Fifth Circuit Reconsiders Who Counts as a Limited Partner

For years, businesses and tax advisors have searched for a clear answer to a deceptively simple question: When is a limited partner truly a “limited partner” for self-employment tax purposes?

Earlier this year, the Fifth Circuit appeared to provide that answer, tying the analysis largely to a partner’s legal status and liability protection. Many taxpayers viewed the decision as a welcome source of certainty. That certainty proved to be short-lived. In a surprising reversal, the Fifth Circuit, on a petition for rehearing in Sirius Solutions, L.L.L.P. v. Commissioner, withdrew its own opinion and replaced it with a new one that focuses not on what partnership documents say, but on what partners actually do. The result is a decision that may affect thousands of partners and could reshape future disputes involving self-employment tax.

Why Limited-Partner Status Matters

Individuals who work for themselves generally pay Social Security and Medicare taxes through the self-employment tax system. A partner’s share of income from a business partnership is usually included when calculating that tax.

The tax law, however, contains a special rule for limited partners. Under Section 1402(a)(13), a limited partner generally does not include the partner’s allocated share of business income in self-employment earnings. Payments received specifically for services are treated differently.

The difficult question has always been deceptively simple: Who qualifies as a limited partner for this purpose?

State law may call someone a limited partner and protect that person from personal liability. Federal tax law, however, does not clearly explain whether those legal protections are enough. That uncertainty has produced years of disagreement among taxpayers, the IRS and the courts.

The Fifth Circuit’s Original Opinion

In January 2026, the Fifth Circuit issued an opinion in Sirius Solutions. The court concluded that state-law status and limited liability generally controlled the analysis. In practical terms, a person recognized as a limited partner under the governing partnership law could claim the federal tax exception even if that individual was active in the business.

That decision offered taxpayers something they rarely receive in this area: a relatively clear rule.

The Fifth Circuit also rejected the Tax Court’s approach in Soroban Capital Partners LP v. Commissioner. There, the Tax Court focused on the partner’s real-world responsibilities and concluded that the exception was intended for investors who were not actively conducting the partnership’s business.

The January 2026 decision, therefore, framed the dispute as a choice between legal status and actual conduct. A partner’s formal classification appeared to win. That clarity did not last.

A New Rule Focused on the Partner’s Role

On August 12, 2026, the Fifth Circuit withdrew its earlier opinion and issued a replacement in the case, which is now captioned K Alain v. Commissioner. The court held that limited liability alone does not settle the federal tax question.

Under the replacement opinion, the court still rejected the Soroban approach but held that a limited partner is one who plays no significant role in managing or running a business. The court reached that conclusion by considering how the term “limited partner” was commonly understood when Congress enacted the exception in 1977 (i.e., it considered the same authorities it did in the first opinion). It stated that an “informed reader of the English language in 1977 would have understood that a ‘limited partner’ could not manage the partnership, . . . but perhaps could participate in certain non-managerial aspects of the business.” Thus, the same judges considered the same authorities and reached a different conclusion.

Significantly, the court did not adopt the Soroban view that a limited partner must remain completely passive. Some participation may be permitted. At the other end of the spectrum, someone who controls or materially directs the business is unlikely to fit within the court’s understanding of a limited partner. The court landed in the middle, but it creates uncertainty because it did not define when involvement becomes significant enough to disqualify a partner from the exception.

For example, the opinion does not provide a numerical test based on time, compensation or ownership. It does not tell businesses whether serving on a committee is more important than developing clients, supervising employees or advising on strategy. Those questions were left for further proceedings in the Tax Court.

What Partnerships Should Consider

The new opinion shifts the inquiry from an organizational chart to the facts on the ground. A title in a partnership agreement remains relevant but no longer carries the day. The IRS and the courts are likely to examine how decisions are made, who has authority over the business and whether an owner’s activities are central to operating the partnership.

This distinction may be particularly important for professional and financial services firms. An owner can be highly productive without necessarily managing the organization. Conversely, an individual may spend relatively little time on the business but still possess substantial decision-making authority.

Accordingly, the analysis should not be reduced to a simple hours-based test. Businesses may need to distinguish between three different types of activity:

The Fifth Circuit did not establish these as formal categories, but they are practical ways to organize the factual review required by its new standard.

Partnerships may also benefit from comparing governing documents with actual business practices. If an agreement suggests that a partner has little management authority, but the individual approves budgets, sets firm policy or oversees major operations, the written document may not tell the complete story.

The Broader Dispute Is Not Over

The Fifth Circuit’s change of direction does not resolve the issue nationally. The Soroban case is before the Second Circuit, and Denham Capital Management is pending before the First Circuit. As of August 14, 2026, neither appellate court had issued its decision. Different outcomes could produce varying rules among federal circuits.

The Bottom Line

The central question is no longer merely whether partnership documents label an owner as a limited partner. The more important question is whether that owner plays a significant role in managing or running the business, because the exception is now available only to a partner who does not.

Until the Tax Court applies the new standard pursuant to the remand in K Alain, businesses will have limited guidance on where that line falls. Partnerships should review the duties, authority and actual activities of partners whose income is treated as falling within the limited-partner exception. They should also consider whether their reporting position is supported by consistent agreements, governance records and operating practices.

The Fifth Circuit’s latest opinion provides a direction, but not a roadmap. For many businesses, that means more attention to the facts, more documentation and, at least for now, less certainty.