Fifth Circuit Rejects Government's "Passive Investor" Test for Limited Partner Exception

The U.S. Court of Appeals for the Fifth Circuit issued a pivotal decision in Sirius Solutions, L.L.L.P. v. Commissioner on January 16, 2026, rejecting the government's "passive investor" test and instead finding that a "limited partner" is a partner in a state-law limited partnership with limited liability. Holland & Knight tax controversy attorneys Mary McNulty and Lee Meyercord represented Sirius Solutions in this landmark victory for taxpayers.

Under Internal Revenue Code Section 1402(a)(13), a partner's distributive share of partnership income is exempt from self-employment tax if the partner is a "limited partner," except for guaranteed payments for services. The IRS and U.S. Tax Court had interpreted "limited partner" to mean a passive investor.

Fifth Circuit's Decision

The Fifth Circuit rejected the IRS interpretation and found the government's attempt to define a limited partner as a "passive investor" unpersuasive and unsupported by the statute, stating unequivocally that a "limited partner is a partner in a limited partnership that has limited liability." This holding follows the statutory framework that Congress enacted and forecloses an expansive IRS approach that threatened to upend long‑settled partner expectations.

Significance for Taxpayers

• Broader Application: The decision substantially broadens how the IRS must apply the Section 1402(a)(13) exemption for limited partners within the Fifth Circuit (Texas, Louisiana and Mississippi), potentially lowering self-employment tax liability for many limited partners whose activities go beyond passive investment.
• State-Law Focus: By anchoring the definition of "limited partner" in state partnership law rather than applying a passive investor test with "an indefinite number of factors," the ruling allows a taxpayer to determine whether they qualify for the exemption without "the help of an army of lawyers and accountants."
• Refund Opportunities: Limited partners in the Fifth Circuit who previously paid self-employment tax on their distributive shares (based on prior IRS or Tax Court interpretations) should consider potential refund claims, subject to the applicable statutes of limitations.

Wider Circuit Court Implications

The First and Second Circuits also have cases pending on the meaning of "limited partner" for purposes of the self-employment tax. If those circuits adopt a passive investor test, a circuit split would result, and the US. Supreme Court could eventually resolve the question.

Conclusion

Sirius Solutions marks a significant shift back to following the statute's plain text and restores a state-law grounded definition of "limited partner" in the Fifth Circuit. While it brings much needed clarity in the Fifth Circuit, the litigation in other circuits will continue. For questions about how this ruling may impact you, please contact the authors or another member of Holland & Knight's Tax Controversy and Litigation Practice.

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