Fifth Circuit Decision Undermines IRS Position on Self-Employment Tax

At a Glance

• On January 16, 2026, the Fifth Circuit’s Sirius Solutions case found that state law limited partners are not subject to self-employment tax.¹
• The Fifth Circuit rejected the Internal Revenue Service’s (IRS) “passive investor” test, which would have required partners to be uninvolved in the business to meet the Self-Employment Contributions Act tax exception.
• This issue will likely continue to be challenged in other pending cases.

Background

Historically, many investment management firms that wanted pass-through income tax treatment organized as a two-tier structure — where an LLC or corporation acted as the general partner of a limited partnership that was the operating company providing investment management services — in an attempt to limit the exposure of the principals to self-employment tax.

The principals would own the general partner entity — which would hold a small interest in the operating limited partnership and provided services to the operating limited partnership as employees of the general partner entity (for which they were reasonably compensated) — and the principals would also hold direct interests as limited partners of the operating limited partnership. The operating limited partnership would then take the position that the principals would not be subject to self-employment tax on their distributive share of income received in their capacity as limited partners. The IRS has been challenging this position successfully in the US Tax Court in Soroban Capital Partners v. Commissioner.

Fifth Circuit Decision

In January 2026, the Fifth Circuit issued a ruling in Sirius Solutions L.L.L.P. v. Commissioner, which undermines the IRS’s arguments in these prior US Tax Court cases. Section 1402(a)(13) of the Internal Revenue Code excludes a limited partner’s share of partnership income (except for “guaranteed payments” for services) from self-employment tax calculations. The IRS and Tax Court had previously required a “functional analysis” to decide if a partner was a passive investor, not just a partner with limited liability. In Sirius Solutions, the Fifth Circuit rejected this approach, stating that the plain language of the law means any partner with limited liability under state law qualifies for the exception.

The court further reasoned that if someone is both a general and limited partner, only their general partner income is subject to Self-Employment Contributions Act (SECA) tax. The Fifth Circuit’s ruling applies specifically to limited partnerships under state law (not LLCs or LLPs).

The IRS may petition for a rehearing en banc and/or may appeal to the Supreme Court. Pending cases in other circuits could result in a circuit split, including Soroban, where the Tax Court had applied a functional analysis.

Implication

The decision in Sirius Solutions is a welcome result for investment managers but is not likely the end of this saga. It will be important to watch for further IRS actions or court decisions in the Soroban and Denham Capital Management LP v. Commissioner cases, including potential appeals or conflicting rulings in other circuits.

For More Information

For further information, you may contact the authors or a member of the firm’s investment management team or transactional tax team.

Legal clerk Moe Roberson contributed to this update.