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Best of Times

You landed a hard-to-come-by position at a prestigious Manhattan-based company. The hours spent at the office, including most weekends and many holidays, were outrageous by any reasonable person’s measure. Your combined federal, New York State and City income tax burden[i] was hefty, and the cost of living in the City[ii] was daunting. The work was both challenging and demanding. It was also exhilarating, and there were opportunities for advancement, the annual compensation was good, and the year-end bonuses were generous.

After a few years and some significant life events, you gave up the convenience of living in Manhattan and moved to an affluent community in New Jersey, which entailed a nearly two-hour commute each way.

It’s true that New Jersey consistently ranks among the five states with the highest income tax rates in the country[iii] and, yes, you continued to file personal income tax returns with New York State, but as a nonresident, meaning you paid New York tax only on your New York source income. Unfortunately, that included your only significant source of income, which was the same as before – i.e., the earnings from work performed in New York, all of which was allocated to New York.[iv]

There was a silver lining, however: because you were not a resident of New York City, it could not tax your income even though such income was sourced in the City.

That fact was probably of small comfort because the county in which you chose to reside in New Jersey has consistently placed in the top fifteen nationally for real property taxes.

Still, you believed that the economic and other, intangible, benefits were worth the effort and the cost.

Time Passes

Eventually, the daily commute to and from the City started to take a toll on you, as did the continuing long hours spent at work, notwithstanding your having moved up in the company’s hierarchy. You tried to work from home occasionally, which spared you the travel time but, thanks to New York’s convenience rule, did nothing in the way of reducing your New York income tax liability.

Years passed, the kids were finishing their studies and about to enter the workforce, the satisfaction of the mortgage on your house no longer felt like some remote event, and you managed to save some money in a tax-deferred retirement account.  

Although, by most standards, you were doing well financially, you hadn’t acquired investment assets that generated a regular, let alone significant, revenue stream.

Instead, like most people, you remained dependent on the cashflow generated by your services to cover your expenses; this cashflow would continue so long as you kept working.

Still, it was time for a change, and you had recently received an inheritance which, although far from life-changing, gave you the wherewithal to pursue an option you had long been considering.

In order to reduce the time you spent commuting, and to provide yourself a “base” from which to start enjoying all that the City offered[v] – beyond the meals delivered to your office once or twice a day over many years – you decided to acquire a small apartment in Manhattan.[vi]

In January of Year One,[vii] you financed the acquisition of a studio condominium unit for the “reasonable” sum of approximately $600,000 (about the median price at the time), though the amount of the monthly common charges – which are now at approximately $2,000 per month – nearly equaled the monthly payment on your loan. There were times, subsequently, that you regretted the decision, but would remind yourself that a City residence represented a smart, long-term investment.[viii]

Worst of Times

Shortly after filing your nonresident personal income tax return with New York State for Year One, you received a notice informing you that, because you maintained a “permanent place of abode” in the City[ix] for “substantially all” of Year One, and because you spent more than 183 days in the City during that year – you worked in Manhattan – you were treated as a statutory resident of the City for that year and, therefore, were subject to New York State and City personal income taxes on all of your Year One taxable income regardless of its nature or source.

Because you planned to continue working and maintaining an apartment in Manhattan for the foreseeable future, you resigned yourself to being treated as a resident of New York State and City, and to paying taxes to those jurisdictions on all your income for several years to come.

The DSA in City Hall

A few more years passed. You survived a couple of incompetent mayoral administrations. Shortly after the election of the current mayor, you heard that he wanted to impose a new surcharge (basically, a property tax) on co-op and condominium apartments worth more than $5 million, that were owned by nonresidents – dubbed a “pieds-a-terre tax.” Proponents of the tax claimed that the wealthy, absentee owners of such apartments enjoyed many of the services and protections provided by the City but, as nonresidents, did not contribute toward the cost thereof.

Subsequently, you learned that the tax had been enacted,[x] and that the City would be notifying those individuals that it had preliminarily determined may be subject to the new tax.

Until recently, you weren’t overly concerned about the new tax because your apartment was not worth anywhere near $5 million, though it is located in what may be described as a “hot” neighborhood, so you are certain it is worth substantially more than what you paid for it.  

What’s more, even though you are domiciled in New Jersey, you’re taxed as a resident of New York City, reporting and paying income tax on all your income, regardless of its source. You figure that you cannot be one of the taxpayers at which the new tax is aimed – i.e., the non-tax paying wealthy absentee owner.

The Notice

Then, in late July 2026, you received a notice from the City’s Dept. of Finance (the “DOF”) informing you that, for the 2026-to-2027 fiscal year, you may be subject to the new pied-à-terre tax being imposed on certain residential properties[xi] in the City that do not serve as the “primary residence” of the owners of such properties.

The notice indicated that your apartment’s “assessed market value” – not its fair market value – as of January 5, 2026,[xii] on the basis of which the tax will be calculated, was $1.25 million.

You did some research and discovered that, on August 1, the City extended to Sept. 18, 2026 the application deadline for owners of a “covered property”[xiii] to establish that such property is their “primary” residence or to otherwise demonstrate they are not subject to the new tax.[xiv]

Primary Residence

Primary residence? The law provides that the DOF will make an initial determination annually regarding the status of a condo or co-op dwelling unit as the owner’s primary residence. Among the factors the DOF will consider are the whether the dwelling unit was identified on individual income tax returns or other documents filed with the City as the owner’s permanent home, and whether the individual owner occupied the property for a majority of days during the immediately prior calendar year. 

You view your New Jersey home as your permanent home and identify it as such on all your tax filings and other “official” documents.[xv] You are domiciled in New Jersey; that is where your primary residence is located.

The Manhattan apartment serves as a convenient place to stay during a hard-paced work week, and as a base for “nights on the town” and for exploring the City.

In other words, it is the kind of property to which the new tax would apply, provided the value of the property exceeded the prescribed dollar threshold.

Phase One

After some additional research,[xvi] you realize that the tax is being implemented in two phases; during the first phase, the $5 million threshold you had heard so much about only applied to residential real property with not more than three dwelling units.[xvii]

For fiscal years beginning on or after July 1, 2026 and before July 1, 2028 – “phase one” – the tax will be imposed on a “residential condominium dwelling unit” or a “residential cooperative dwelling unit” with a “phase one market value” equal to or greater than $1 million.

Based on your apartment’s “phase one market value”[xviii] shown on the notice – about $1.25 million – and applying a rate of 4 percent to the full amount thereof, the pied-a-terre tax to be imposed on the apartment for the 2026-to-2027 fiscal year is approximately $50,000; i.e., an additional cost of more than $4,100 per month, as compared to your common charge of about $2,000 per month.[xix]

You also note that the same rate and threshold value will be applied to the assessed market value of the apartment for the 2027-to-2028 fiscal year (still phase one). Then, beginning with the 2028-to-2029 fiscal year (the start of “phase two”), the threshold value[xx] for the imposition of the tax is scheduled to increase to $5 million for all covered properties (which includes condominium dwelling units), and will remain in effect until the tax sunsets after the 2030-to-2031 fiscal year.[xxi]  

Although the prospect of one more year of the additional tax based on the current $1 million threshold is odious, it is just one payment, and you’ll bear it if you must.[xxii]

What to Do?

Notwithstanding the scheduled increase in the threshold value beginning in phase two, and notwithstanding the scheduled sunset of the tax after June 30, 2031, you are concerned that, after the tax and its enforcement mechanisms have been successfully implemented and actually tested, the $5 million threshold will be lowered to capture more taxpayers, and that the tax will eventually be made permanent.

With these concerns in mind, you contact Adviser (a tax professional) for some guidance.  Among the items you considered with Adviser, including potential options, were the following:

  1. i. Should property owned by a NYC Statutory Resident who is domiciled in New Jersey be subject to the tax? 
    • a. Considering the reasons given for the enactment of the tax, its imposition on a property owned by a statutory resident seems unwarranted.
    • b. Still, a literal reading of the Tax Law, the Administrative Code, the Regulations and Rules promulgated under those statutes, respectively, supports imposition of the tax under those circumstances.
    • c. The Adviser concludes the tax applies, but also states that he’ll be monitoring any pronouncements from the DOF that may clarify the issue
  2. ii. Is there any way to treat the Manhattan apartment as a primary residence?
  3. a. A covered property[xxiii] or a residential cooperative dwelling unit, is a primary residence if it is used[xxiv] as such by:
    • i. a covered owner[xxv] who is a natural person,
    • ii. an immediate family member of a covered owner,[xxvi]
    • iii. a lessee who is a natural person occupying such covered property or residential cooperative dwelling unit pursuant to a bona fide lease agreement that was negotiated in an arms-length transaction with a term of not less than one year.
      • 1. an arms-length transaction is one that was entered into in good faith and for valuable consideration that reflects the fair market rental value of the covered property or dwelling unit between two informed and willing parties, where neither is under any compulsion to participate in the transaction, and circumstances do not indicate a reasonable possibility that the lease was entered into primarily for the purpose of avoiding imposition of the surcharge.
  4. b. Based on the foregoing, perhaps you should suggest to one of your kids (who will be working in the City) that they might consider living in the apartment? Assuming one of them is amenable to doing so, and is able to establish it as their primary residence, the tax would not apply. You might even consider charging them some below-market rent to help with the costs of maintenance.
    • i. Easier said than done. It’s a studio. Where would you stay when you decide to use it? Would your ability to use it jeopardize its treatment as the primary resident of a family member? What’s more, would either of your kids want you as a roommate?
    • ii. Would the arrangement be more defensible if you charged fair market rent? What if such rent was beyond the kid’s financial wherewithal? What if they missed a payment every now and then? Could you reasonably expect to defend against a claim that the lease was entered into primarily for the purpose of avoiding imposition of the tax?
  5. iii. What if you transferred the apartment into an LLC, another business entity, or a trust?[xxvii]
    • a. Unfortunately, such a transfer would accomplish little under the scenario described.
    • b. Under different circumstances, there may be bona fide investment-related reasons for using one of these entities to hold title to the apartment; for example, where the property is to be leased in an arm’s length transaction. That is not the case described herein. And while there may be legitimate estate planning reasons for transferring the property into one of these entities, doing so will not remove the property from the reach of the tax.
    • c. Indeed, if you were trying to take advantage of the exception from the tax for primary residences, using an entity could make it more difficult to qualify.
      • i. For example, if a family LLC owned the apartment, the primary residence exception would only be available to a member who held a majority interest in the LLC.[xxviii]

Parting Thought

The “regular guy” described above is not a titan of industry or master of the universe or whatever else such folks are called or call themselves. He’s a hard-working individual who has done well by earning his success. He was fortunate enough to receive a windfall that enabled him to acquire the apartment. He’s not the kind of condo owner in front of whose building the mayor is going to film a video touting the “justice” meted out by the pied-a-terre tax.

Yet, here he is, subject to the tax during phase one of its implementation, and not unreasonably concerned that the threshold value for application of the tax may, in the not-too-distant future, be reduced.

There’s something wrong with this picture. Stay tuned.

[i] A combined effective rate that ranked in the top three nationally.

[ii] About double the national average.

[iii] 10.75% on taxable income over $1 million.

[iv] As a resident of New Jersey, you were permitted to a claim a credit against the New Jersey income tax imposed on the same New York source income.

[v] Of course, this all happened pre-Mamdani.

[vi] “YOLO,” they say, right?

[vii] I was channeling 2012; can’t say why – just was.

[viii] Query whether this will change during the current mayoral administration.

[ix] Before 1999, Form IT-203 asked whether the nonresident or part-year resident taxpayer or their spouse maintained “living quarters” in New York City. After 1998, the form asks only about a New York State residence.

That being said, Form IT-203-B (Nonresident and Part-Year Resident Income Allocation) asks the taxpayer to provide the number of days spent in New York (including the number of working days) during the year for which it is being filed. The form also asks for the address of the New York living quarters maintained by the taxpayer or their spouse.

[x] The tax was signed into law by the Governor (don’t get me started) on May 28, with an effective date of July 1, 2026 and an expiration date of June 30, 2031, unless renewed earlier by Albany. 

N.Y. Tax Law, §§ 1350 et seq.; N.Y.C. Admin. Code tit. 11, ch. 32, §§ 11-3201 et seq.; 19 R.C.N.Y. ch. 62.

It is often the case that a “temporary” New York tax does not expire; instead, it is “temporarily extended” several times.

[xi] One-to-three-family homes, condominiums, and co-ops when owners have a separate primary residence.

[xii] This is the “taxable status date” – the January fifth immediately preceding the fiscal year in which the surcharge is imposed. NYS Tax Law Sec. 1351(q).

[xiii] NYS Tax Law Sec. 1350. The tax is imposed on a so-called “covered property.” This includes one, two and three family residential real property, including such dwellings used in part for nonresidential purposes but which are used primarily for residential purposes or, in the case of a covered property that is a residential cooperative property, a residential cooperative dwelling unit, that is not a primary residence, provided that:

(a) for fiscal years beginning on or after July 1, 2026 and before July 1, 2028 – Phase One – first, two thousand twenty-eight, the phase one market value of such covered property that is a class one property is equal to or greater than five million dollars, the phase one market value of such covered property that is a residential condominium dwelling unit is equal to or greater than one million dollars, or, in the case of a covered property that is a residential cooperative property, the phase one market value of a residential cooperative dwelling unit within such residential cooperative property is equal to or greater than one million dollars; and

(b) for fiscal years beginning on or after July first, two thousand twenty-eight and ending June 30, 2031, the phase two market value of such covered property or, in the case of a covered property that is a residential cooperative property, such residential cooperative dwelling unit, is equal to or greater than five million dollars.

[xiv] https://www.nyc.gov/mayors-office/news/2026/08/mayor-mamdani-and-commissioner-lee-extend-deadline-for-pied-a-te. Homeowners were originally given until the week beginning August 24 to submit applications for exemption from the tax. https://www.nyc.gov/site/finance/property/non-primary-residence-surcharge.page.

[xv] For example, federal and state income tax returns.

[xvi] DOF has launched a dedicated webpage (nyc.gov/npsurcharge) that features frequently asked questions, an eligibility tool, detailed guidance, and instructions for submitting documentation.

[xvii] Class One properties. NYS Tax Law Sec. 1351 refers to Sec. 1802 of the Real Property Tax Law.

[xviii] NYS Tax Law Sec. 1351(k).

[xix] https://www.nyc.gov/site/finance/property/non-primary-residence-surcharge.page.

[xx] “Phase two market value” within the meaning of NYS Tax Law Sec. 1351(l).

[xxi] Ending June 30, 2031.

[xxii] It’s highly doubtful that the apartment will appreciate so much within such a shirt period so as to be subject to the tax during phase two.

[xxiii] “Covered property” generally means real property classified as: (1) class one property, other than vacant land; (2) class two property that is a residential cooperative property in which at least one residential cooperative dwelling unit: (A) has a phase one market value equal to or greater than one million dollars or phase two market value equal to or greater than five million dollars; and (B) is not a primary residence; and (3) class two property that is a residential condominium dwelling unit.

[xxiv] As of the taxable status date immediately preceding the fiscal year in which the tax is imposed.

[xxv] “Owner” means: (1) an owner or owners of real property classified as class one property; (2) a tenant-stockholder of a cooperative corporation whose interest in a portion of real property held by such corporation is represented by shares of stock in such corporation, or such corporation; or (3) an owner or owners of a residential condominium dwelling unit.

A “covered owner” means (1) an owner or owners of real property classified as class one property; (2) a tenant-stockholder of a cooperative corporation whose interest in a portion of real property held by such corporation is represented by shares of stock in such corporation; (3) an owner or owners of a residential condominium dwelling unit; (4) where real property classified as class one or a residential condominium dwelling unit is held, or shares of stock in a cooperative corporation are held, in trust, a beneficial owner or owners of such trust, provided that such beneficial owner or owners are the sole beneficiaries of such trust; or (5) where real property classified as class one or a residential condominium dwelling unit is held, or shares of stock in a cooperative corporation are held, by a partnership, corporation or limited liability company, a partner or partners, shareholder or shareholders or member or members of such partnership, corporation, or limited liability  company, respectively, provided that such partner or partners, shareholder or shareholders, or member or members hold a majority interest in such partnership, corporation or limited liability company respectively.

[xxvi] The phrase “immediate family member” means a spouse, child, sibling, parent, grandparent, or grandchild of the covered owner.

[xxvii] 19 RCNY Sec. 62-02.

[xxviii] 19 RCNY Sec. 62-01. In the case of an LLC, the term “majority interest”  means entitlement to more than 50% of the capital or profits of such LLC. 

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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.

[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.”

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Basic Principles

What does the term “gross income” mean to you? For most folks, it refers to the amount of money that is paid to someone in exchange for their services or property, or for the use of their property.

The Code describes the gross income of a taxpayer more expansively to mean all of the taxpayer’s income from whatever source derived, and in whatever form realized.[i] In other words, any accretion in wealth realized[ii] by a taxpayer is included in gross income.

Continue Reading When a Non-Shareholder Contributes Capital to a Corporation
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I’m delighted to share that FeedSpot has ranked TaxSlaw 21 in its list of the 100 Best Tax Blogs to Follow in 2026.

This blog is a labor of love, and it feels good to know that my weekly efforts have gained some recognition.

Sending a special thank you to my loyal readers who link to my content on social media and ask thought-provoking questions about the posts.

Keep on reading (and sharing)!

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The Latest

The IRS recently announced its intention to propose regulations relating to the 21 percent tax[i] imposed with respect to any “excess” executive compensation paid by certain tax-exempt organizations, including public charities and private foundations (i.e., charitable organizations),[ii] to their covered employees.[iii]

This news followed by almost a year the amendment to the definition of “covered employee” made by OBBBA,[iv] which represents Congress’s latest effort at trying to limit the amount of executive compensation payable by a charitable organization.  

Continue Reading Congress’s Continuing Quest to Restrict Executive Compensation at Charitable Organizations, With a Twist
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Can It Get Worse?

I’m certain that most of us were disappointed with the Appellate Department’s decision last week in Prof. Zelensky’s continuing dispute with New York over its application of the notorious “convenience of the employer” test;[i] disappointed, but not entirely surprised.[ii]

One can still hope that the Courts will one day become less deferential toward the tax folks in Albany.

Continue Reading Applying New York’s Convenience Rule to a Former Resident, Truly Remote Non-Resident Employee
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Here It Comes

According to many, the long-awaited intergenerational transfer of assets from the Baby Boomer generation, and from what remains of the Silent Generation, to younger members of their families[i] – estimated by some to exceed $100 trillion in total, worldwide, over the next two decades – is well under way.

Most of this shift in wealth will occur within families whose members already count themselves among the wealthiest on the planet.[ii] Indeed, according to one source, “[t]he wealthiest 10 percent of households will be giving and receiving a majority of the riches.” Within that group, the top 1 percent holds about as much wealth as the bottom 90 percent, and it “will dictate the broadest share of the money flow.”[iii]

Continue Reading With Tax Increases Lurking Just Over the Horizon, and With Large Dispositions of Wealth Underway, Now’s the Time to Identify and Correct Earlier Missteps
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A client tells you that many, if not most, of their employees work remotely. How would you interpret that statement? It’s a matter of context, right?

In most cases it suggests that the employer-client has some sort of hybrid arrangement with their employees that requires them to be present at the employer’s place of business two-to-three days a week, and allows them to work from home the remaining days.

Continue Reading When is a Remote Employee Not Remote Enough to Escape New York Tax?
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Personal Use

“But it’s mine!”

That’s not some toddler speaking.

You’ve just advised an entrepreneurial client for the “Nth” time that they should not treat the corporation[i] they control, and out of which they operate their business, as their personal bank account.

Such behavior may jeopardize the limited liability protection that the corporate shield would otherwise afford a shareholder. It may also expose the shareholder to unexpected and unwelcome income tax consequences, as we’ll see shortly.

Continue Reading If I Own the Corp, and the Corp Owns the Assets of the Business, Aren’t  Those Assets Mine?
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Encourage But Verify

“It is more blessed to give than to receive.”[i]

Undoubtedly, you’re familiar with the foregoing proverb that seeks to encourage “charitable behavior” among the members of society, and to dissuade them from pursuing only their innately selfish proclivities.[ii]

The Code recognizes the conflict that an individual taxpayer may experience in the course of deciding whether to make a charitable contribution of a property, or to retain such property (or the proceeds from its sale) for the individual’s own use.

Continue Reading “For Want of a Nail” – A Poor Reason to Lose a Charitable Contribution Deduction