Limited Partner Self-Employment Tax Exception Faces Critical Appellate Test

The question of who qualifies as a “limited partner” for purposes of Section 1402(a)(13) is now before the federal appellate courts, with potentially significant implications for partnerships and their owners. What began as a dispute over a narrow statutory exception for limited partners has evolved into a fundamental debate over whether self-employment tax liability should be determined by a partner’s legal status under state law or by the partner’s actual role in the business. With the Fifth Circuit in Sirius Solutions v. Commissioner rejecting the IRS’s position and the Second Circuit now weighing the issue in Soroban Capital Partners v. Commissioner, partnerships, fund managers and closely held businesses are watching a case that could reshape the taxation of partnership income nationwide. A divergence between the courts could increase the likelihood of Supreme Court review.

The Limited Partner Exception Under Section 1402(a)(13)

The issue received significant attention in January 2026 when the Fifth Circuit in Sirius Solutions held that, for a partner in a state-law limited partnership or LLLP, status as a “limited partner” under state law is sufficient to qualify for the self-employment tax exclusion. In so holding, the court rejected the IRS’s preferred multi-factor approach that requires taxpayers to analyze the facts and circumstances as part of a “functional analysis” to determine a partner’s level of participation in the business. The Fifth Circuit’s analysis did not disturb the statutory rule that guaranteed payments for services remain subject to self-employment tax.

Diverging Appellate Approaches

The controversy moved to the Second Circuit on June 25, 2026, when oral arguments were heard in Soroban Capital Partners. The three-judge panel appeared skeptical that a state-law “limited partner” label, standing alone, should determine federal tax treatment. The judges focused on the historical understanding of limited partners as passive investors and questioned whether Congress intended active partners to benefit from the exception. In addition to the substantive issue under §1402(a)(13), the Second Circuit is also considering whether the IRS may raise the limited partner inquiry in partnership-level proceedings under the TEFRA rules.

Questions Around the IRS’s Functional Test

At the same time, the court raised significant concerns about the IRS’s preferred functional test. The judges questioned whether a subjective analysis of a partner’s level of control could be administered consistently and noted the absence of meaningful regulatory guidance defining how much participation is too much. The panel suggested that such an approach could create uncertainty for taxpayers and lead to continued litigation.

The discussion also highlighted broader policy considerations. Historically, Congress enacted the exception against a backdrop in which passive investors were seeking Social Security coverage through partnership interests. Today, the debate centers on whether active partners can avoid self-employment taxes by relying on limited liability protections available under state partnership statutes.

What Partnerships Should Watch

A Second Circuit decision favoring the IRS would create a direct conflict with the Fifth Circuit’s ruling, increasing the likelihood of eventual Supreme Court review. Until then, taxpayers and advisors face continued uncertainty as courts attempt to define the reach of one of the most consequential exceptions in the self-employment tax rules.

For partnerships, fund managers and other closely held businesses, the stakes remain substantial. The ultimate resolution of the limited partner exception will determine whether self-employment tax liability is driven by legal form, economic substance or some combination of the two. Until additional guidance emerges, taxpayers and advisors should continue monitoring developments in both Soroban and related appellate decisions when evaluating self-employment tax positions.