The 5th U.S. Circuit Court of Appeals recently issued a long-awaited decision related to the application of self-employment tax (SE tax) in a state law limited partnership operating as an investment fund manager. The 5th Circuit disagreed with the U.S. Tax Court by concluding that the limited partners shouldn’t be subject to SE tax on their distributive share of profits from the partnership. This is a very important decision with respect to SE tax regime as it applies to partnerships. But it’s also only one additional step in a saga that’s likely to continue for years to come.
What is the issue with the application of self-employment tax?
Section 1402(a)(13) exempts from SE tax the “distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … to that partner for services actually rendered to or on behalf of the partnership.” The phrase “limited partner, as such” isn’t defined by the statute or regulations. The IRS and Treasury had issued proposed regulations in 1997 that would’ve defined “limited partner” to exclude those who could contract on behalf of the limited partnership or participated in the business of the limited partnership for at least 500 hours. Congress became concerned about these proposed regulations and prevented them from being finalized for some time. Even after that prohibition ended, the IRS and Treasury never acted to finalize the regulations or otherwise clarify the definition.
Since then, the IRS challenged several taxpayers that took the position that the limited partner exception applied to partners providing services to the partnership, including a law firm operating as a limited liability partnership and one operating as a professionally limited liability company. In both cases, the Tax Cout concluded that the law firm partners should be subject to SE tax on all of their income from the firm regardless of whether it was “salary” or an allocation of firm profits.
In 2018, the IRS initiated an audit campaign to target investment fund managers organized as limited partnerships who took the position that a service partner was eligible for the limited partner exemption in Section 1402(a)(13) as long as they only held an interest as a limited partner. In many of these audits, the IRS argued that the entire income of the investment fund managers should be subject to SE tax. A number of these limited partnerships are in the process of litigating this result. Several of these cases have already been heard by the Tax Court, and it has consistently concluded that a limited partner isn’t exempt from SE tax merely by being a limited partner under state law. Instead, a functional analysis is required to determine if the partner is actually acting in the capacity as a limited partner.
What happened with self-employment tax in Sirius Solutions?
Several of the recent Tax Court decisions have been appealed. On Jan. 16, 2026, the first appellate decision was issued by the 5th Circuit in the Sirius Solutions case. In a 2-1 decision, the 5th Circuit disagreed with the Tax Court and essentially concluded that a limited partner is exempt from SE tax as long as it has limited liability under state law. The amount of services the limited partner provides, the Sirius court said, isn’t relevant to the SE tax determination. This was primarily based on the common understanding of the term “limited partner” in 1977 when the limited partner exception to the SE tax was first enacted and on the language of the IRS instructions and SSA interpretations since that date. The dissenting judge generally agreed with the Tax Court’s conclusion that the statutory language should be interpreted to apply only when a limited partner isn’t acting as a passive investor and not as a service partner.
What does this mean for taxpayers right now?
While this decision is a significant victory for taxpayers similar to Sirius, the immediate implications are likely limited. Given its recent history in similar situations, the Tax Court is unlikely to simply change its point of view in response to the 5th Circuit’s decision.
We can expect the Tax Court to continue deciding this issue under its own functional analysis test in the way it had been before Sirius. The notable exception to that is for any cases that would be appealed to the 5th Circuit (i.e., Louisiana, Mississippi, and Texas). This is the so-called Golsen rule, which says the Tax Court is only bound by circuit court decisions to the extent that they would control an appeal. The Tax Court has recently strictly followed the Golsen in other high-profile cases, so that position is likely to continue for any SE tax cases.
Therefore, while taxpayers located in the 5th Circuit (i.e., Louisiana, Mississippi, and Texas) likely have a simpler path to a successful resolution to their arguments with the IRS (or a stronger position on current tax returns), taxpayers in every other circuit likely won’t see an immediate change in their path going forward. Still, a taxpayer-favorable decision in any circuit is an important element for any taxpayer trying to evaluate the risks of a tax position even if they reside outside of that circuit since no other circuit has an adverse opinion right now.
Where do things go from here?
There are several paths that this issue could take from here, none of which are mutually exclusive.
- Continued litigation of other cases — There are a number of other cases making their way through the legal system. Several of those have already been appealed to their respective circuits (Denham Capital in the 1st Circuit and Soroban in the 2nd Circuit), so decisions in 2026 are possible. These decisions will be significant because having three circuit courts weigh in on an issue will provide much more legal authority to both taxpayers and the IRS. In addition, those two circuit courts cover New York, Massachusetts, and Connecticut where there’s a high concentration of investment fund managers directly subject to the conclusions of these cases. Importantly, while the 5th Circuit enjoys a general reputation of being taxpayer-favorable when it comes to regulatory challenges, the 1st and 2nd Circuits have different reputations, with the 2nd Circuit in particular being considerably less likely to sustain regulatory challenges.
- Supreme Court certiorari — The IRS has the right to petition the Supreme Court to review the Sirius Solutions decision. In general, the Supreme Court isn’t required to accept any case that’s appealed to it, and review is exceedingly rare — the Supreme Court in recent years decides only 50–70 cases each year. The Supreme Court tends to accept cases of significant legal importance or those where circuit courts have come to different conclusions and, again, the 2nd and 5th Circuits tend to pull in different regulatory directions. Given that SE tax might not be viewed as having unique legal significance and the 5th Circuit is the only one to have weighed in so far, it might not be likely for the Supreme Court to take an appeal even if one were made.
- Rehearing en banc — In the short term, it’s far more likely that the government will petition the 5th Circuit for rehearing en banc. Sirius was decided by a three-judge panel, with one judge dissenting. The case was fully briefed and argued for nearly a year before the panel issued a decision, signaling the three judges involved struggled with how to resolve the issue. It’s uncommon for circuit courts to rehear cases en banc, but en banc review is far less rare than Supreme Court review. Rehearing en banc by the full 5th Circuit — all 17 judges — would open the door for further refinement of the analysis by this court.
- IRS guidance — The IRS has indicated for several years that it’s working on comprehensive guidance on this issue. An IRS victory in Sirius Solutions at the 5th Circuit might have accelerated the timeline for the release of this guidance. This loss may delay any future guidance until there is more legal certainty on the issue. However, the IRS recently removed guidance on this subject from its priority guidance plan, so this guidance might not have been imminent either way.
- Congressional action — The entire issue stems around the perceived lack of clarity on the term “limited partner, as such” in Section 1402(a)(13). Any potential ambiguity in that phrase could be cleared up by future congressional action. Congress is now in the process of pushing through bipartisan legislation that would “fix” the result in a high-profile case (Zuch, the U.S. Supreme Court tax case from last year). While the Trump administration has continued to the litigation on this matter that was begun under the Biden administration, expanding SE tax to pass-through income has historically not been a policy support by Republicans but has been supported by some Democrats. Therefore, congressional action on this topic may not be likely under the current administration and current Congress.
What to do now?
While a circuit level decision is always meaningful when interpreting tax law, the broader circumstances on this issue will likely justify a wait-and-see approach for taxpayers outside of the 5th Circuit. This one decision might not change the landscape enough to cause a taxpayer to change their point of view, and waiting to see how the Denham Capital and Soroban cases are decided in the 1st and 2nd Circuits will provide much more information. However, this is an incredibly nuanced legal issue, so any impacted taxpayer should certainly continue to evaluate their position. On the other hand, taxpayers in the 5th Circuit have a much clearer legal landscape in which to make decisions — at least for the time being.
