A Sirius shift (again): Fifth Circuit redetermines the limited partner exception to self-employment tax

Background and Legislative Context

Historically, all partners were subject to self-employment taxes on their respective distributive shares of partnership income. In 1977, Congress amended section 1402(a) to exclude from “net earnings from self-employment” the distributive share of partnership income of “a limited partner, as such,” other than guaranteed payments to that partner for services actually rendered as remuneration for such services to or on behalf of the partnership. One of Congress’s stated objectives in amending section 1402 was to reconcile the provisions of federal law conferring Social Security benefits with the provisions of federal tax law imposing the self-employment tax. The separate statutory provisions were enacted in tandem such that certain limited partnership income, i.e., that which is basically of an investment nature, was excluded both from the calculation of Social Security benefits and from net earnings subject to the self-employment tax.

Over the years, the courts and IRS in rulings have addressed the limited partner exception for self-employment tax purposes. More recently, the IRS has argued the statutory language “limited partner, as such” applies only to limited partners that are mere “passive investors” in a limited partnership. In 2023, the Tax Court held in Soroban Capital Partners LP v. Commissioner, that a partner’s activities – i.e., his or her “functions and roles” – with respect to a state law limited partnership must be analyzed (the functional test) in order to determine whether the partner is a “passive investor” for purposes of the limited partner exception. In Sirius I and Sirius II, the Fifth Circuit rejected the Tax Court’s “passive investor” test, although its reasoning in Sirius II evolved.

The Case and the Majority Opinion

The partnership at issue in both Sirius I and Sirius II is the same, Sirius Solutions, L.L.L.P. (Sirius), which changed its name between the previous and current decisions, and operates a consulting business through a Delaware limited liability limited partnership. For the years at issue, Sirius allocated partnership income to its limited partners and excluded the income from self-employment tax. The IRS disagreed and issued Notices of Final Partnership Administrative Adjustment (FPAAs), reclassifying the distributive shares as net earnings from self-employment. 

In 2020, Sirius filed a challenge to the FPAAs in Tax Court, and while the case was pending, the Tax Court issued its decision in Soroban. To facilitate an appeal to the Fifth Circuit, the parties in Sirius I stipulated that Soroban was controlling. The Tax Court issued a dispositive order which allowed Sirius to appeal the decision to the Fifth Circuit. The Fifth Circuit, in Sirius I, found no textual basis for reading the term “limited partner” as referring only to “passive investors.” Instead, the Fifth Circuit held that the “single, best meaning” of the term “limited partner” is “a partner in a limited partnership that has limited liability.” Subsequently, Sirius filed a petition for rehearing en banc, which was denied. The Sirius II panel treated the petition for rehearing en banc as a petition for rehearing, which they granted and, correspondingly, issued the instant opinion. 

In Sirius II, the Fifth Circuit, observing that the term “limited partner” is not defined in the relevant statute, ascertained the meaning of the term by considering the ordinary meaning at the time Congress enacted the statute. The court found that the commonly accepted definition of “limited partner” turned on the partner’s role in the enterprise. In its analysis, the court considered contemporaneous legal dictionaries, treatises and relevant statutes, all of which, generally speaking, refer to “limited partners” as contributing capital and sharing in profits, but taking no part in “running the business.” Although the words used may differ, such as “participating in management,” or “taking part in the control” of the business, the fundamental test turns on a functional analysis.

In addition, the Fifth Circuit found that Plasteel Products Corp. v. Helman provided a definition of “limited partner” around the time that the relevant statute was enacted. The Plasteel court had recognized that if a partner controlled partnership affairs, it was no longer “functioning” as a limited partner. However, the court suggested that a limited partner could have lesser involvement, such as signing the partnership agreement, without losing its limited partner status.

Referencing Loper Bright, the Fifth Circuit concluded that the plain text of the statute points to its conclusion. Consequently, the Tax Court (and the dissent’s) interpretation cannot stand as they are inconsistent with the statutory text. Accordingly, the Fifth Circuit vacated the Tax Court’s decision and remanded the case for further proceedings.

The Dissent

The decision of the Fifth Circuit in Sirius II (as was the case in Sirius I) was not unanimous. The dissent focused on Congress’s stated intent to exclude only passive income from self-employment taxes. In the dissent’s view, the phrase “limited partner, as such” reflects a functional limitation, restricting the exception to partners acting in a passive, investor-like capacity. In addition, the dissent felt that the majority ignored the various definitions that it cited, overlooked other applicable cases, and misconstrued the plain text of the statute and Plasteel. 

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