Fifth Circuit rejects ‘passive-investor’ definition of limited partner

The Fifth Circuit, overruling the Tax Court, held that for purposes of Sec. 1402(a)(13), “limited partner” means a partner in a limited partnership that has limited liability.

Limited partner exception from self-employment income

Sec. 1401(a) imposes a Social Security and Medicare tax based on the self–employment income of every individual. “Self–employment income” is defined in Sec. 1402(b) as “the net earnings from self–employment derived by an individual … during any taxable year.” Under Sec. 1402(a), net earnings from self–employment (NESE) includes an individual’s “distributive share (whether or not distributed) of income or loss described in Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member.”

However, under the limited partner exception of Sec. 1402(a)(13), NESE income (and by extension, self–employment income) does not include “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.” Sec. 707(c) states that “payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership.”

Putting Secs. 1402(a)(13) and 707(c) together, a limited partner’s passthrough share of partnership income (or loss) is exempt from the Sec. 1401 Social Security and Medicare tax. Sec. 1402(a)(13) was enacted in 1977 in Section 313(a) of An Act to Amend the Social Security Act and the Internal Revenue Code of 1954 to Strengthen the Financing of the Social Security System, and for Other Purposes, P.L. 95–216, and has remained unchanged since then.

Under 42 U.S.C. Section 415, the amount of Social Security benefits a self–employed individual receives, just like the amount of Social Security tax paid, depends on the taxpayer’s self–employment income. In Section 313(b) of P.L. 95–216, Congress adopted a limited partner exception for Social Security benefits (42 U.S.C. §411), identical to the Sec. 1402(a)(13) limited partner exception to self–employment income. Thus, while an individual’s passthrough share of partnership income (or loss) of a limited partner is not subject to Social Security and Medicare taxation, it does not count toward the Social Security benefits the individual may receive later in life.

Background of case

Sirius Solutions LLLP is a limited liability limited partnership that operates a business–consulting firm based in Texas. In 2014, Sirius was owned by nine limited partners and one general partner, Sirius GP, which was also its tax matters partner. Sirius GP held a 0.6457% interest in the partnership. Four limited partners sold their partnership interests in 2014, so in 2015 and 2016, there were five limited partners alongside Sirius GP, the general partner. During 2015 and 2016, Sirius GP held a 0.7529% interest in the partnership.

Sirius reported ordinary business income of $5,829,402 in 2014; $7,242,984 in 2015; and a loss of $490,291 in 2016. Sirius allocated all that income and loss to its limited partners. Based on the limited partnership tax exception in Sec. 1402(a)(13), Sirius excluded the limited partners’ distributive shares of partnership income (or loss) from its calculation of NESE during those years, reporting $0 of NESE.

The IRS audited Sirius’s 2014 tax returns and issued a notice of final partnership administrative adjustment (FPAA) for the 2014 return. In the FPAA, the IRS determined that the Sec. 1402(a)(13) limited partner exception did not apply because none of Sirius’s limited partners were limited partners for purposes of the exception. Consequently, the IRS adjusted Sirius’s NESE reported on the 2014 tax return from $0 to $5,915,918. Sirius petitioned the Tax Court for readjustment of its 2014 tax return.

The IRS also audited Sirius’s 2015 and 2016 tax returns. In June 2021, the Service issued more FPAAs to Sirius GP, again determining that the limited partner exception did not apply to Sirius. The 2015 FPAA adjusted Sirius’s NESE from $0 to $7,372,756, and the 2016 FPAA adjusted it from $0 to ($490,291). Sirius filed a second petition to the Tax Court seeking readjustment for the 2015 and 2016 tax returns. The Tax Court consolidated Sirius’s two cases.

In 2024, the Tax Court rejected Sirius’s challenges and upheld the adjustments (Sirius Solutions, LLLP, 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 Tax Court’s decision to the Fifth Circuit. The sole issue raised in the appeal was the meaning of “limited partner” in Sec. 1402(a)(13).

The Fifth Circuit’s decision

The Fifth Circuit held that for purposes of Sec. 1402(a)(13), a limited partner is a partner in a limited partnership that has limited liability. It based this determination on the text of Sec. 1402(a)(13) and the Social Security Administration (SSA) and the IRS’s contemporaneous and long–standing interpretation of the term.

Citing Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247, 249 (1941), the Fifth Circuit found that the language of Sec. 1402(a)(13) should be given its ordinary meaning at its time of enactment. Further, it found that under its own precedent, it should resort to dictionaries as a principal source of ordinary meaning (Belt v. EmCare, Inc., 444 F.3d 403, 412 (5th Cir. 2006)). After reviewing a number of contemporaneous general and legal dictionaries, the court determined that, in 1977, when Sec. 1402(a)(13) was enacted, “limited partner” was defined as a partner in a limited partnership that has limited liability. According to the court, the definitions in each of the dictionaries it consulted in its review had “one and only one characteristic in common: limited liability.” Thus, the court stated that based on the dictionary meaning of “limited partner,” “[t]he touchstone of a ‘limited partner’ in 1977 was limited liability.”

The Fifth Circuit also noted that for well over 40 years (including the years at issue in Sirius’s case), the IRS, in its instructions to Form 1065, U.S. Return of Partnership Income, defined “limited partner” as a partner “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.” During that time, no “passive–investor” definition or any other definition was hinted at in the form’s instructions. Citing Loper Bright Enterprises v. Raimondo, 603 U.S. 369, 394 (2024), the court stated that the long history in the Form 1065 instructions of interpreting “limited partner” as a partner with limited liability in a limited partnership was “especially useful” in determining the meaning of that phrase.

The IRS’s long–standing interpretation of “limited partner” in the Form 1065 instructions was, in the Fifth Circuit’s view, bolstered by the matching interpretation of the phrase adopted by the SSA for purposes of the Social Security benefit limited partner exception in 42 U.S.C. Section 411. In 1980, just three years after that provision was enacted, the SSA finalized a rule (20 C.F.R. §404.1080(b)(3)) providing a definition of “limited partner” that remains in effect today. That rule provides, “You are a ‘limited partner’ if your financial liability for the obligations of the partnership is limited to the amount of your financial investment in the partnership.”

The Fifth Circuit observed that, once again, the touchstone of a “limited partner” in the Social Security benefit regulation was limited liability. Also, like the long–standing interpretation of “limited partner” in the Form 1065 instructions, the court considered these regulations to be “especially useful” in interpreting “limited partner.”

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.”

Rejection of ‘passive-investor’ interpretation

The Fifth Circuit discussed three flaws in the “passive–investor” interpretation of “limited partnership” espoused by the IRS and the Tax Court in Soroban that led the appellate court to bluntly state, “The passive investor interpretation is wrong.”

First, the Fifth Circuit found that the passive–investor interpretation of “limited partner” “makes little sense of the ‘guaranteed payments’ clause” in the limited partner exception. The court noted that the text of the exception itself contemplates that limited partners would provide actual services to the partnership and thus participate in partnership affairs. Therefore, a strict passive–investor interpretation that defines “limited partner” in a way that prohibits the partner from providing any services to the partnership would make the guaranteed–payments clause “entirely superfluous.” Consequently, the court concluded that the guaranteed–payments clause undermined the passive–investor interpretation from Soroban and accorded with the court’s limited–liability interpretation.

Second, the Fifth Circuit found that if Congress wished to exclude only passive investors from the tax, it could have easily written the exception in Sec. 1402(a)(13) to do so. For example, it could have used the term “passive investor,” or some other similar term, as it did in other provisions of the Code (for example, in Sec. 1372(e)(5), using the term “passive investment income” and Sec. 4943(d)(4), using the term “passive sources”). Or, as the court pointed out, Congress could have stated that a limited partner did not qualify for the exception if it provided services to or on behalf of the partnership — which it had done in Sec. 1402(a)(10), just three paragraphs away from Sec. 1402(a)(13). However, the court noted, Congress had not done so.

Third, the Fifth Circuit referred to the negative practical consequences of adopting a passive–investor interpretation. Under the limited–liability interpretation of “limited partner,” which the IRS had followed for over 40 years, the court stated, “it was easy for a limited partner in a state–law limited partnership to discern his tax liability and plan his affairs accordingly.” However, using the passive–investor interpretation would require the IRS “to balance an infinite number of factors” in performing a functional analysis test of the limited partner’s activities. This, the court concluded, would make the task of estimating tax liability beforehand for thousands of limited partners across the country much more difficult and possible “[o]nly with the help of an army of lawyers and accountants — and a whole lot of luck.”

Meaning of ‘limited partner, as such’

Sec. 1402(a)(13) refers to a “limited partner, as such.” While the IRS did not raise this issue in Sirius’s case in the Fifth Circuit, the Tax Court had taken the position in Soroban that the words “as such” indicated that the limited partner exception applied only to a subset of limited partners, not all limited partners, because otherwise, “as such” would be meaningless in the provision.

The Fifth Circuit disagreed with the Tax Court regarding the effect of “as such,” finding that the phrase was “quite meaningful” because it clarified how individuals who were both limited and general partners are taxed. The court concluded that “as such” clarified that when a taxpayer is functioning as a limited partner, the taxpayer’s distributive share of partnership income (or loss) is excluded from NESE, but when functioning as a general partner, the taxpayer’s distributive share is included in NESE.

Fundamental tax principles

The IRS alleged that the court’s position was inconsistent with three specific fundamental tax principles: federal law, not state law, controls the interpretation of federal tax statutes; federal tax law is concerned with economic reality, not labels; and federal tax law should be uniform nationwide.

The Fifth Circuit found that its interpretation of “limited partner” did not violate any of these principles. With regard to which law controlled, the court stated, “We have no doubt that the meaning of ‘limited partner’ in a federal tax statute ‘is ultimately a question of federal law'” (quoting Craft, 535 U.S. 274, 278 (2002)). The court reasoned that the definition of “limited partner” is in a federal law, Sec. 1402(a)(13), but “because the creation of a limited partnership and the grant of limited liability are matters of state law,” it was required to look to state law “to determine if those preconditions of the federal statutory definition are satisfied.”

The Fifth Circuit also found that its interpretation of “limited partner” did not rely on state labels. Rather, the federal law relies on the substantive interests that state law creates, such as whether a person has the rights and duties associated with a limited partnership or whether that individual has limited liability. Thus, according to the court, under Sec. 1402(a)(13), a person is not a limited partner “simply” because a state calls the person one. To be a limited partner, a person must under state law be a member of a limited partnership and have limited liability.

Finally, the court determined that there was “no serious risk of disuniformity” based on its interpretation of “limited partner.” The court found 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 “very little risk of a patchwork of entirely different rules” around the country.

History of limited partnership law

The IRS also argued that the history of limited partnership law established that the limited partner exception reaches only passive investors. The Fifth Circuit, however, found that state law on limited partnerships “was in constant flux throughout the twentieth century,” and the only clear rule that could be derived from the history of the law was that a limited partner had limited liability. While the court acknowledged that many states and the Revised Uniform Limited Partnership Act of 1976 set some limits on limited partners’ ability to participate in the control of a limited partnership, it reasoned that this did not “change the core of what it means to be a limited partner. Such restrictions on or regulations of limited partners do not affect their status as limited partners.”

Legislative history

The IRS and the Tax Court in addition relied on legislative history in their arguments. The Fifth Circuit, however, found that, based on its own precedent, legislative history is “generally of dubious value” (quoting Deanda v. Becerra, 96 F.4th 750, 763 (5th Cir. 2024)), and, based on Supreme Court precedent, it cannot be relied upon by judges if textual arguments provide a clear answer (citing Food Mktg. Inst. v. Argus Leader Media, 588 U.S. 427, 436 (2019)). Furthermore, the Fifth Circuit determined that even if the legislative history cited by the IRS and the Tax Court was considered, it was at best ambiguous and did not support their arguments.

Reflections

In a dissent to the majority opinion, the dissenting judge would have affirmed the Tax Court’s decision, concluding that the text and structure of Sec. 1402(a)(13) are clear that the statute’s tax exemption for limited partners applies only to partners functioning as passive investors.

While the Tax Court, under the Golsen rule (Golsen, 54 T.C. 742 (1970)) is now bound to apply the Fifth Circuit’s limited–liability interpretation of “limited partner” in any cases appealable to the Fifth Circuit, the Tax Court can and almost certainly will continue to apply its passive–investor interpretation of “limited partner” from Soroban to cases before it that are appealable to any of the other circuits. An appeal of Soroban itself is now pending in the Second Circuit. In addition, in another case in which the Tax Court employed the passive–investor interpretation in its decision, Denham Capital Management, LP, T.C. Memo. 2024–114, an appeal is pending in the First Circuit.

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

---

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.