Tax Law Blog

Business owners who operate through partnerships or LLCs taxed as partnerships should take note: a recent Fifth Circuit Court of Appeals decision could significantly reduce the amount of self-employment tax certain partners owe.

Under long-standing tax law, partners generally pay self-employment (SECA) tax—currently 15.3%—on their share of business income. However, there is an important exception: the distributive share of income earned by a “limited partner” is typically not subject to SECA tax (although payments for services, called “guaranteed payments,” still are).

The problem has been that Congress never clearly defined the term “limited partner.” Over the years, the IRS and courts often argued that only “passive investors” qualify—meaning partners actively involved in the business should still pay SECA tax on their income. The Fifth Circuit has since defined the term differently.

The Fifth Circuit Changes the Landscape

In January 2026, the U.S. Court of Appeals for the Fifth Circuit rejected the “passive investor” approach in the case of Sirius v. Commissioner of Internal Revenue, 165 F.4th 374. Instead, it ruled that a limited partner is simply a partner in a limited partnership who has limited liability under state law.

Why does this matter? The court emphasized that the tax statute already accounts for active involvement by taxing payments for services separately. In other words, a partner can still be involved in the business and retain limited partner status for purposes of excluding their share of profits from SECA tax.

What This Means for Business Owners

This decision is a significant win for taxpayers, but it is not the final word. Limited partners in jurisdictions where the Fifth Circuit Court’s interpretation applies may be able to avoid SECA taxes on their distributive share if they have limited liability. However, those seeking to avoid SECA taxes under this new definition of limited partner should exercise caution, as the Fifth Circuit’s interpretation might not be the only applicable one, and shifting interpretations by other courts may supersede or conflict with this decision.

Other courts have reached different conclusions, applying a “functional” test that looks at how active a partner is in the business. As a result, the law may vary depending on where a case is heard, and additional appellate decisions (or even the Supreme Court) could ultimately resolve the issue. Business owners should stay informed on the controlling case law in their jurisdiction and plan accordingly to avoid potential mistakes when restructuring business entities. If a business utilizing a partnership structure is in a jurisdiction where this interpretation controls, they may have an opportunity to limit SECA taxes for their limited partners.  

Practical Takeaways

For business owners and investors, this ruling opens the door to planning opportunities:

• Review your entity structure. If you operate as a limited partnership (or similar structure), your distributive share may qualify for SECA tax relief.
• Evaluate compensation design. Clearly separating service-based compensation (guaranteed payments) from profit allocations is increasingly important.
• Consider amended or protective filings. Prior years may be eligible for refunds if a more favorable interpretation applies.
• Proceed carefully. The IRS has challenged similar positions in the past and may continue to do so while the law develops.

Bottom Line

The Fifth Circuit’s decision signals a more taxpayer-friendly interpretation of the limited partner exception, potentially reducing employment taxes for many partnership owners. However, the rules are still evolving. Businesses should take a proactive but measured approach, reviewing structures now while monitoring how other courts and the IRS respond.

Could your partnership structure be costing you more in self-employment taxes than necessary? Our tax attorneys can help you evaluate your entity structure, review compensation arrangements and determine whether this development could benefit your business.