On Friday, the Fifth Circuit, in a 2–1 decision in Sirius Solutions, LLLP v. Commissioner, held that the term “limited partner” in section 1402(a)(13) is “a partner in a limited partnership that has limited liability,” reversing the Tax Court’s rule that a limited partner refers only to passive investors in a partnership. This post will summarize the court’s decision and describe some of the implications of the decisions. I then offer some preliminary thoughts on the court’s reasoning and how courts might think about the limited partner exception going forward.

Background to the Limited Partner Exception

The Tax Court’s ruling in Renkemeyer LLP was anchored in two primary considerations. First, the legislative history indicated that the limited partner exception was to exclude earnings that were basically an investment in nature. Second, the Tax Court also observed that when section 1402 was first enacted in 1977, there was a clear delineation in state law between limited partners and general partners, but as states have come up with new business forms that are tax partnerships, the term “limited partner” necessarily must be adapted as well. (In fact, 1977 was the same year that the first limited liability statute was enacted in Wyoming.) 

In 1997, the IRS promulgated proposed regulations that set a benchmark of 500 hours of work on behalf of the partnership that would subject a partner to the SECA tax. However, amid criticism of the proposed rule, Congress enjoined finalization of those regulations for a year, and despite expiration of the limitation, regulations have never been finalized to codify that benchmark. In 2023, the Tax Court extended its holding in Renkemeyer LLP to limited partners in limited partnerships, holding in Soroban Capital Partners LP v. Commissioner that “[t]he Court must apply a functional analysis test [as in Renkemeyer LLP] to determine whether a partner in a state law limited partnership is a ‘limited partner, as such’ for purposes of section 1402(a)(13).” 161 T.C. 310, 325 (2023). 

The Fifth Circuit’s Decision in Sirius Solutions, LLLP

However, the interpretation of “limited partner” under section 1402(a)(13) has long been a source of contention between taxpayers and the IRS, with taxpayers typically looking for a broader interpretation of the statute. Judge Oldham, who wrote the majority opinion in Sirius Solutions, LLLP, took a different approach from the Tax Court, siding squarely with the taxpayers on this issue. Consistent with the form of textualism Judge Oldham has become known for, his opinion began with the assumption that “[t]he language in the Tax Code, ‘just as in any statute, is to be given its ordinary meaning’ at the time of enactment.” Slip op. at 5. (It is perhaps worth highlighting that while the quote comes directly from Helvering v. William Flaccus Oak Leather Co., a Supreme Court case from 1941, nothing in that opinion suggests that the ordinary meaning of a statute must be derived at the time of enactment. Whatever merits of such an approach, I suggest below that this opinion in particular demonstrates one weakness of this form of textualism.) 

With this approach, the opinion begins by looking to how the term “limited partner” was understood in 1977 by reciting dictionary definitions from 1977. Reviewing these, the court found that “[t]he touchstone of a ‘limited partner’ in 1977 was limited liability.” Slip op. at 7. The court then went on to review how the IRS had defined “limited partner” in its instructions to IRS Form 1065. After concluding the IRS’s published instructions were examples of “agency interpretation” and positing that the definition of “limited partner” provided in the instructions should be understood as extending to section 1402(a)(13), the court concluded as follows:

At bottom, in any complex statutory dispute, the best course is to follow the statute’s plain text. When § 1402(a)(13) says “limited partner,” it is referring to a limited partner in a state-law limited partnership that has limited liability. In sum, the IRS, and Tax Court, and dissent’s arguments for a passive investor rule fail.

We hold that a “limited partner” in § 1402(a)(13) is a limited partner in a state-law limited partnership that is afforded limited liability. And we reject the IRS’s newly adopted passive investor rule.

Slip op. at 23. As intuitive as that might appear to be, it is, as a hyper-textualist matter, inapposite to the case at issue in Sirius Solutions, LLLP, where the petitioner was not a limited partnership as such, but a limited liability limited partnership (i.e., where all partners have limited liability). 

This appears to be the first circuit court to reject the Tax Court’s rule that “limited partners” for the purposes of section 1402(a)(13) is limited to passive investors. (The First Circuit is reviewing a similar appeal in Denham Capital Management LP v. Bessent.) The consequence of the Fifth Circuit’s decision appears to be that any partner (tax term) in a partnership (tax term) that has limited liability will be able to exclude his or her distributive share from SECA taxes. (Guaranteed payments are still included.) 

Preliminary Thoughts on the Limited Partner Exception Going Forward

As a practical matter, the biggest consequence (at least in the Fifth Circuit) will likely be for owners of pass-thru entities treated as partnerships for tax purposes to be able to avoid paying Medicare taxes on their distributive shares of partnership income. (While Judge Oldham’s opinion focuses on the Social Security aspect of SECA taxes, it may well be Medicare taxes—which, unlike Social Security taxes, are uncapped—that are the bigger casualty of this decision.) If this is extended to other circuits, this would extend the existing S corporation loophole to all pass-thru entities.

As a policy matter, it seems fairly clear that the IRS position is right, particularly in light of the enactment of the net investment income tax in section 1411. Of course, it does not follow that the law, as written, reflects the correct policy, nor is it obvious that the courts or the IRS have the requisite authority to read a material participation requirement into the limited partner exception. Accordingly, I take no view on the ultimate merits of the case—other than to suggest that Congress could (and should) fix this. (A simple fix would be to extend section 1411 to all income not subject to SECA or FICA taxes.) 

That said, the opinion in Sirius Solutions, LLLP reveals a challenge to the type of textualist approach used in the opinion. The opinion treats the definition of “limited partner” as being fixed in 1977, the date of the statute’s enactment. But “limited partner” is a term of art that only has a meaning in relation to a partnership, and as a tax term, “partnership” has undergone a radical shift in the last half-century. The textualism on display in Sirius Solutions, LLLP does not fully grapple with the fact that terms of art are often derivative of antecedent terms that themselves have shifting meanings.

That tension is actually revealed in the case itself. Under the old Kintner entity-classification regulations—the ones in existence in 1977—Sirius Solutions, LLLP (the petitioner in the case) may very well have been treated as a corporation for tax purposes. The fact that it is now treated as a partnership is a reflection of the fact that “partnership” is a tax term that has, over time, developed a definition quite different from how the term is understood for non-tax purposes. (This phenomenon is what I have elsewhere referred to as a “tax incongruity.”) 

Absent action by Congress, the Fifth Circuit will not be the last court to address the limited partner exception, and so other courts will need to define what “limited partner” means in the context of section 1402(a)(13). But as courts do the work of interpreting that term, it must do so against the backdrop of how the underlying term “partnership” has evolved since 1977. Today, since the term partnership encompasses everything from LLCs to Bermuda limited companies, what a “limited partner” is cannot be divorced from what a “partnership” is for tax purposes. Thus, as the scope of what constitutes a “partnership” has changed dramatically over the past half century, it stands to reason that this shift should also inform how the term “limited partner” should be understood today as well.