Fifth Circuit Rules on Self Employment Tax Exception

The Fifth Circuit Court of Appeals, in Sirius Solutions v Comm’r, ruled the term “limited partner” for purposes of an exception to self-employment taxes means “a partner in a limited partnership that has limited liability.”

Background of the Ruling

As background, section 1402(a)(13) provides that a limited partner’s distributive share of income is not subject to self-employment taxes (although a guaranteed payment is subject to self-employment taxes).

The statute does not define the term “limited partner.” Definitions of the term could include state law classification or a focus on whether a partner is performing active services for a partnership.

There is also uncertainty over whether a partner could essentially hold two roles in the same partnership: a limited partner role, free of self-employment taxes, and a service role that is compensated either with a guaranteed payment or an allocation of self-employed income.

Impact of The Ruling

At issue in the case was whether income from a consulting business, allocated to state law limited partners, is subject to self-employment taxes. The IRS alleged the partners were not “limited partners” because they performed material services for the partnership.

The Fifth Circuit held that whether a partner is passive or active in a partnership is not determinative, and the reference to “limited partner” in section 1402(a)(13) is to “a limited partner in a state-law limited partnership that is afforded limited liability.”

Under this holding, income is not subject to self-employment taxes, even though the limited partners perform services for a services-oriented partnership.

Additionally, this case recognizes the possibility that there could be dual treatment of income allocated to a partner, with a portion of the income not subject to self-employment taxes.

Wider Significance

There are several similar cases working through other Circuit Courts. There is a distinct possibility that another Circuit Court may, for example, hold the term “limited partner” focuses not on state law classification but on passive vs. active partners.

Additionally, the IRS continues to litigate this issue by focusing on service-based partnerships and arguing that no matter the state law classification, all the income is subject to self-employment taxes for active partners.

For now, taxpayers who are limited partners under the jurisdiction of the Fifth Circuit Court of Appeals can rely upon this decision for tax reporting purposes. Additionally, taxpayers in other jurisdictions could, with the right facts and circumstances, use this decision as authority for a position on a tax return.

Next Steps You Can Take

The Sirius case will likely be appealed, and the issue may eventually end in front of the Supreme Court, particularly if there is a future split with other Circuit Courts.

The Sirius case focuses on state law limited partnerships, and the Court does not directly address other types of state law entities classified as partnerships, like limited liability companies.

Still, given that owners in these types of entities have limited liability, it may be possible to use this Sirius case as an analogous authority. Finally, guaranteed payments for services remain subject to self-employment taxes, no matter the type of state law entity involved.