership income of a ‘limited partner, as such’ is not.”

The question before it, the Court continued, was to determine the meaning of the term “limited partner” as used in the Code’s definition of NESE.

It then answered this question by holding that “the ordinary public meaning of this term ‘limited partner’ is a partner who plays no significant role in managing or running a business.”^[ix]

The Court explained that two principles guided its inquiry: “First, tax law is federal law. Once it has been determined that state law creates sufficient interests in the [taxpayer] to satisfy the requirements of [the statute,] state law is inoperative. . . . Second, the Tax Code’s phrase ‘limited partner’ is undefined. Thus, our job is determining what, as a matter of federal law, the phrase ‘limited partner’” as used in the exclusion from NESE means. “To do so,” the Court continued, “we ‘interpret the words consistent with their ordinary meaning . . . at the time Congress enacted the statute.’”

What better place to look for the meaning of words than a dictionary?

The Court reviewed several “contemporaneous legal dictionaries” which defined a “limited partnership” as a partnership with general partners “who manage business” and limited partners who “contribute capital and share in profits but . . . take no part in running business.” The Court stated that “[w]hile such texts are not dispositive of the original public meaning, they reveal a common, mainstream definition of ‘limited partner’ that turns on the role partners played in the enterprise.”^[x]

Again, doesn’t that approach sound familiar? Of c purse it does. Yet, just when you thought the Court was about to correct its course, . . .

Wait A Sec

At that point, however, the Court began to draw another line. The literal text of the Exclusion, it explained, contemplates that “limited partners” may provide actual services to the partnership and thus participate in partnership affairs without forfeiting their status as limited partners for purposes of the self-employment tax, except to the extent of any “guaranteed payments” for services.^[xi]

The Court then tried to reconcile its statement, that a limited partner is a partner “who plays no significant role in managing or running a business,” with the language of the Exclusion which permits a partner to participate in the affairs of the partnership – by providing services to the partnership in exchange for guaranteed payments – without losing their limited partner status.

However, the Court failed in its attempt. For one thing, the guaranteed payments to which it refers are determined without regard to the income of the partnership; they are treated as made to one who is not a member of the partnership – i.e., someone to whom an obligation is owed.^[xii] The Court says nothing about a state law limited partner who is allocated a distributive share of the partnership’s profits in “compensation” for his services; i.e., one who is treated as a limited partner, “as such.”

In the end, it applied a quasi-functional analysis and adopted what the Court described as “the ordinary public meaning” (?) of limited partner, which includes a partner who may have provided services but did not play a significant role in managing or running the partnership’s business. In other words, provided the limited partner did not become involved in managerial matters, his status as a limited partner for purposes of the Exclusion would not be forfeited, seemingly without regard to the extent of such non-managerial services.  

With that, the Court again rejected what it described as the Tax Court’s statements that, at least for purposes of the Exclusion, the term “limited partner” could only refer to a “passive investor.”

Set aside for the moment that the Court took the Tax Court’s statements out of context. In the next paragraph of its opinion, the Court stated that “[a]n informed reader of the English language . . . would have understood that a ‘limited partner’ could not manage the partnership, . . . but perhaps could participate in certain nonmanagerial aspects of the business . . . That is a different and more refined analysis than the one the Tax Court offered.”^[xiii]

With that, the Fifth Circuit remanded the case to the Tax Court “for further proceedings consistent with” the Circuit Court’s new opinion.^[xiv]

What’s Next?

So, where does that leave us?

Let’s recap, first.

The Fifth Circuit dropped its original position, which applied the Exclusion to a state law limited partner who was accorded limited liability protection.

It again rejected the Tax Court’s and the IRS’s statements about treating a limited partner as “akin” to a passive investor – perhaps the Tax Court and the agency would have been better served by merely describing the limited partner as an “investor,” one who contributes capital.

Although the Court also rejected the functional analysis approach –which constitutes a bona fide application of the “substance over form” doctrine – it nevertheless applied a variation of the foregoing to support its conclusion that a limited partner may render services to a partnership – i.e., one who is not a “passive” investor – without losing his limited partner status for purposes of the Exclusion, provided the partner did not participate in managerial activities; basically, a functional analysis.

Notwithstanding that the Court’s examination of a limited partner’s activities represents a step in the right direction, it also opens a path for ostensible limited partners to avoid self-employment tax by avoiding the assumption or performance of any managerial responsibilities or activities, notwithstanding that the “limited partner” in question has not made a capital contribution to the partnership yet still enjoys a distributive share of the partnership’s profits.

Query, however, at what point a limited partner’s non-managerial services become so substantial that even the Fifth Circuit would be hard-pressed to treat him as a limited partner for purposes of applying the Exclusion?

We haven’t heard the last of this, as we wait for the First and Second Circuits to opine.

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[i] The “Court of Appeals,” the Circuit Court,” the “Court.”

[ii] Sirius Solutions, L.L.L.P. v. Comm’r, 165 F.4th 374 (5th Cir. 2026).

[iii] IRC Sec. 1402(a)(13).

The Court also disregarded the current “practice” of many businesses in the financial sector that organize as limited partnerships for the purpose of avoiding the imposition of the self-employment tax upon the entire limited partner distributive share of those individual limited partners who are actively engaged in the operation and management of the partnership’s business.

[iv] As you know, the Code imposes a self-employment tax with respect to an individual taxpayer’s “net earnings from self-employment.” An individual’s earnings from self-employment include such individual’s distributive share of partnership income that is derived from any trade or business carried on by a partnership of which the individual is a partner. 

The foregoing provision is derived from the general statutory concepts that (a) an individual shall be considered as being engaged in the trade or business carried on by the partnership of which the partner is a member, and (b) the character of any partnership “tax item” attributable to such trade or business, and included in the partner’s distributive share, shall be determined as if such item were realized directly from the source from which realized by the partnership.

[v] After denying the government’s motion for a rehearing en banc.

[vi] IRC Sec. 1402(a)(13).

[vii] The Tax Court approved the IRS’s functional analysis approach in Soroban I (161 T.C. 310 (2023)).

[viii] The fact that a partner’s capital contribution was relatively insignificant compared to others’, while his distributive share of profits was disproportionately greater, may demonstrate that the partner’s distributive share of income was not a return on investment but, rather, an amount received for the partner’s services.  

[ix] The Court did not assign much importance to the fact of limited liability under state law, as in its earlier opinion,

except to the extent of stating it could be jeopardized by the degree of a limited partner’s participation in the business of the partnership.

[x] After quoting from a number of dictionaries to the same effect, the Court quoted from several treatises that pointed “towards the same result” – i.e., limited partners do not participate in the management of the partnership.

[xi] Described in IRC Sec. 707(c).

[xii] IRC Sec. 1402(a)(13) and Sec. 707(c).

[xiii] Ouch, and unwarranted.

[xiv] It should noted that there was one of the three Circuit Judges dissented from the Court’s opinion. The following summarizes the dissenter’s position pretty well:

“the majority’s position on a functional analysis is both contradictory and unclear. It does not appear that the majority actually takes issue with the Tax Court’s definition of “limited partner, as such.” Instead, the majority appears to be improperly attempting to define “passive investor” and taking issue with the application of a functional analysis test, while simultaneously essentially arguing that a functional analysis test allows for some level of participation. But the majority is also unable to point to any evidence that the level of control or participation here was not as significant as the parties stipulated. There is little clarity as to the intended effect of the majority’s decision and its “rejection” of Soroban. It is clear, however, that the majority has created an indefensible, illogical, and illegal loophole which allows millions of dollars in net earnings from self-employment to go untaxed as earnings even though that is exactly what they are.”