Update: The Second Circuit has weighed in on the limited partner self-employment tax exclusion.
On Sept. 17, 2026, the court affirmed the Tax Court's decision in Soroban Capital Partners holding that the firm's three principals are not "limited partners" under §1402(a)(13) because they exercised managerial control over the business, despite their formal limited partner status under Delaware law.
The panel didn't just defer to the Tax Court but built its own test from the statute's text, structure, and 1977 legislative history: a limited partner must have limited liability AND take no part in running the business. A limited partner providing some services does not automatically fall subject to this test; the line is whether those services amount to controlling, managing, or running the business. This means the test is not a bright-line rule making the determination a facts-and-circumstances determination.
The Second Circuit ruling then addressed the Fifth Circuit's August ruling in K Alain ("no significant role in managing" standard) head-on and suggested the two tests may not be as far apart as they look. It confirmed Soroban's principals would lose under either version, meaning that the Fifth Circuit’s ruling is not as taxpayer friendly as it may have originally appeared.
The circuit split many expected may be narrower than it appeared in August. But the underlying exposure for principals holding "limited partner" interests while actively running the business hasn't gone away but rather is now more clearly defined. The First Circuit's Denham decision, argued in February, is still pending and could either reinforce this convergence or reopen the gap.
On Aug. 12, 2026, the Fifth Circuit granted rehearing, withdrew its own Jan. 16, 2026, opinion in Sirius Solutions, L.L.L.P. v. Commissioner (now also captioned K Alain, L.L.L.P. v. Commissioner, No. 24-60240), and issued a substitute opinion reversing course on who qualifies as a “limited partner” under the Section 1402(a)(13) self-employment tax exclusion.
§1402(a) generally requires partners to include their distributive share of partnership trade or business income in net earnings from self-employment. However, §1402(a)(13) carves out an exception for "the distributive share of any item of income or loss of a limited partner, as such" (excluding guaranteed payments under §707(c)), but Congress never defined "limited partner" for this purpose, which is exactly what these cases are litigating.
The January Sirius opinion was a clean, taxpayer-friendly bright-line rule: a state-law limited partner with limited liability qualified for the exclusion, regardless of the partners’ involvement in the business. That rejected the Tax Court’s “functional analysis”/passive-investor standard from Soroban Capital Partners (161 T.C. 310) and Denham Capital Management (T.C. Memo 2024-114).
That bright-line rule is gone too. The August substitute opinion still rejects Soroban’s passive-investor test, but it also abandons its own January limited-liability standard. The new rule: A limited partner is one who plays "no significant role in managing or running a business," which constitutes a management-and-control test grounded in contemporary legal dictionaries, the 1916 Uniform Limited Partnership Act, the 1976 Revised Uniform Limited Partnership Act, and period treatises rather than state-law labels or bright-line liability rules.
Why This Decision Matters
The Fifth Circuit’s decision is significant for many reasons:
- The opinion may contain two different standards. The holding asks whether a partner plays a "significant role in managing or running" the business but later frames the inquiry as a "managerial versus non-managerial" distinction and suggests some non-managerial participation is permitted. Whether those are the same test is unclear; for example, a partner with substantial operational duties could still argue those duties are "non-managerial."
- Dual-capacity partners are now in limbo. The withdrawn January opinion had addressed the statute’s "as such" language to explain how someone holding both general and limited partner interests should be treated. The substitute opinion drops that discussion entirely, leaving no guidance for partners who wear both hats, which is a common structure in private-equity-backed and search fund structures.
- Judge James Graves dissented from both opinions, calling the result an “indefensible, illogical, and illegal loophole” that allows compensation for services to avoid the self-employment tax.
- Soroban and Denham are still on appeal in the Second and First Circuits. A circuit split is a live possibility, and neither of those courts is bound by the Fifth Circuit’s reasoning.
Key Takeaways
The legal landscape is continuing to evolve and some questions remain unanswered. Key issues to watch include:
- The management-and-control test is back, but the Fifth Circuit’s own opinion may be internally inconsistent about what it requires.
- Dual-capacity partners (general and limited partner in the same structure) have no clear answer under this opinion.
- Partnerships that changed structuring or reporting after the January decision should revisit those positions now that the bright-line rule they relied on no longer exists.
- Watch the Second and First Circuits before treating this as settled law.
Reach out to our team if you would like to talk through how this affects a specific fund or partnership structure.