Fifth Circuit reverses Tax Court on ‘limited partner’ definition

The Fifth Circuit vacated and remanded a Tax Court decision, holding that the limited partner exception from net earnings from self-employment under Sec. 1402(a)(13) applies to a partner in a limited partnership with limited liability. The court rejected the IRS’s and Tax Court’s “passive-investor” definition of limited partner for purposes of the Sec. 1402(a)(13) exception.

Facts: Sirius Solutions LLLP is a business-consulting limited liability limited partnership based in Houston. Sirius Solutions GP LLC served as the tax matters partner for the LLLP.

The appeal pertained to Sirius’s federal tax returns for 2014, 2015, and 2016. In 2014, the firm was owned by nine limited partners and one general partner, Sirius GP. Sirius GP held an interest of only 0.6457%. Following the departure of four limited partners, in the 2015 and 2016 tax years, the firm was owned by five limited partners and Sirius GP. During these two years, Sirius GP’s interest increased slightly to 0.7529%.

Sirius reported ordinary business income of $5,829,402 in 2014 and $7,242,984 in 2015 and a loss of $490,291 in 2016. Sirius allocated all this income and loss to its limited partners. In doing so, Sirius excluded these distributive shares from its calculation of net earnings from self-employment.

The IRS audited Sirius’s 2014 tax return and issued a notice of final partnership administrative adjustment (FPAA) in June 2020. This was followed by audits and FPAAs for the 2015 and 2016 tax years in June 2021. The IRS determined that the Sec. 1402(a)(13) exception did not apply because the limited partners were not limited partners under the provision in any of the years in question. Consequently, the IRS adjusted Sirius’s net earnings from self-employment from $0 to $5,915,918 for 2014 and from $0 to $7,372,756 and -$490,291 for 2015 and 2016, respectively.

Sirius filed two petitions in Tax Court, one for 2014 and one for 2015 and 2016, challenging the IRS determinations and seeking readjustments for the tax returns for those years. The two cases were consolidated.

In 2024, the Tax Court rejected Sirius’s challenges and upheld the adjustments (Sirius Solutions, L.L.L.P., No. 30118-21 (Tax Ct. 2/20/24) (order and decision)). It based its decision on Soroban Capital Partners LP, 161 T.C. 310 (2023), in which it had held that for purposes of the Sec. 1402(a)(13) exception, the term “limited partners” only “refer[s] to passive investors” (Soroban, 161 T.C. at 320). Finding that Sirius’s limited partners were not passive investors, the Tax Court concluded that Sirius was not entitled to the limited partner exception.

Sirius timely appealed the decision to the Fifth Circuit.

Issues: The sole issue on appeal was the meaning of “limited partner” in Sec. 1402(a)(13). To determine that meaning, the Fifth Circuit considered the text of the statute and the contemporaneous and long-standing interpretation of the term “limited partnership” by the IRS and the Social Security Administration (SSA). Regarding the text of Sec. 1402(a)(13), the Fifth Circuit found that statutory language must be given its ordinary meaning at the time of enactment (i.e., 1977) and that it should consult contemporaneous dictionaries to discover the term’s ordinary meaning. Thus, the court consulted several contemporaneous general and legal dictionaries.

Webster’s Third New International Dictionary (1971 and 1981 editions) defined “limited partner” as “a partner whose liability to creditors of the partnership is usu[ally] limited to the amount of capital he has contributed to the partnership providing he has not held himself out to the public as a general partner and has complied with other requirements of law.” Legal dictionaries such as the 1977 edition of The Law Dictionary and Black’s Law Dictionary (1979) confirmed that the key feature of a limited partner is limited liability. According to the court, “Each contemporaneous dictionary has one and only one characteristic in common: limited liability. The touchstone of a ‘limited partner’ in 1977 was limited liability.”

Under the Supreme Court’s decision in Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024), a court must exercise independent judgment but may consider agency interpretations that are “issued contemporaneously with the statute” and “have remained consistent over time.”

With this principle in mind, the Fifth Circuit noted that, starting in 1978, the IRS’s own instructions for Form 1065, U.S. Return of Partnership Income, defined a “limited partner” based solely on limited liability. During the tax years at issue in the case, those instructions defined “limited partner” as “a partner in a partnership formed under a state limited partnership law, whose 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.”

Furthermore, the SSA finalized a regulation in 1980 (20 C.F.R. §404.1080(b)(3)) — that remains in effect today — explicitly defining a limited partner by their limited financial liability (for purposes of a similar exception under 42 U.S.C. Section 411 for determining Social Security benefits based on self-employment). The court found that this contemporaneous, long-standing, and consistent interpretation by two agencies confirmed that a “limited partner” is a partner with limited liability in a limited partnership.

In summary, the Fifth Circuit stated, “Dictionary definitions and the longstanding views of the two agencies tasked with administering the Social Security Amendments of 1977 all point in one direction.” Thus, the court concluded that the “single, best meaning,” of “limited partner” “is a partner in a limited partnership that has limited liability.”

The Fifth Circuit stated that the argument espoused by the IRS and the Tax Court that “limited partner” meant a passive investor in a limited partnership failed for three reasons. First, it made little sense of the statute’s provision that the exclusion does not apply to guaranteed payments under Sec. 707(c) for a partner’s services rendered to or on behalf of the partnerships that are in the nature of remuneration for those services. The court reasoned that if a limited partner were required by definition to be a passive investor who performs no services, this clause regarding the taxation of their services would be “entirely superfluous.”

Second, if Congress had wanted to exclude only passive investors, it could have used terms such as “passive investor” or “passive income,” which appear numerous times elsewhere in the Code.

Third, the IRS considered the negative practical consequences of the passive-investor definition of “limited partner.” Using the passive-investor definition would be burdensome for taxpayers, who would have to “balance an infinite number of factors” in performing the functional-analysis test required to determine whether a taxpayer was a passive investor, the court concluded.

The IRS argued that three fundamental tax principles undermined the Fifth Circuit’s interpretation of Sec. 1402(a)(13) and supported its own position: that federal tax law (1) controls the interpretation of federal tax statutes, not state law; (2) concerns economic reality, not labels; and (3) should be uniform nationwide. To the first argument, the court noted that, while the meaning of “limited partner” is ultimately determined by federal law, it “largely depends upon state law” (Craft, 535 U.S. 274, 278 (2002)). The court noted that state law creates the legal interests — such as membership in a state-created entity such as a limited partnership and limited liability — while federal law determines when and how those interests are taxed (Burnet v. Harmel, 287 U.S. 103 (1932)).

On the second principle, the court explained that its interpretation did not depend on labels applied by states but on “the substantive ‘interests’ that state law creates” (id. at 110). Thus, the court found that under Sec. 1402(a)(13), a person is not a limited partner “simply” because a state calls the person one. Rather, to be a limited partner, a person must under state law be a member of a limited partnership and have limited liability.

Regarding the third principle of disuniformity in tax law, the court determined that “because the federal exception is explicitly tethered to state interests and rights, if there are any differences among the States in creating these interests and rights, there is no lack of uniformity in the federal law — it remains the same across the country.” The court further noted that because of the widespread adoption of uniform limited partnership acts, there was little risk of disuniformity in the law.

Holding: In vacating the Tax Court’s decision, the Fifth Circuit held that a limited partner for purposes of Sec. 1402(a)(13) is a partner in a limited partnership who has limited liability. The court rejected the passive-investor requirement, stating that the statute’s plain text, historical dictionary definitions, and the long-standing contemporaneous interpretations by the IRS and SSA all confirmed that limited liability — not lack of participation — is the defining characteristic of a limited partner. The Fifth Circuit remanded the case to the Tax Court for further proceedings consistent with this interpretation.

• Sirius Solutions, L.L.L.P., No. 24-60240 (5th Cir. 1/16/26)

— Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.