Fifth Circuit Rejects IRS 'Passive Investor' Test for Limited Partners

If you're a limited partner who actively participates in your partnership's business, the IRS has long argued you don't qualify for the self-employment tax exemption. The Tax Court agreed. But on January 16, 2026, the Fifth Circuit said: that's not what the statute says.

In Sirius Solutions, L.L.L.P. v. Commissioner, the court held that limited liability—not passivity—is what makes someone a "limited partner" for purposes of IRC § 1402(a)(13). Under this reading, a limited partner under state law with limited liability qualifies for the exemption—regardless of how actively they participate.

Here's the statute at the center of the dispute:

§ 1402(a)(13): "There shall be excluded 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."

This is the first time any appellate court has addressed the question. And it directly contradicts the Tax Court's position.

What Was the Dispute?

Sirius Solutions is a Delaware limited liability limited partnership that provides business consulting services. Between 2014 and 2016, it allocated ordinary business income to its limited partners and reported zero self-employment tax on those amounts—relying on the statutory exemption for limited partners.

The IRS disagreed. It issued adjustment notices reclassifying the distributive shares as subject to self-employment tax, arguing the partners were too active in the business to count as "limited partners" under the statute.

The Tax Court sided with the IRS. It applied a "functional analysis" test from its earlier Soroban Capital Partners decision, examining whether the partners were "passive investors" based on their "roles and responsibilities."

The partners were active. The Tax Court said they didn't qualify.

What Did the Fifth Circuit Say?

The Fifth Circuit reversed, vacating the Tax Court's decision 2-1.

The court started where textualists always start: what did "limited partner" mean when Congress wrote the statute in 1977?

Every dictionary from that era defined "limited partner" by one characteristic: limited liability.

Not passivity. Not lack of involvement. Limited liability.

The court found the same in the IRS's own Form 1065 instructions from 1978, which defined a limited partner as one whose "personal liability for partnership debts is limited to the amount of money... contributed." No mention of being passive. For over 40 years.

The court's holding was direct:

"The Tax Court interpreted 'limited partner' to refer only to passive investors in a limited partnership. It therefore upheld the IRS's upward adjustment of Sirius Solutions's net earnings from self-employment. We disagree. A 'limited partner' is a partner in a limited partnership that has limited liability."

Why the "Passive Investor" Test Fails

The Fifth Circuit identified three problems with the IRS position:

1. The Statute Anticipates Active Limited Partners

The exemption in § 1402(a)(13) explicitly excludes "guaranteed payments described in section 707(c)." Section 707(c) defines these as payments made regardless of partnership income:

§ 707(c): "To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership..."

This presupposes that limited partners might actually work for the partnership—and receive payment for that work. If Congress assumed limited partners were always passive, why would it need to exclude payments for their services?

2. Congress Knew How to Say "Passive"

When Congress wants to impose a passivity requirement, it does so explicitly—like the passive activity loss rules under § 469:

§ 469(c)(1): "The term 'passive activity' means any activity... in which the taxpayer does not materially participate."

Congress defined "passive" and "material participation" when it needed those concepts. The absence of that language in § 1402(a)(13) is meaningful.

3. "As Such" Doesn't Mean "Passive"

The IRS argued that "limited partner, as such" required a functional inquiry into activities. The court disagreed. The phrase simply means the income must be received in the partner's capacity as a limited partner—not through guaranteed payments for services. It's not a hidden passivity test.

Who Does This Affect?

The immediate impact is in the Fifth Circuit: Texas, Louisiana, and Mississippi. In those states, if you're:

• A limited partner under state law
• With limited liability
• Receiving distributive shares (not guaranteed payments for services)

The Fifth Circuit's holding suggests the § 1402(a)(13) exemption applies, regardless of how actively you participate.

This matters most for:

What About Everyone Else?

Outside the Fifth Circuit, the Tax Court's "passive investor" test still applies. Cases are pending in the First Circuit (Denham Capital) and Second Circuit (Soroban Capital). If either of those courts sides with the IRS, we'll have a circuit split—and likely Supreme Court review.

The IRS has until early March 2026 to seek rehearing or certiorari.

What This Means Going Forward

In the Fifth Circuit:

The law is now clearer in Texas, Louisiana, and Mississippi. However, the IRS may continue to challenge limited partner classifications, and taxpayers in disputed cases will want to document their state-law status and limited liability protections.

Outside the Fifth Circuit:

The Tax Court's functional test remains the governing standard. Sirius Solutions may provide a basis for appeal in other circuits—and the outcome of pending appeals could change the landscape nationwide.

Key distinctions to understand:

• Distributive shares (potentially exempt under § 1402(a)(13)) vs. guaranteed payments for services under § 707(c) (always subject to self-employment tax)
• State-law limited partner status vs. functional participation level
• The pending First and Second Circuit cases may resolve whether this becomes binding precedent beyond the Fifth Circuit

The Bigger Picture

This case is a reminder that statutory text matters. For 40 years, the IRS defined "limited partner" by limited liability in its own instructions—until it decided that wasn't restrictive enough. The Fifth Circuit called that out.

Whether other circuits follow remains to be seen. But for limited partners in Texas, Louisiana, and Mississippi, the standard is now clearer than before.

Case References

Statutes

This article is for informational purposes only and does not constitute legal or tax advice. For advice specific to your situation, consult a qualified tax professional or attorney.