The U.S. Court of Appeals for the Fifth Circuit has clarified the definition of a “limited partner” under Section 1402(a)(13) of the Internal Revenue Code of 1986, emphasizing that it is determined by state law. This ruling, emerging from the case Sirius Solutions LLP v. Commissioner, overturns a prior decision by the Tax Court in Soroban Capital Partners LP v. Commissioner.
The Fifth Circuit ruled that a “limited partner” is identified by their limited liability under state law rather than their level of engagement in the partnership’s activities. This decision rejects the Tax Court’s earlier functional analysis which allowed only passive investors to qualify for exemptions from self-employment tax, irrespective of their state law classification.
This ruling underscores the importance of Section 1402(a)(13), which states that self-employment income typically includes a partner’s share from a partnership’s business. However, it specifies that the distributive share of a limited partner is exempted from self-employment taxation unless it pertains to guaranteed payments for services rendered.
The Tax Court’s approach in Soroban was based on the active participation of limited partners, which raised significant confusion regarding their tax obligations. In contrast, the Fifth Circuit’s decision affirms that as a matter of law, limited partners in a limited partnership are not subject to self-employment tax, irrespective of their involvement level.
Historical context plays a vital role in this ruling. The Fifth Circuit referenced the original purpose of Section 1402(a)(13) enacted in 1977, where limited liability was established as the defining characteristic of a limited partner. This finding was also supported by dictionary definitions from the period and consistent IRS guidance highlighting limited liability as the core factor.
The implications of this ruling are significant as they restore clarity regarding the self-employment tax obligations for limited partners, easing concerns that had arisen from the Tax Court’s previous analysis. Partnerships should reassess their tax positions in light of this ruling, especially if self-employment tax has been paid while partners were classified as limited under state law, as they may be eligible for refunds.
Looking ahead, there are similar cases currently under consideration in the First and Second Circuits, which could potentially lead to differing interpretations in various jurisdictions. This developing situation suggests a heightened importance for partnerships and their advisors to remain informed and prepared for possible legal shifts in the classification of limited partners.