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February 16, 2026 •HoganTaylor
On January 16, in a decision that reshapes the landscape for partnership taxation, the U.S. Court of Appeals for the Fifth Circuit officially rejected the IRS's "passive investor" test. The ruling in Sirius Solutions, LLLP v. Commissioner provides a significant victory for partners in state-law limited partnerships, potentially exempting their distributive shares from self-employment taxes regardless of their activity level in the business.
For years, the IRS and the U.S. Tax Court have aggressively applied a "functional analysis" to determine who qualifies for the limited partner exception under Section 1402(a)(13). This test argued that only passive investors could be considered "limited partners" for tax purposes and that partners materially participating in the business of the firm would be subject to self-employment taxes. Recent tax court results in the cases of Soroban Capital Partners LP and Denham Capital Management LP have given the IRS significant victories in this area.
However, the Fifth Circuit flatly rejected this approach, holding that the statutory text is clear: a "limited partner" is simply a partner in a state-law limited partnership who enjoys limited liability. The court noted that if Congress had intended to exclude all active partners, the separate rules for taxing "guaranteed payments" for services would be entirely unnecessary.
This ruling is a monumental shift toward a simpler, state-law-based framework, but its application has technical boundaries. The decision is currently binding only in the Fifth Circuit (Texas, Louisiana, and Mississippi). Taxpayers elsewhere must still contend with the more restrictive Tax Court standards.
The court specifically addressed state-law limited partnerships and limited liability limited partnerships (LLLPs). It did not resolve whether members of LLCs or LLPs qualify for the same exception and left open the question of applicability to these types of arrangements. Also, compensation paid to a partner as a guaranteed payment for services rendered to the partnership remains subject to self-employment tax.
With similar appeal cases pending in the First Circuit (Denham Capital) and Second Circuit (Soroban Capital), a conflicting ruling could eventually trigger a U.S. Supreme Court review to settle the definition nationwide.
The IRS has until early March 2026 to petition for a rehearing. Until then, partners who participate materially in their business can still expect IRS challenges outside the Fifth Circuit. Eligible taxpayers within the Fifth Circuit who previously paid self-employment taxes based on the IRS's "passive investor" test should consult with their HT advisor regarding potential refund claims for open tax years. Taxpayers outside the circuit may want to consider making protective claims in order to avoid statute limitations. Also, service-based firms currently operating as LLCs may want to evaluate the potential benefits and risks of converting to a state-law limited partnership to align with the Sirius holding.
If you have any questions about the content of this publication, or if you would like more information about HoganTaylor's Tax practice, please email James Keehn, Tax Practice Lead, at jkeehn@hogantaylor.com.
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