5th Circuit Hears Limited Partner SECA Tax Case

At Feb. 6 oral arguments in Sirius Solutions, the 5th Circuit appeared skeptical of the government’s position that the U.S. Tax Court’s functional analysis test applies to determine whether limited partners in a state-law limited partnership are eligible for the limited partner exception under Section 1402(a)(13). Other similar cases are working their way through the court system. However, the 5th Circuit is the first appellate court to consider the issue in the context of a state-law limited partnership and its decision could influence the outcome in other cases.

Background

Section 1402(a)(13) excludes from net earnings subject to self-employment tax the distributive share of income of a “limited partner, as such,” other than guaranteed payments for services (limited partner exception). For decades, limited partners in state-law limited partnerships have relied on the limited partner exception. In 2023, the Tax Court held in Soroban v. Commissioner that limited partners in a state-law limited partnership were not eligible for the limited partner exception. The court explained that eligibility for the limited partner exception was not determined by the state law classification of the partner and the partnership, but instead is determined under a functional analysis inquiry to ascertain the roles and responsibilities of partners to determine their status for tax purposes. The functional analysis test originally was applied by the Tax Court in Renkemeyer, Campbell & Weaver LLP v. Commissioner to determine whether partners in a limited liability partnership were limited partners for purposes of the limited partner exception.

Sirius Solutions

Sirius Solutions was decided by the Tax Court in February 2024 and the taxpayer filed its appeal with the 5th Circuit on May 15, 2024. A three-judge panel of the 5th Circuit heard oral arguments on Feb. 6. The panel expressed skepticism about the extraordinary list of factors that the court would be required to weigh to determine limited partner status if the government’s position prevailed. The judges also pointed out that the regulations, IRS forms, and instructions do not reflect the government’s position that a functional analysis is required in the case of a state-law limited partnership, and they questioned whether it is appropriate for the government’s position to be effectively imposed through litigation.

Crowe observation

Taxpayers were buoyed by the cold reception the government’s arguments received by the court and are hopeful that the court will issue its decision in favor of Sirius Solutions.

Looking ahead

Taxpayers will be closely watching the results of the case. While the oral arguments seemed to go in the taxpayer’s favor, it is possible that the 5th Circuit could agree with the Tax Court or apply a version of a functional analysis that restricts the factors that are used to make the limited partner determination. Limited partners in state-law limited partnerships should consult with their tax advisers to evaluate how this case could impact them.