Overview
The scope of the "limited partner exception" from self-employment tax continues to be the subject of significant controversy, with several cases on this issue currently making their way through the courts. While the Tax Court has applied a "functional analysis" approach that limits the exception to passive investors and requires an analysis of the specific facts and circumstances, the Fifth Circuit recently rejected that approach and interpreted the exception to cover partners in limited partnerships with limited liability, without regard to the limited partners’ specific activities. Appeals on the limited partner exception are now pending in the First and Second Circuits. The outcome of these cases will have important implications for fund managers, professional service partnerships, and other owners of passthrough businesses seeking clarity on their self-employment tax obligations.
Overview of the Limited Partner Exception
To fund the Social Security system, section 1401(a) imposes a 12.4% tax on an individual’s self-employment income for the taxable year. Net earnings from self-employment (NESE) are defined in section 1402(a) as including, with certain exclusions, an individual’s "distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member." Section 1402(a)(13) provides a special exclusion under which NESE does not include the "distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) 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 meaning of "limited partner, as such" in this context has been the subject of uncertainty for decades, and efforts by Treasury and the IRS to provide additional clarity have been unsuccessful thus far. In 1997, Treasury issued a proposed regulation providing that an individual would not be treated as a limited partner if the individual had personal liability for partnership debts, had authority to contract on behalf of the partnership, or participated in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year.[1] The proposed regulation was heavily criticized, with some arguing that the proposal went beyond Treasury’s regulatory authority and would effectively change the statute administratively without congressional action. In response, Congress issued a moratorium prohibiting Treasury from issuing any temporary or final regulation with respect to the definition of a limited partner under section 1402(a)(13) until July 1, 1998.[2] Since the moratorium, no final regulation on the definition of limited partner has been issued.
Tax Court Applies the "Functional Analysis" Approach in Soroban
The IRS has generally taken the position that state law limited partners do not qualify for the limited partner exception if they are actively managing or exercising control over the partnership’s business operations. The Tax Court endorsed this view in several recent decisions.
In Soroban Capital Partners LP v. Commissioner,[3] decided in 2023, the Tax Court concluded that Congress intended the exception to apply only to "passive investors," and that a functional analysis test should be applied to determine whether a limited partner in a state law limited partnership is eligible for the exception.[4] Focusing on the "as such" language in section 1402(a)(13) and the legislative history, the court determined that the provision applies only when a partner is truly acting in the capacity of a limited partner, and that Congress enacted section 1402(a)(13) to exclude earnings from mere investment from NESE, not earnings derived from active participation in the partnership’s business. In a later 2025 memorandum opinion, the Tax Court applied the functional analysis test to the facts and held that Soroban’s three limited partners were not limited partners "as such," because they were essential to generating the firm’s income, exercised managerial control, worked full time in the business, and contributed little or no capital relative to their income allocations.[5]
The Tax Court followed its approach in Soroban in Denham Capital Management LP v. Commissioner,[6] a 2024 case that involved state law limited partners in a partnership offering investment advisory and management services to affiliated private equity funds. The Tax Court examined the partners’ roles and responsibilities to determine whether they operated as passive investors or active participants akin to employees. Specifically, it reviewed the sources of Denham’s income during the years at issue, the partners’ involvement in generating that income, and the relationship between their distributive shares and any capital contributions. The court ultimately found that the partners were not "limited partners, as such" under section 1402(a)(13). It emphasized that Denham’s principal business was providing investment management services to fund clients, and that the partners oversaw nearly all aspects of those services. They devoted substantially all their time to the firm, and their expertise and judgment were a key attraction for investors. In addition, their capital investments in the partnership were relatively small compared to the income they received from its operations.
Appeals in both Soroban and Denham are currently pending, with each challenging the Tax Court’s interpretation of the "limited partner" exception and application of the functional analysis test.[7] The Soroban appeal is pending before the Second Circuit, where briefing has been completed and oral argument is scheduled for June 25, 2026. The Denham appeal is before the First Circuit, which heard oral argument on February 5, 2026, and subsequently ordered supplemental briefing in May 2026. The parties now await the First Circuit’s decision.
Fifth Circuit Rejects Functional Analysis Test in Sirius
Earlier this year, the Fifth Circuit rejected the Tax Court’s functional analysis approach in a split 2-1 decision in Sirius Solutions, LLLP v. Commissioner,[8] holding that a limited partner in this context is a partner in a limited partnership that has limited liability. Focusing on the plain meaning of the term when the law was written in 1977, the majority noted that dictionaries at the time defined "limited partner" as a partner in a limited partnership that has limited liability. Further, both the IRS and the Social Security Administration issued contemporaneous interpretations of "limited partner" consistent with this definition. Thus, in the majority’s view, limited partner status should be determined based on "whether a person has the rights and duties associated with a limited partnership or whether that individual has limited liability" under state law, regardless of state labels.
The majority disagreed with the Tax Court’s interpretation of the "as such" language in section 1402(a)(13) and found that the phrase did not undermine the ordinary meaning of limited partner. The majority noted that at the time the statute was enacted, a partner could have a role as both a limited partner and a general partner, and thus the phrase clarifies how such individuals are to be taxed. Under this view, when a taxpayer acts in its capacity as a limited partner, the taxpayer’s distributive share of partnership income should be excluded from NESE; when the taxpayer acts in its general partner role, their distributive share of partnership income is included in NESE.
In contrast, the dissent would have upheld the Tax Court’s functional analysis approach and agreed with the Tax Court that the partners at issue were "limited" in name only, and that the facts demonstrated that they performed numerous management and control functions that went beyond passive investor status. Specifically, the dissent criticized the majority for offering only select portions of various definitions to form an oversimplified definition of "limited partner," arguing that "the overwhelming authority cited herein establishes that limited liability depends on whether [the partners] are functioning as passive investors."
The Justice Department filed a petition on April 1, 2026 for a rehearing en banc, stating the majority’s ruling "wreaks havoc on Congress’s design by turning a narrow exclusion into what amounts to a broad exemption from self-employment taxes for any partners in a limited partnership with limited liability under state law, even where they work full-time managing and controlling the business." The Justice Department contends that the decision will lead to "heavy losses in tax revenues" that "would erode critical funding for Social Security and Medicare." In a response brief filed on April 17, 2026 opposing the government’s petition, Sirius argued that government was "merely recycl[ing] arguments that the panel properly rejected," and that the majority’s decision correctly interpreted the plain text of the statute. The parties are now awaiting a decision from the Fifth Circuit on whether en banc review will be granted.
Looking Forward
Passthrough owners labeled as "limited partners" who also perform services or exercise control over the partnership’s business should follow the ongoing litigation over the limited partner exception closely. The IRS is likely to continue to litigate these issues aggressively given the Tax Court’s decisions in the Soroban and Denham cases. For now, taxpayers situated in the Fifth Circuit (covering Texas, Louisiana and Mississippi) generally can rely on the Sirius decision thanks to the "Golsen rule," under which the Tax Court will follow the precedent of the US Court of Appeals to which an appeal of its decision would lie.[9] However, there are questions that remain unresolved. For example, the majority in Sirius stated in a footnote that it was not addressing whether members of other types of entities, such as limited liability partnerships or limited liability companies, could qualify for the limited partner exception.
It remains to be seen whether the First and Second Circuit will agree with the Fifth Circuit. If a circuit split emerges, that could pave the way for potential review by the Supreme Court.
[1] See Prop. Treas. Reg. § 1.1402(a)-2(h)(2), 62 Fed. Reg. 1702 (Jan. 13, 1997).
[2] Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 935, 111 Stat. 788, 882.
[3] 161 T.C. 310 (2023).
[4] The Tax Court previously applied a functional analysis test in determining whether the limited partner exception applied to partners in a law firm organized as an LLP. See Renkemeyer, Campbell & Weaver v. Commissioner, 136 T.C. 137 (2011).
[5] Soroban Capital Partners v. Commissioner, T.C. Memo. 2025-52.
[6] T.C. Memo 2024-114.
[7] Both appeals also involve a jurisdictional issue under TEFRA concerning whether an adjustment to NESE is a partnership item determinable at the partnership level in a TEFRA proceeding.
[8] 165 F.4th 374 (5th Cir. 2026).
[9] See Golsen v. Commissioner, 54 T.C. 742 (1970).
