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Fifth Circuit Provides Limited Partners with Self-Employment Tax Exclusion

February 17, 2026

Fifth Circuit Provides Limited Partners with Self-Employment Tax Exclusion

February 17, 2026

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In light of this case, we believe it is important to approach this situation thoughtfully and strategically.

On January 16, 2026, a long-awaited U.S. Court of Appeals ruling handed a significant victory to taxpayers, holding that partners with limited liability under state law qualify for an exclusion from the self-employment tax, potentially paving the way for other circuits to follow.

The Fifth Circuit Court of Appeals, which oversees Texas, Louisiana and Mississippi, ruled favorably for limited partners in the case of Sirius Solutions, LLLP v. Commissioner. This ruling rejected both the IRS's argument and previous United States Tax Court decisions that have applied a "functional analysis test" in determining whether limited partners are subject to self-employment tax. Rather, in a 2-1 opinion, the Fifth Circuit applied a more broad interpretation of the exemption provided by the statute.

Background

Internal Revenue Code 1402(a) defines self-employment income and under Subsection 13, excludes “the distributive share of any item of income or loss of a limited partner … other than guaranteed payments” made in exchange for services provided to the partnership. However, recent U.S. Tax Court decisions across the United States have applied a “functional analysis test” to determine whether a limited partner’s distributive share of income was subject to self-employment tax.

Under the test, if a limited partner performed certain functions such as participation in management and/or other business matters of the partnership, or had the authority to legally bind the partnership, the income passed through to the limited partner would be subject to self-employment tax, regardless of the statutory exemption provided by IRC 1402(a)(13). The IRS and Tax Courts have essentially ignored this important statutory exemption and created this much broader “functional analysis test” to argue limited partners were more than simply passive investors, and thus subject to self-employment tax.

In Sirius Solutions, the Fifth Circuit found no statutory or regulatory basis for imposing such a test, meaning that limited partners do not need to pay self-employment taxes solely based on their involvement in the partnership. This decision stands in contrast to several U.S. Tax Court cases that have applied the “functional analysis test” to determine if limited partners were acting more like general partners.

TAG’s Perspective

In light of this case, we believe it is important to approach this situation thoughtfully and strategically:

  • As a result of this decision, limited partners, whether passive or actively managing or working in the business, may rely on this precedent to avoid self-employment tax in the Fifth Circuit.
  • While the Sirius opinion applies to businesses in Louisiana, Mississippi and Texas—the region covered by the Fifth Circuit—partnerships elsewhere may still be bound by the functional "active/passive" analysis test in the U.S. Tax Court under a 1970 rule that court set in Golsen v. Commissioner. Due to the “Golsen rule,” the court is not yet bound by the Sirius decision for taxpayers outside of the Fifth Circuit's territory. As a result, for example, businesses in Connecticut, New York and Vermont (Second Circuit), and Pennsylvania, New Jersey, Delaware and the Virgin Islands (Third Circuit) may still be subject to the more restrictive test until their respective appeals courts weigh in.
  • This ruling applies only to limited partnerships, as the Fifth Circuit remained silent on applicability to other state-law legal entity structures such as members of limited liability companies and limited partners of limited liability partnerships.
  • Guaranteed payments are still subject to self-employment taxes, even for limited partners in a limited partnership. The IRS will likely pay even closer attention to the proper classification of payments to limited partners for services rendered in light of this recent decision.
  • Material participation rules under IRC 469 do not impact whether a limited partner is subject to self-employment tax; however, as previously stated, proper classification and reporting of guaranteed payments to limited partners is paramount.

Limited partners who have been paying self-employment tax on limited partnership income, particularly in the Fifth Circuit, should consider filing protective refund claims for open tax years.

While a huge development, the IRS may still challenge "active" limited partners in other circuits, so vigilance is required. A letter from IRS counsel last week in the First Circuit matter indicates that the IRS will continue to apply a functional "active/passive" analysis test in other venues across the country.

While ongoing appeals of similar Tax Court rulings are currently pending in the First and Second Circuits, decisions are likely several months away at least. If these appeals ultimately do create a circuit split, the case will then be ripe for review by the U.S. Supreme Court.

For More Information 

If you would like more information about this topic or discuss your own unique situation, please contact Luke J. Bartlinski or Michael A. Gillen. For information about other pertinent tax topics, please visit our publications page.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.