Few partnership tax controversies have generated as much attention in recent years as the fight over the scope of the self-employment tax exception for limited partners under §1402(a)(13). The Fifth Circuit’s decision in Sirius Solutions (now K. Alain) marked a notable development in August 2026, and the latest chapter arrived on September 17 with the Second Circuit’s decision in Soroban Capital Partners, which affirmed the Tax Court’s decision and deepened the uncertainty for taxpayers seeking to rely on the limited partner exception.
At its core, the controversy centers on a simple question: when Congress excluded the distributive share of a “limited partner, as such” from self-employment income, did it intend a bright-line rule based on state-law status, or did it intend to protect only passive investors?
The Soroban dispute arose from a Delaware limited partnership that managed investment funds. For the 2016 and 2017 tax years, the firm’s three individual limited partners received both guaranteed payments and approximately $141.5 million in distributive shares of partnership income. While the guaranteed payments were reported as self-employment income, the partnership excluded the distributive share allocations from self-employment tax on the theory that the recipients were limited partners.
The IRS disagreed. Relying on a series of cases culminating in Soroban and Denham Capital, the IRS argued that the statutory exception applies only to partners acting as passive investors. The Tax Court agreed and applied a “functional analysis” test; in a later opinion in the same case, it applied that test to the principals, focusing on how the partnership generated income and the role the partners played in receiving the allocations. It reached the same result for a private equity manager in Denham Capital Management.
The court placed significant weight on the partners’ active involvement in the business. The limited partners worked full-time in the business, exercised significant managerial authority and contributed the skills and judgment essential to generating the firm’s income. Their capital contributions were relatively insignificant compared to the income allocated to them. Based on those facts, the Tax Court concluded that they were not acting as limited partners in any meaningful economic sense and therefore could not rely on the §1402(a)(13) exclusion.
The Tax Court’s reasoning appeared to gain momentum until the Fifth Circuit issued its decision in Sirius. The Fifth Circuit rejected the IRS’s preferred functional analysis and instead focused on the statutory text. In January 2026, the court concluded that a partner in a state-law limited partnership that is afforded limited liability is generally entitled to the protection of §1402(a)(13). It criticized the IRS’s approach as creating uncertainty, complexity and extensive litigation without clear statutory support.
In August 2026, the court withdrew the earlier opinion and issued a replacement in the case, which is now known as K. Alain v. Commissioner. The court held that limited liability alone does not settle the federal tax question. Instead, a partner falls outside the exception if the partner plays a significant role in managing or running the business.
The conflict came to a head again in Soroban. During oral arguments, the Second Circuit expressed skepticism concerning both sides’ positions. The court questioned whether Congress intended active investment managers to qualify for an exclusion that historically was associated with passive investors. At the same time, the panel raised concerns about the administrability of the IRS’s fact-intensive approach and the lack of clear guidance for taxpayers.
Nevertheless, the court ultimately affirmed the Tax Court, holding first that the Tax Court had jurisdiction over the proceedings and then that the principals were not limited partners. According to the Second Circuit, partners who exercise managerial control and whose services drive the production of partnership income are not “limited partners” within the meaning of §1402(a)(13), notwithstanding their formal status as limited partners under state partnership law. Writing for a unanimous panel, Judge Chin explained that a limited partner “is one who has limited liability and who does not run, manage, or otherwise exert control or managerial authority over the partnership.” He also conceded, as the IRS did in its appellate brief, that limited partners can provide some services to the partnership, but concluded that “[s]o long as the activities in question do not constitute controlling, managing, or running the business, a partner may play a role in the partnership and still qualify as ‘limited’ under §1402(a)(13).” Because the Tax Court found that Soroban’s principals exerted managerial control over the firm, and that finding was not contested on appeal, their distributive shares are subject to the self-employment tax.
The consequences extend far beyond hedge funds. Many professional service firms, private equity sponsors, real estate investment groups and closely held businesses rely on limited partnership structures. The difference between being inside or outside of §1402(a)(13) can result in millions of dollars of additional self-employment tax over time.
The Fifth and Second Circuits now agree that state-law limited partner status alone is not dispositive, but they differ on the proper standard for determining when a partner loses the protection of §1402(a)(13). The Fifth Circuit imposes self-employment tax on limited partners if they play a significant role in managing or running, and the Second Circuit imposes the tax if they run, manage or control the partnership’s business. Thus, the split between these two decisions is not that wide, and while participation matters, trial courts will have to grapple with where to draw the line.
Separately, the First Circuit is considering the issue in Denham, which was argued in February 2026, but the court may sidestep the issue and decide the case on jurisdictional grounds.
From a policy perspective, both approaches have appeal. The Tax Court and Second Circuit seek to prevent active service partners from recharacterizing compensation as exempt distributive-share income. The Fifth Circuit’s concern is equally valid: taxpayers should not be subjected to a vague, fact-intensive standard that Congress never expressly enacted.
Notably, neither circuit fully embraced the parties’ positions. The Fifth Circuit rejected the IRS’s expansive functional analysis, while the Second Circuit rejected the notion that state-law status alone determines federal tax treatment. As a result, the emerging debate is no longer whether a functional test exists, but rather how much management and participation is sufficient to disqualify a partner from the protection of §1402(a)(13).
The differing approaches suggest the ultimate resolution may come from Congress, Treasury or the U.S. Supreme Court. Until then, taxpayers in the Fifth Circuit can rely on K. Alain for substantial authority, which vacated and remanded rather than deciding where the line falls, and taxpayers in the Second Circuit can rely on Soroban. Taxpayers outside the Second and Fifth Circuits now navigate competing appellate authority and may have substantial-authority arguments under either line of reasoning, depending on their specific facts.
The Tax Court is likely to continue to rely on its functional analysis; however, under the Golsen rule, it must apply the Fifth Circuit’s “no significant role” standard in cases appealable to that circuit. Until a higher court resolves the issue, the self-employment tax consequences of identical partnership structures may depend as much on geography as on the underlying facts.
For more information on this topic, please contact a member of our team.
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