Sirius Decision Holds Limited Partner Exception Applies

On Jan. 16, the U.S. Court of Appeals for the 5th Circuit in Sirius Solutions LLLP v. Commissioner of Internal Revenue held that a “limited partner” under IRC Section 1402(a)(13) means a partner with limited liability in a state-law limited partnership, vacating and remanding a Tax Court decision that treated the term as limited to passive investors. If the ruling stands, it could reduce self-employment tax exposure for certain limited partners in 5th Circuit jurisdictions. However, even if this decision becomes a final decision of the 5th Circuit, it is not binding outside that circuit and does not resolve whether the exception applies to partners or members in other structures, such as limited liability partnerships (LLPs) or limited liability companies (LLCs).

Background

IRC Section 1402 imposes Social Security and Medicare taxes on net earnings from self-employment, which generally includes a partner’s distributive share of partnership trade or business income. Section 1402(a)(13) excludes from net earnings subject to self-employment the distributive share of income of a “limited partner, as such,” other than guaranteed payments for services (limited partner exception).

The IRS has extensively litigated whether partners in LLPs or LLCs should qualify for the limited partner exception. In those cases, the Tax Court has applied a functional analysis test to determine eligibility for the limited partner exception, for example as in Renkemeyer, Campbell & Weaver LLP v. Commissioner of Internal Revenue.

More recently, the IRS has begun litigating whether the limited partner exception should apply to limited partners in state-law limited partnerships. The Tax Court applied a functional analysis test in Soroban Capital Partners LP v. Commissioner of Internal Revenue, and held that the phrase “limited partner, as such” in Section 1402(a)(13) limits the limited partner exception to partners functioning as passive investors.

Sirius decision

Sirius involves a Delaware limited liability limited partnership (LLLP) that operated a consulting business and reported on its Form 1065, “U.S. Return of Partnership Income,” ordinary business income in 2014 and 2015 and a loss in 2016, allocating the income to its limited partners. The IRS audited the partnership’s 2014-2016 Form 1065s and issued final partnership administrative adjustments for those years, asserting that the partners were not limited partners for purposes of Section 1402(a)(13) and increasing net earnings from self-employment from zero to the partnership’s operating results. The Tax Court upheld the adjustments in February 2024, concluding that its decision in Soroban applies. Sirius appealed.

The 5th Circuit rejected the Tax Court’s functional analysis approach articulated in Soroban and held that the exception in Section 1402(a)(13) applies to partners with limited liability in a state-law limited partnership. The court, therefore, rejected Soroban’s passive-investor test and held that a “limited partner” for Section 1402(a)(13) is a partner with limited liability in a state-law limited partnership. The court also noted it was not deciding whether owners of other entity types, such as LLPs or LLCs, qualify for the exception.

Sirius was heard by a three-judge panel of the 5th Circuit. The government has until March 2 to request that the full panel of the 5th Circuit rehear Sirius en banc. If the court agrees to rehear the case, the decision in Sirius is vacated.

Crowe observation
While Sirius is a 5th Circuit case, similar cases are pending in other circuits, setting up the possibility of a circuit split and a potential for future litigation in front of the U.S. Supreme Court.

Looking ahead

Although the Jan. 16 decision in Sirius could be vacated, taxpayers in the 5th Circuit should prepare in case the government does not request a rehearing or the 5th Circuit denies such a request. Preparation includes evaluating whether the partnership is operating through a state-law limited partnership and whether the partners at issue have limited liability under the governing agreement and applicable state law. Partnerships also should review compensation structures, because guaranteed payments for services remain subject to self-employment tax even if distributive shares are excluded.

While the Sirius decision isn’t applicable for LLPs, LLCs, and taxpayers outside the 5th Circuit, the opinion offers helpful arguments. However, the case does offer limited certainty because the court specifically did not address these entities and other jurisdictions are not required to follow the decision.

Additionally, decisions in jurisdictions outside the 5th Circuit are pending and taxpayers should monitor those decisions as well. Taxpayers that might be affected or that are considering filing refund claims for previously paid self-employment tax should consult their tax advisers and consider engaging counsel for further legal advice.