Background
On January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit (the Court), in a 2-1 decision, overturned and sent back the Tax Court’s decision, ruling that a “limited partner” as defined by Internal Revenue Code section 1402(a)(13) refers to a partner in a limited partnership who has limited liability.
Self-employment income is defined as “the net earnings from self-employment derived by an individual . . . during any taxable year”.1 Net earnings from self-employment include an individual’s share of income or loss from any partnership business they are part of, whether distributed or not.2 However, §1402(a)(13) goes on to exclude a limited partner’s distributive share of partnership income from net earnings from self-employment, and thus from self-employment tax, except for guaranteed payments for services rendered to the partnership.
The Tax Court interpreted “limited partner” to refer only to passive investors in a limited partnership and upheld the IRS’s upward adjustment of Sirius Solutions’ s net earnings from self-employment, however, the Court disagreed.
Historical Definition of ‘Limited Partner’
The Court started their analysis of the statute with the ordinary meaning at the time of enactment of the statute. Dictionaries at the time of §1402(a)(13)’s enactment defined “limited partner” as a partner in a limited partnership that has limited liability. After walking through the “limited partner” definition of multiple dictionaries around the time of enactment, it was found that each dictionary had only one characteristic in common – limited liability.
The Court then used the interpretation by the Social Security Administration (SSA) and Internal Revenue Service (IRS) to determine the meaning of the statutory provision. Both the IRS and SSA issued concurrent and consistent interpretations of “limited partner” in the Social Security Amendments of 1977. In the first year in which the “limited partner” exception could be implemented, the IRS issued partnership tax return instructions3 that defined “limited partner” as “one whose potential personal liability for partnership debts is limited to the amount of money or other property that the partner contributed or is required to contribute to the partnership.” For over 40 years, the IRS’s instructions made clear that the term “limited partner” in §1402(a)(13) did not have a narrower meaning from the rest of the Code. In looking at the definition of “limited partner” by the SSA, the Court arrived at the same determination; the term’s single, best meaning is a partner in a limited partnership that has limited liability.
Limited Partner is Not a Mere Passive Investor
The Court determined that the passive-investor interpretation by the IRS was incorrect for a multitude of reasons. The Code indicates that all of a limited partner’s distributive share of partnership income (or loss) is excluded from net earnings from self-employment, “other than guaranteed payments described in §707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.”4 The Court indicated that the text of the exception itself suggests that a “limited partner” would actively serve and take part in partnership matters. If “limited partner” is strictly defined as just a passive investor who can’t provide any services to the partnership, then the “guaranteed payments” clause would have no purpose at all. The IRS argued that some participation is permissible, but only an amount determined by the agency itself. The Court responded it would be unnecessary for Congress to put forth the effort to include a guaranteed payments clause to ensure that excessively small amounts of money are still taxed and further stated if Congress wished to exclude passive investors from the tax, it could have easily written the exception to do so. Finally, the Court stated, that with the IRS’ passive-investor interpretation, the average limited partner would not be able to discern their tax liability without the help of lawyers and accountants.
Fundamental Tax Principles Do Not Undermine Court’s Interpretation
The IRS argued that three fundamental tax principles undermine the Court’s interpretation. First, federal law, not state law, controls the interpretation of federal tax statutes. Second, federal tax law is concerned with economic reality, not labels. And third, federal tax law should be uniform nationwide.
There is a federal definition of “limited partner” in §1402(a)(13): a partner in a limited partnership that has limited liability. However, according to the Court, because the creation of a limited partnership and the grant of limited liability are matters of state law, one must look to state law to determine if those preconditions of the federal statutory definition are satisfied. If they are, federal law exempts such individuals from self-employment tax.
The Court’s interpretation of “limited partner” does not turn on state labels. One is not a “limited partner” under §1402(a)(13) simply because a particular State calls them one. Rather than looking to state labels, the Court states federal law looks to the substantive “interests” that state law creates.
Finally, there is no serious risk of disuniformity in tax law based on the Court’s interpretation. The federal exception is directly connected to state interests and rights. According to the Court, even if states vary in how they establish these interests and rights, federal law remains consistent nationwide. Additionally, since most states have adopted uniform limited partnership acts, there is minimal risk of a patchwork of conflicting regulations across the country. In contrast, the IRS’s interpretation would likely lead to extensive litigation and inconsistencies regarding what level of involvement in a partnership is considered excessive.
What is the impact of this ruling?
While the decision overturns the Tax Court and rejects the IRS’ test for determining whether a partner is a “limited partner” for purposes of the exception to self-employment tax under §1402(a)(13), the area is still unsettled. The 5th Circuit’s ruling is narrowly focused on the status of limited partnership members. In footnote 1 in the opinion, the court states that, although the opinion refers to membership in a limited partnership throughout, it does not address whether members of other entities, such as limited liability partnerships (LLPs) or limited liability companies (LLCs), may also qualify for the limited partner exception under §1402(a)(13). The Court’s analysis and holding are expressly limited to state-law limited partnerships and do not opine on the treatment of partners or members in other types of entities for purposes of the self-employment tax exception.
Furthermore, the ruling in this case is a binding precedent only within the boundaries of the Fifth Circuit, which includes Texas, Louisiana, and Mississippi. The Tax Court and federal district courts located in these states must follow the Court’s interpretation of “limited partner” under §1402(a)(13) when cases are appealable to the Fifth Circuit. This ruling does not automatically bind courts in other circuits. The Tax Court, when deciding cases appealable to other circuits, follows the precedent of the circuit to which an appeal would lie, even if that precedent differs from its own or from other circuits’ interpretations. If a similar case arises in a state outside the Fifth Circuit, the Tax Court will apply the law as interpreted by the relevant circuit court of appeals for that jurisdiction, unless and until that circuit adopts the Fifth Circuit’s reasoning or the Supreme Court resolves the issue.
Currently, there are pending appeals in the First and Second Circuits on the same issue, and those courts could reach a different conclusion. If a circuit split develops, the Supreme Court may ultimately decide the question to ensure uniformity nationwide.
How Forvis Mazars Can Help
For further information on the impact of this ruling on your organization, please contact a professional at Forvis Mazars.