Limited Partner Exclusion
Last week, the federal Court of Appeals for the Fifth Circuit 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.[i]
In doing so, the Court relied upon a narrow and dated reading of the Code that disregarded the current “practice” of many businesses in the financial sector, including investment firms, 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.
IRC Sec. 1402(a)(13)
Before considering the Court’s analysis, it would behoove us to review the pertinent provision of the Code, which states, in relevant part, as follows:
“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. . .”
This seemingly broad definition of net earnings from self-employment (“NESE”) is immediately qualified by the following exclusionary rule:
“. . . 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. . .”
The Court’s Opinion
The Court held that a “limited partner” for purposes of the exclusion from NESE is a limited partner in a state-law limited partnership that is afforded limited liability. Period.
The reasoning behind the Fifth Circuit’s decision may be summarized as follows:
- self-employment income is defined as the NESE derived by an individual during any taxable year;
- NESE 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 the 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;
- payments to a partner for services or for the use of capital are considered as made to one who is not a member of the partnership;
- the terms used in the foregoing rules 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;
- until recently, the foregoing interpretation of “limited partner” had remained constant for almost 50 years;
- limited partners may treat as self-employment income only guaranteed payments for personal services actually rendered to the partnership;
- otherwise, a partner in a limited partnership with limited liability (i.e., a limited partner) could exclude its distributive share of partnership income from the partner’s self-employment income;
- never has the term “limited partner” been defined to mean a “passive investor”;
- thus, a limited partner’s pass-through share of partnership income (as distinguished from a guaranteed payment for services rendered) is exempt from self-employment tax.
I suppose the Court of Appeals could have stopped there but, instead, it dedicated the balance of its opinion to dismissing the “functional analysis” test – and the legislative history[ii] – on the basis of which, according to the Court, the IRS and the Tax Court have, in effect, equated the status of a limited partner with that of a passive investor.
Functional Analysis
Just a couple of years ago, the Tax Court approved the IRS’s functional analysis into the roles and responsibilities of certain “limited partners” to determine whether these members of a state law limited partnership were bona fide limited partners.[iii]
According to the Tax Court, the functional analysis is designed to be an inquiry into whether a partner is generally akin to a passive investor. Under this test, 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.
Guaranteed Payment for Services
Quoting the literal text of the Code, the Fifth Circuit stated that all of a limited partner’s distributive share of partnership income is excluded from taxation, “other than guaranteed payments”[iv] to that limited partner for services actually rendered by the partner 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.[v]
The literal text of the exclusion from NESE, the Circuit Court 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.
Indeed, the Court continued, a strict passive-investor interpretation that defines “limited partner” in a way that prohibits the limited partner from providing any services to the partnership would make the “guaranteed payments” clause of the exclusionary rule entirely superfluous.
The Court noted that an individual, including a limited partner, can have multiple functions or capacities in the partnership – he could serve as both a limited partner and a general partner. The phrase “as such” in the exclusionary rule, therefore, “is quite meaningful,” the Court explained, because it clarifies how individuals who serve as both a limited and general partner are to be taxed.
“Without the qualification,” the Court stated, “a dual-status partner might think his entire distributive share is not subject to taxation.” Thus, the words “as such” avoid ambiguity by clarifying that when functioning as a limited partner, an individual taxpayer’s distributive share of partnership income is excluded from net earnings from self-employment; when functioning as a general partner, the individual’s distributive share is included in NESE.
Other Considerations
The Court concluded its rejection of the IRS’s functional analysis by making two additional points. First, if Congress wished to only exclude passive investors from the self-employment tax, it could have easily written the exception to do so, but it did not do so;[vi] and second, from a practical perspective, “how are thousands of limited partners across the country to determine ex ante what their tax liability will be? The short answer: Only with the help of an army of lawyers and accountants – and a whole lot of luck.”
How Did We Get Here?
Why was the Fifth Circuit reluctant to apply a functional – i.e., form over substance – analysis in determining whether the distributive share of an individual partner of a state law limited partnership was excludible from NESE?
Legislative History[vii]
The exclusionary rule was added to the Code in 1977.[viii] The summary of the legislation prepared by the Senate Finance Committee explained that:
“In recent years, a growing number of businesses have offered limited partnerships as a means of acquiring social security coverage solely through the income on investments in such partnerships. The bill excludes from social security coverage the distributive share of income or loss which a limited partner receives from a trade or business.”[ix]
According to a report prepared by the House Ways and Means Committee, “[t]he income from a partnership which is received by a limited partner who performs no service for the partnership will be excluded from social security coverage.”[x]
A related report prepared by the Social Security Administration stated that the addition of the Exclusion to the Code was intended “to exclude from coverage the distributive share of income or loss of a partnership received by a limited partner who does not perform any services for the partnership.” The report then summarized the new provision as follows:
“Effective for taxable years beginning, after December 31, 1977, the distributive share of income or loss from the trade or business of a partnership received by a limited partner who performs no service for the partnership are excluded from social security coverage. Under the old law, a partner’s share of partnership income was includable in his net earnings from self-employment irrespective of the nature of his membership in the partnership.”
The subcommittee on Social Security of the House Ways and Means Committee summarized the provision as follows:
“[It] excludes for social security coverage purposes the distributive share of income or loss from the trade or business of a partnership received by a limited partner who performs no service for the partnership.
“The exclusion from coverage does not extend to guaranteed payments such as salary and professional fees, received for services actually performed by the limited partner for the partnership, or distributive shares received as a general partner.”[xi]
Finally, another report issued by the Subcommittee on Social Security of the House Ways and Means Committee explained that “the bill would exclude from coverage as self-employment income certain limited partnership income which is more in the nature of investment income than compensation for actual services performed.” The former is excluded from NESE, the latter is not.
Now let’s see how the IRS applied the foregoing principles.
IRS Regulations
Following the explosion of state limited liability company laws in the early 1990’s, taxpayers and the IRS struggled with determining whether a member’s interest should be classified as the equivalent of a general partner or as a limited partner interest for purposes of the tax on NESE. Under these statutes, the members of an LLC were, generally, not liable for the debts and obligations of the LLC beyond their contributions to the LLC. At the same time, the LLC was not required to have a manager but could, instead, be managed by all of its members. Because LLCs were generally treated as partnerships for federal tax purposes, the issue regarding the treatment of an LLC’s members for purposes of the self-employment tax and, specifically, whether any of the members were properly treated as “limited partners” within the meaning of the exclusionary rule.
1994 Prop. Regs
In response to this uncertainty, in 1994 the IRS proposed regulations[xii] providing that, generally, a member’s NESE included the member’s distributive share (whether or not distributed) of income or loss from any trade or business carried on by an LLC. However, the regulation provided that a member of an LLC would be treated as a limited partner for purposes of the exclusionary rule if: (1) the member was not a manager, and (2) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner in that limited partnership under applicable law. If a member of an LLC was treated as a limited partner under this proposed regulation for purposes of the self-employment tax, then the member’s distributive share of income or loss from the LLC would not be included in NESE, except for guaranteed payments for services.
For purposes of the first requirement, a manager was defined as a person who, alone or together with others, was vested with the continuing exclusive authority to make the management decisions necessary to conduct the LLC’s business. If there was no designated or elected manager of the LLC with such authority to manage the LLC, then all of the members would be treated as managers.
For purposes of the second requirement, under state law, a limited partner may become liable for the obligations of a limited partnership as a general partner when the limited partner participated in the management or control of the business. Thus, this requirement sought to ensure that both a member of an LLC and a limited partner in a limited partnership who participated in the management or control of the entity to the same extent were treated in the same manner for self-employment tax purposes.
1997 Prop. Regs
The business community gave the foregoing proposed regulation a cold greeting. In response, in 1997 the IRS replaced its prior proposal with a new set of proposed rules[xiii] that sought to define which partners of a federal tax partnership were considered limited partners for self-employment tax purposes. These proposed regulations would have applied to all entities classified as a partnership for federal tax purposes, regardless of the state law characterization of the entity. Thus, the same standards would have applied when determining the status of an individual owning an interest in a state law limited partnership or the status of an individual owning an interest in an LLC. In order to achieve this conformity, the proposed regulations adopted an approach which depended on the relationship between the partner, the partnership, and the partnership’s business. State law characterizations of an individual as a “limited partner” or otherwise would not be determinative.
Generally, an individual would be treated as a limited partner under the proposed regulations unless the individual (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership under the statute pursuant to which the partnership was organized; or, (3) participated in the partnership’s trade or business for more than 500 hours during the taxable year.
If, however, substantially all of the activities of a partnership involved the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provided services as part of that trade or business was not considered a limited partner.
According to the IRS, by adopting these functional tests, the proposed regulations ensured that similarly situated individuals owning interests in entities formed under different statutes or in different jurisdictions would be treated similarly. The need for a functional approach resulted not only from the proliferation of new business entities such as LLCs, but also from the evolution of state limited partnership statutes. When Congress enacted the limited partner exclusion rule under the self-employment tax, state laws generally did not allow limited partners to participate in the partnership’s trade or business to the extent that state laws allow limited partners to participate today. Thus, even in the case of a state law limited partnership, a functional approach was necessary to ensure that the self-employment tax consequences to similarly situated taxpayers did not differ depending upon where the partnership organized.
Still, the proposed regulations allowed an individual who was not a limited partner for purposes of the self-employment tax to nonetheless exclude from NESE a portion of that individual’s distributive share if the individual held more than one class of interest in the partnership.
Similarly, the proposed regulations permitted an individual that participated in the trade or business of the partnership to bifurcate his or her distributive share by disregarding guaranteed payments for services. In each case, however, such bifurcation of interests was permitted only to the extent the individual’s distributive share was identical to the distributive share of partners who qualified as limited partners under the proposed regulation (without regard to the bifurcation rules) and who owned a substantial interest in the partnership. Together, these rules excluded from an individual’s NESE amounts that were demonstrably returns on capital invested in the partnership.
Taxpayer Relief Act 1997
The 1997 regulatory proposal must have struck another nerve in the business community because the Taxpayer Relief Act of 1997[xiv] included a provision that expressly referenced the proposed regulation and imposed a moratorium on the issuance before July 1, 1998 of any regulations relating to the definition of a limited partner for self-employment tax purposes.[xv]
The IRS’s Position
The moratorium expired long ago. The proposed regulations have not been withdrawn. New regulations have not been proposed, let alone finalized.
Still, in 2011, the Tax Court rejected a taxpayer’s argument that an individual member of a state law limited liability partnership (“LLP”) should be treated as a limited partner for purposes of the exclusionary rule.[xvi] According to the Court, a limited partnership
“has two fundamental classes of partners, general and limited. General partners typically have management power and unlimited personal liability. On the other hand, limited partners lack management powers but enjoy immunity from liability for debts of the partnership. Indeed, it is generally understood that a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is generally akin to that of a passive investor.”
The Court examined the legislative history for the exclusionary rule. On the basis thereof, the Court determined that the intent of the rule “was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations (which was the archetype of limited partners at the time) would not receive credits toward Social Security coverage.”[xvii]
The Court then pointed out that all of the partnership’s revenues were derived from services performed by the partners in their capacities as partners. It then added that the partners had made only nominal capital contributions for their interests, and their distributive shares of the partnership’s income did not arise as a return on the partners’ investment and were not “earnings which are basically of an investment nature;” instead, those shares arose from the services performed by the partners on behalf of the partnership.[xviii]
Then, in March 2018, the IRS announced a compliance campaign that would focus on individual partners, including service partners in service partnerships organized as state-law limited liability partnerships, limited partnerships, and limited liability companies, that have inappropriately claimed to qualify as “limited partners” not subject to self-employment tax.[xix]
Moreover, based upon the functional analysis it applied in Sirius and in several other cases that are now pending before other federal Circuit Courts, it appears the IRS continues to believe that the concepts set forth in the 1997 Proposed Regulations remain sound.[xx]
What’s Next?
It remains to be seen whether the Fifth Circuit’s decision in Sirius will influence the outcome of similar appeals from the Tax Court regarding the imposition of self-employment tax upon the distributive share of certain limited partners.[xxi]
Of course, a decision by any of these Circuits would bind the Tax Court only within that Circuit.[xxii]
A split among the Circuits would seem to invite the U.S. Supreme Court to resolve the disagreement and ensure the uniform application of the self-employment tax.
Or perhaps the Court will allow Congress to settle the issue; i.e., to tell us what it intended when the exclusionary rule was enacted.[xxiii]
Perhaps the solution is to require “reasonable” guaranteed payments to the partners for the services rendered?
Parting Thoughts
Whenever I’m confronted with this issue, I immediately think of a scenario in which: a service business is organized as a limited partnership;[xxiv] the entity acting as the general partner holds a very small equity interest; the principals of the general partner also hold much larger limited partner interests that they acquired in exchange for insignificant capital contributions, especially when compared to the rest of the limited partners who are “merely” investors; the principals’ share of partnership income attributable to their limited partner interests in significantly disproportionate to their capital contribution, especially as compared to the other limited partners.
Under these circumstances, is it proper to rely on the “label” placed on a partner for state law purposes? Can one ignore the economic reality of the partner’s relationship to the partnership’s business?
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Sirius Solutions, L.L.L.P. v. Comm’r, No. 24-60240 (5th Cir. 2026).
[ii] According to the Court, “legislative history is ‘generally of dubious value in statutory interpretation.’” I suppose that depends upon the desired outcome.
[iii] https://www.taxslaw.com/2025/06/the-limited-partner-exclusion-from-self-employment-tax-but-who-is-a-limited-partner/#_edn18.
[iv] Described in IRC Sec. 707(c).
[v] IRC Sec. 1402(a)(13).
[vi] That old chestnut of an excuse for passing the buck.
[vii] All of the materials cited may be found at: https://www.ssa.gov/history/pdf/Downey%20PDFs/Social%20Security%20Amendments%20of%201977%20Vol%203.pdf..
[viii] P.L. 95-216. “Social Security Amendments of 1977.”
[ix] Does this mean the limited partner is “merely” an investor?
[x] In other words, as an investor, the limited partner does not perform any services for or on behalf of the partnership?
[xi] Meaning, these services are not provided by the limited partner in their capacity as such?
[xii] 59 Fed. Reg. 67253.
[xiii] 62 Fed. Reg. 1701.
[xiv] P.L. 105-34, Sec. 935.
[xv] A Sense of the Senate resolution with respect to this provision stated:
SEC. 734. SENSE OF THE SENATE WITH RESPECT TO SELF-EMPLOYMENT TAX OF LIMITED PARTNERS.
Findings.-The Senate finds that-
*** (4) certain types of entities, such as limited liability companies and limited liability partnerships, were not widely used at the time the present rule relating to limited partners was enacted, and that the proposed regulations attempt to address owners of such entities;(5) the Senate is concerned that the proposed change in the treatment of individuals who are limited partners under applicable State law exceeds the regulatory authority of the Treasury Department and would effectively change the law administratively without congressional action; and(6) the proposed regulations address and raise significant policy issues and the proposed definition of a limited partner may have a substantial impact on the tax liability of certain individuals and may also affect individuals’ entitlement to social security benefits.
(b) Sense of Senate.-It is the sense of the Senate that- (1) the Department of the Treasury and the Internal Revenue Service should withdraw Proposed Regulation 1.1402(a)-2 which imposes a tax on limited partners; and (2) Congress, not the Department of the Treasury or the Internal Revenue Service, should determine the tax law governing self-employment for limited partners. 143 Cong. Rec. 13297 (1997).
[xvi] Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011).
[xvii] The Court then added that, “The legislative history of section 1402(a)(13) does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes.”
[xviii] See also Castigliola v. Comm’r, T.C. Memo. 2017-62.
[xix] https://www.irs.gov/businesses/corporations/lbi-active-campaigns#seca-tax
[xx] I agree.
[xxi] Denham Capital Management appealed to the 1st Circuit in April 2025 (No. 25-01349); Soroban Capital Partners LP appealed to the 2nd Circuit in August 2025 (2025 (No. 25-2079). https://www.taxslaw.com/2025/06/the-limited-partner-exclusion-from-self-employment-tax-but-who-is-a-limited-partner/#_ednref46.
[xxii] Golsen v. Comm’r, 54 T.C. 742 (1970), aff’d on other grounds, 445 F.2d 985 (10th Cir. 1971), cert. denied, 404 U.S. 940 (1971).
[xxiii] P.L. 95-216. “Social Security Amendments of 1977.” Chuckle. Unlikely in this Congress.
[xxiv] Who still uses a limited partnership f not for the reasons discussed here?