The Fifth Circuit Just Handed Limited Partners a Major Tax Win. Here's Who Can Claim It.

If you're a limited partner who has been paying self-employment tax on your partnership distributions, you may have been overpaying. Significantly.

On January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit issued a 2-1 decision in Sirius Solutions, L.L.L.P. v. Commissioner that changes how limited partners are taxed. The court rejected the IRS's position that you need to be a "passive investor" to avoid self-employment tax on partnership income. Instead, the Fifth Circuit held that if you're a limited partner under state law, you qualify for the exemption. Period. Regardless of how active you are in the business.

For founders and executives with partnership interests in Texas, Louisiana, or Mississippi, this creates an immediate opportunity to recover taxes paid in prior years. For everyone else, it signals a coming fight that may reshape entity structuring decisions nationwide.

A Quick Primer: Limited Partnerships and Self-Employment Tax

Before diving into the ruling, here's some background if you're new to these concepts.

A limited partnership (LP) is a business structure with two types of partners. General partners run the business and have unlimited personal liability for the partnership's debts. Limited partners are typically investors who contribute capital but don't manage day-to-day operations. In exchange for staying out of management, limited partners get liability protection: if the business fails, they can only lose what they invested, not their personal assets.

Self-employment tax is the Social Security and Medicare tax that self-employed people pay. When you work for an employer, your employer pays half of these taxes and you pay the other half through payroll withholding. But when you're self-employed, including as a partner in a partnership, you pay both halves yourself. The combined rate is 15.3% on most earnings.

Here's where it gets important: back in 1977, Congress created an exemption. Under Section 1402(a)(13) of the Internal Revenue Code, limited partners don't have to pay self-employment tax on their share of partnership profits. The idea was that limited partners are more like investors than workers, so their partnership income is more like investment income than wages.

The question this case answers: what does "limited partner" actually mean for purposes of this exemption?

What the Court Decided

The case involved Sirius Solutions, a Texas-based limited partnership that provided management consulting services. The IRS argued that the partners weren't "real" limited partners because they were actively involved in the business, not passive investors sitting on the sidelines. The Tax Court agreed with the IRS, applying a functional "passive investor" test it had developed in Soroban Capital Partners LP v. Commissioner (2023).

The Fifth Circuit reversed.

Writing for the majority, Judge Oldham held that the statute's language is clear: a "limited partner" under the tax code is simply "a partner in a limited partnership that has limited liability." Nothing more, nothing less.

The court made three key points:

The statutory text contemplates that limited partners may provide services. The exemption carves out "guaranteed payments... for services actually rendered," which only makes sense if Congress expected some limited partners would be performing work. You don't need a carve-out for something that was never supposed to happen.

When Congress enacted this provision in 1977, the defining characteristic of a "limited partner" was limited liability, not passivity. The legislative history shows Congress wanted to prevent passive investors from claiming Social Security benefits based on investment returns. Not to distinguish between active and inactive partners.

And the IRS tried this before. In 1997, it proposed regulations with a 500-hour activity test. Congress blocked it. The Taxpayer Relief Act of 1997 imposed a moratorium on those regulations, with the Senate expressing concern that the IRS was trying to "change the law administratively without congressional action." Those regulations were never finalized.

The bottom line: if your state recognizes you as a limited partner with limited liability, the Fifth Circuit says you qualify for the exemption.

What This Means for You

The self-employment tax rate is 15.3% on earnings up to the Social Security wage base (around $176,000 in 2026), plus 2.9% Medicare tax on everything above that, plus an additional 0.9% Medicare surtax for high earners. For a partner receiving $1 million in distributions, that's roughly $38,000 or more in annual tax savings if the exemption applies.

Here's who benefits:

Clearly covered: Limited partners in state-law limited partnerships (LPs) in Texas, Louisiana, or Mississippi. If you're structured as an LP and your partners have limited liability under state law, this ruling applies directly to you.

Uncertain status: LLC members and LLP partners. A limited liability company (LLC) and a limited liability partnership (LLP) are different legal structures from a traditional limited partnership. The Fifth Circuit explicitly reserved judgment on whether its holding extends to these entity types. LLCs and LLPs didn't exist in 1977 when Congress wrote the exemption, and the court wasn't asked to decide how they fit. If you're an LLC member or LLP partner, the ruling is persuasive but not binding on your situation.

Outside the Fifth Circuit: The ruling doesn't bind courts in other circuits, but it creates powerful precedent. Taxpayers in other jurisdictions can cite it in disputes with the IRS, though the agency will continue applying the "passive investor" test outside Texas, Louisiana, and Mississippi.

One critical limitation: guaranteed payments for services remain subject to self-employment tax. What's a guaranteed payment? It's a fixed amount the partnership agrees to pay you regardless of whether the partnership makes a profit, typically in exchange for services you provide. Think of it like a salary. The exemption applies only to your distributive share of partnership income, which is your portion of the partnership's profits based on your ownership percentage. If the partnership pays you a guaranteed amount for your services, that's still taxable.

The Circuit Split Coming

This isn't over.

Two other cases involving the same legal question are pending in federal appeals courts. Denham Capital Management LP v. Commissioner is before the First Circuit (covering Maine, Massachusetts, New Hampshire, Rhode Island, Puerto Rico). Soroban Capital Partners LP v. Commissioner, the case whose reasoning the Fifth Circuit just rejected, is on appeal to the Second Circuit (covering New York, Connecticut, Vermont). If either circuit sides with the Tax Court's "passive investor" test, you'll have a direct conflict between the circuits.

A circuit split typically prompts the Supreme Court to step in. We could see this issue before the justices within the next 18 to 24 months.

The IRS has until early March 2026 to petition for rehearing en banc in the Fifth Circuit, asking all 17 judges to reconsider the three-judge panel's decision. Whether or not that happens, expect the IRS to keep fighting this in other circuits.

What You Can Do Right Now

The statute of limitations for claiming a refund is generally three years from when you filed your return. If you paid self-employment tax on limited partner distributions for tax year 2022, filed in April 2023, your window to file an amended return closes in April 2026.

For partners in Fifth Circuit states (Texas, Louisiana, Mississippi)

• Pull your K-1s from the past three years. The K-1 is the tax form your partnership sends you each year showing your share of partnership income. Look at Box 14, Code A, which shows self-employment earnings.
• Separate your distributive share (your profit allocation as an owner) from any guaranteed payments (fixed amounts paid for your services)
• Calculate the self-employment tax you paid on your distributive share
• File Form 1040-X to claim a refund. You can now file amended returns electronically for tax years 2022 through 2024.
• Document your limited partner status under state law

For partners outside the Fifth Circuit

• Consider filing a protective refund claim to preserve your rights while the appeals play out
• A protective claim pauses the statute of limitations clock and keeps your options open if the law changes in your favor
• Work with your tax advisor to assess the strength of your position given your entity structure and the pending circuit court decisions

For entity planning

• If you're currently an LLC, evaluate whether converting to a limited partnership makes sense for your business, but document the business reasons beyond tax savings
• Review your partnership agreement to clearly distinguish between limited partner distributive shares and guaranteed payments for services
• Prepare for IRS scrutiny if you take an aggressive position based on this ruling

Board and Investor Considerations

If you're raising a fund or closing an acquisition involving partnership interests, this ruling may affect your deal terms. Expect questions from sophisticated investors about:

Tax treatment projections: Financial models that assumed self-employment tax on all partnership income may need updating. For funds in Fifth Circuit states, the difference could be material to carry economics.

Entity structure justification: Why are you an LLC instead of an LP? If tax savings are significant, investors may push for restructuring, and you'll need to weigh that against operational preferences.

Reps and warranties: In M&A transactions involving partnerships, buyers may ask for specific representations about whether the target properly claimed or didn't claim the limited partner exemption, and whether there's exposure for prior positions.

Tax compliance representations in partnership agreements and fund documents may need revision to address the split in authority. Consider language that ties your position to the applicable circuit's law rather than making absolute statements.

The Fifth Circuit just gave limited partners a clean win on statutory interpretation. State-law status controls. Active participation doesn't disqualify you. The IRS's functional test got rejected. But the fight continues in other circuits, and the Supreme Court may ultimately have the final word. If you've been paying self-employment tax on partnership distributions, now is the time to assess whether you can claim a refund and to plan your entity structure with this evolving case law in mind.