Key Takeaways
- The Fifth Circuit’s revised ruling narrows the section 1402(a)(13) limited partner exception by focusing on whether a partner plays a significant management role, not simply state-law status.
- The decision rejects both a state-law-only test and a passive-investor-only test, leaving room for non-managerial participation while creating new factual uncertainty.
- Taxpayers should continue monitoring this issue as the case returns to trial court and similar disputes move through other circuits.
The Fifth Circuit Court of Appeals, in Sirius Solutions v Comm’r, withdrew its earlier ruling that the term “limited partner” for purposes of the self-employment tax exception under section 1402(a)(13) means “a partner in a limited partnership that has limited liability.” The Appeals Court issued a new ruling with a revised — and more narrow — definition of a limited partner.
Background on the Ruling
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.
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 originally 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.”
However, that decision is withdrawn, and the Fifth Circuit's new ruling holds that the "original public meaning" of the term 'limited partner' is a "partner who plays no significant role in managing or running a business."
Under this holding, it appears that state law classification as a limited partner is not determinative. But the government's argument that only passive investors can be limited partners is also rejected, and the Court recognizes that a section 1402(a)(13) limited partner can participate in certain non-managerial activities.
Wider Significance
This new decision results in the case being remanded back to the trial court.
There are several similar cases working through other Circuit Courts, meaning there is a distinct possibility another Circuit Court may diverge from the Fifth Circuit by, for example, holding the term “limited partner” focuses on whether a partner is passive or active.
Additionally, the IRS continues to litigate this issue by focusing on service-based partnerships and arguing that no matter state law classification, all the income is subject to self-employment taxes for active partners.
Still Unknown
This new Fifth Circuit holding still leaves many unanswered questions, including:
- Which factors should be applied in determining the management and control test under the Fifth Circuit’s new ruling.
- Whether a single partner can wear “two hats” in the same partnership — both a general partner interest (subject to SE taxes) and limited partner interest qualifying under the section 1402(a)(13) exception.
- If members in limited liability companies and owners in other entities classified as partnerships for federal tax purposes qualify for the section 1402(a)(13) limited partner exception.
The Future of Self-Employment Tax and the Limited Partner Exception
While the Fifth Circuit backed away from its original conclusion that state law classification controls, the Court still rejects the government’s assertion that only passive partners can qualify as limited partners under section 1402(a)(13).
Taxpayers seeking clarity will continue to wait for another Court decision, regulatory guidance from the government, or perhaps a statutory update from Congress.
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