Recent Circuit Court Cases Examine the Limited Partner Self-Employment Tax Exception

Key Takeaways

• Two recent federal appeals court decisions, K Alain (Fifth Circuit) and Soroban (Second Circuit), held that limited partner status under state law is not, by itself, enough to qualify for the self-employment tax exception under Section 1402(a)(13) of the Internal Revenue Code.
• Both courts focused on whether a partner runs, manages, or controls the business, but differ on the standard: the Second Circuit affirmed the U.S. Tax Court’s functional analysis, while the Fifth Circuit adopted a broader “no significant management control” test.
• There is ongoing litigation on the issue, so future cases may hold differently.

Two recent Circuit Court of Appeals cases have provided additional guidance on the scope of the self-employment tax exception for limited partners’ distributive share of partnership income under Section 1402(a)(13).[1]

In August 2026, the U.S. Court of Appeals for the Fifth Circuit withdrew its prior opinion in Sirius Solutions, L.L.L.P. v. Commissioner[2] and issued a substituted opinion in K Alain, L.L.L.P. v. Commissioner.[3] The withdrawn opinion had focused on state-law limited partnership status and limited liability to determine “limited partner” status for purposes of the self-employment tax exception. However, the recent substituted opinion took a different approach, holding that the original meaning of the term “limited partner” is “a partner who plays no significant role in managing or running a business,” while recognizing that a limited partner may have some lesser involvement without exercising control over partnership affairs.[4]

One month after the Fifth Circuit’s decision, the U.S. Court of Appeals for the Second Circuit issued its ruling in Soroban Capital Partners LP v. Commissioner affirming the U.S. Tax Court’s decision. The Second Circuit found that the term “limited partner,” as used in Section 1402(a)(13), means a partner who has limited liability and does not run, manage, or control the partnership’s business.[5] It further ruled that a designation as a “limited partner” under state law was not sufficient.[6] The Second Circuit agreed with the Tax Court that, because the principals of the Soroban investment firm exercised managerial control (by working full time for the business, managing portfolio investments, serving on governing committees, and participating in hiring and personnel decisions), they did not qualify for the limited partner exception and their distributive shares of partnership income were subject to self-employment tax.[7]

The Tax Court in Soroban held that limited partners are “passive investors” as determined under an analysis of “the functions and roles of the limited partners in the partnership.”[8] In its Denham ruling, the Tax Court applied a similar functional analysis to principals of a private equity firm, and an appeal of that ruling is pending in the First Circuit.[9] For additional background, see our previous summaries of Soroban and Denham.

Although the recent appellate decisions build on and respond to the Tax Court’s decision in Soroban, their different approaches result in ongoing uncertainty as to how to determine whether a partner is a “limited partner” that can exclude its distributive share of partnership income from net earnings from self-employment. The Fifth Circuit maintained that the Tax Court’s Soroban ruling “appears to prohibit even the most minor involvement in corporate affairs” and rejected an extensive functional analysis, stating that “some participation is allowed, so long as the partners do not exercise control over the business.”[10] The Second Circuit noted that the Fifth Circuit “did not expound on what it considers to be a non-significant role,” but stated that, to the extent K Alain allows a limited partner to provide some services without running, managing, or controlling the business, the Second Circuit did “not disagree.”[11] In contrasting the Fifth Circuit’s limited partner definition to the Tax Court’s definition in Soroban, the Second Circuit noted that there seemed to be “little daylight” between the two definitions.[12] One possible area of daylight may be inferred from what each court expressly stated about the Tax Court’s ruling in Soroban. The Second Circuit affirmed the Tax Court’s functional analysis standard for determining what amounts to permissible non-managerial activity. By contrast, the Fifth Circuit rejected the Tax Court’s Soroban ruling in favor of a more general “no significant management control” standard.[13] A First Circuit ruling on the pending Denham case may add further guidance as to what standard is appropriate (or create a further divide).

What the Second Circuit, Fifth Circuit, and Tax Court cases have in common is that a designation as a state law limited partner is not dispositive. Instead, the analysis is fact-intensive, focusing on management, control, and capital. Relevant considerations may include whether the partner is a founder or senior executive, works full time for the management company, is involved in personnel or operations, has investment or valuation committee authority, has deal-sourcing responsibility, or has capital invested that is insignificant relative to the partner’s distributive share of partnership income. However, the level of involvement that disqualifies the partner under the Section 1402(a)(13) exception is unclear. In addition, these cases do not address the application of the limited partner self-employment tax exception to owners of other pass-through entities, such as members of limited liability companies, as these cases have focused on what constitutes a “limited partner” within the meaning of Section 1402(a)(13).[14]

What alternatives are available to an active limited partner that would be subject to self-employment tax after these cases? A fund manager could form an S corporation to hold their management company partnership interest. The S corporation could then pay the fund manager reasonable compensation and maintain that any net distributive share from the S corporation is not subject to self-employment tax.[15] However, using an S corporation in this way could result in significant state and local tax in certain states, rendering the S corporation structure less cost-effective. For example, California generally imposes a 1.5% franchise tax on S corporation net income.

We understand that some active limited partners receive guaranteed payments from the corresponding partnership for their compensation and claim their net distributive share is exempt from self-employment tax.[16] However, in view of the recent self-employment Tax Court decisions, we are of the view that such a claim would be difficult to maintain.

[1] All Section references are to the U.S. Internal Revenue Code of 1986, as amended, or the Treasury Regulations promulgated thereunder.

[2] Sirius Solutions, L.L.L.P. v. Commissioner, 165 F.4th 374 (5th Cir. 2026).

[3] K Alain, L.L.L.P. v. Commissioner, 184 F.4th 766 (5th Cir. 2026).

[4] Id. at 767–70; see also Plasteel Prods. Corp. v. Helman, 271 F.2d 354, 356 (1st Cir. 1959).

[5] Soroban Capital Partners LP v. Commissioner, Nos. 25-2079(L), 25-2250(CON), slip op. at 30 (2d Cir. Sept. 17, 2026), available here.

[6] Id. at 39.

[7] Id. at 14–16, 58–59.

[8] Soroban Capital Partners LP v. Commissioner, 161 T.C. 310, 320–22 (2023).

[9] Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114, appeal docketed, No. 25-1349 (1st Cir. argued Feb. 5, 2026).

[10] K Alain, 184 F.4th at 770–71.

[11] Soroban, Nos. 25-2079(L), 25-2250(CON), slip op. at 57.

[12] Id. at 39 n.16.

[13] See K Alain, 184 F.4th at 771–72.

[14] Other cases have addressed the application of Section 1402(a)(13) to partners or members of entities other than state-law limited partnerships, including LLPs and LLCs. See e.g., Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011); Castigliola v. Commissioner, T.C. Memo. 2017-62; Hardy v. Commissioner, T.C. Memo. 2017-16.

[15] See Sections 1366(a)(1) and 1402(a); Rev. Rul. 59-221, 1959-1 C.B. 225; Ding v. Commissioner, T.C. Memo. 1997-435, aff’d, 200 F.3d 587 (9th Cir. 1999) (S corporation pass-through income not treated as net earnings from self-employment); Radtke v. United States, 895 F.2d 1196 (7th Cir. 1990) (treating purported S corporation dividends paid to a shareholder-employee as wages for employment tax purposes); David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012) (upholding recharacterization of S corporation distributions as wages where shareholder-employee compensation was unreasonably low).

[16] Similarly, a two-tier partnership structure could be formed where the limited partner is paid a salary from the lower-tier limited partnership and a distributive share through an upper-tier partnership. Such a structure is commonly used to maintain salary treatment for an individual who is also a partner. Otherwise such compensation would be treated as a guaranteed payment. See Section 1.707-1(c).