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

Update (October 2026): On August 12, 2026, the Fifth Circuit withdrew the January opinion this article first reported and replaced it. The case is now called K Alain (Sirius Solutions changed its name), and the new opinion turns on your role in running the business, not on your limited liability. The account of the court's reasoning below is of the withdrawn January opinion.

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. The Fifth Circuit rejected the Tax Court's test in January 2026, but on rehearing it adopted a test of its own that still looks at how much you run the business.

In K Alain, L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. Aug. 12, 2026), the court held that a "limited partner" for purposes of IRC § 1402(a)(13) is "a partner who plays no significant role in managing or running a business." Under this reading, limited liability alone isn't enough: if you play a significant role in running the business, you don't qualify for the exemption.

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 was the first time any appellate court addressed the question, and both opinions reject 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 $0 of net earnings from self-employment 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 without holding a trial. Its earlier Soroban Capital Partners decision had held that "limited partners" means only "passive investors," judged by a "functional analysis" of what each partner actually does. Sirius agreed that under Soroban its partners did not qualify, and asked the Tax Court to enter decision for the IRS so it could appeal. In February 2024, the Tax Court did.

What Did the Fifth Circuit Say?

In January, the Fifth Circuit vacated the Tax Court's decision 2-1 and sent the case back.

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

In January, the court read every dictionary from that era as defining "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 January opinion'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."

On rehearing in August, the court withdrew that opinion. The new opinion, again 2-1, replaces the limited-liability test with the "no significant role in managing or running a business" test and again sends the case back.

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)
• Playing no significant role in managing or running the business

The Fifth Circuit's August 2026 opinion suggests the § 1402(a)(13) exemption applies. The court did not define a "significant role," but it suggested some participation is allowed so long as you don't control the business.

The financial stakes can be significant. Self-employment tax is 15.3% on net self-employment income up to the Social Security wage base ($176,100 in 2025), and 2.9% on income above that threshold. For a limited partner with substantial distributive shares, the exemption can mean tens of thousands of dollars per year.

This matters most for:

What About Everyone Else?

Outside the Fifth Circuit, the Tax Court's functional test still applies. On September 17, 2026, the Second Circuit affirmed the Tax Court in Soroban Capital, holding that a limited partner is "one who has limited liability and who does not run, manage, or otherwise exert control or managerial authority over the partnership." It said the Soroban partners would fail the Fifth Circuit's test too, so the two courts may not really disagree. Denham Capital is still pending in the First Circuit.

What This Means Going Forward

In the Fifth Circuit:

In Texas, Louisiana, and Mississippi, the test is now whether you play a significant role in managing or running the business, and the court did not say how much involvement is too much. If the IRS challenges your status, records of what you actually did in the business will matter more than your limited liability. Before you try to get back self-employment tax you already paid, talk to a tax professional: these amounts come from the partnership's return, and you generally have to report them the way the partnership did, so a claim may have to start with the partnership.

Outside the Fifth Circuit:

The Tax Court's functional test remains the governing standard, and the Second Circuit has now upheld a similar test. The First Circuit's ruling in Denham Capital, or a Supreme Court case, could still change the landscape.

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 First Circuit's pending Denham Capital appeal may add a third appellate view

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.

The Second Circuit has since adopted a similar management-based test, and the First Circuit has yet to rule. For limited partners in Texas, Louisiana, and Mississippi, the question is now how big a role you play in running the business.

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.