Revenge of the Lawn: The Fifth Circuit Supports Fund Manager Social Security Tax Planning in Sirius Solutions

Many private fund managers restructured their LP ownership arrangements following the Tax Court decisions in Soroban and Denham and the stipulation originally entered into in Sirius. And while the Fifth Circuit’s decision won’t bind the IRS when appeals lie to other circuit courts, it should allow taxpayers who have capitulated to the IRS position to file refund claims and/or restructure to once again allow them to claim the social security tax exemptions for LPs.

Background
Until the decision in Soroban, supra, it was widely believed that a private fund manager who held both a general partnership interest (or who received a reasonable guaranteed payment) and a LP interest had a viable path towards not being subject to social security taxes on income allocated to them from the LP interest. The technical analysis supporting this conclusion is briefly described below. The decisions in Soroban and Denham disrupted this tax planning by holding that a person who was both a general partner and a limited partner (or received a guaranteed payment for services) could not take advantage of the LP exception. The decision in Sirius Solutions, however, reinvigorates the LP exception planning strategy.

Code § 1402 and Net Earnings from Self-Employment
Federal Insurance Contribution Act (FICA) taxes are imposed on wages, i.e., income from employment paid by an employer. Under a complimentary regime, Self-Employment Contributions Act (SECA) taxes are imposed on earnings from self-employment. For individuals who receive compensation for services from entities taxable as partnerships in which they hold partnership interests, SECA taxes apply. The IRS has ruled FICA does not apply to a partner’s distributive share of partnership income because a partner cannot be an employee of a partnership of which he is a partner.^[7]

SECA has three components:

• The Old Age, Survivors, Disability Insurance (OASDI) Tax. The OASI tax is imposed at a 12.4% rate on net earnings from self-employment (NESE) up to $184,500 for 2026 (the OASDI cap). The OASDI cap is indexed annually for inflation.
• The Hospital Insurance (HI) Tax. The HI tax is imposed at a 2.9% rate on NESE. There is no cap on the HI tax, and it applies to every dollar of NESE.
• The HI High Earner Surtax. The .9% HI High Earner Surtax applies to NESE in excess of $200,000 ($250,000 for married individuals filing a joint return).

Code § 1401(a), (b)(1). NESE is defined in Code § 1402(a) and generally includes an individual’s distributive share of income from any trade or business carried on by a partnership in which he is a partner.

Net Earnings from Self-Employment
Code § 1402(a)(13) excludes from the definition of NESE “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) … for services actually rendered to or on behalf of the partnership, to the extent that those payments are established to be in the nature of remuneration for those services.” Congress added Code § 1402(a)(13) in 1976 in order to prevent individuals from grossing up their NESE by their distributive share of partnership income from partnerships when the allocation of partnership income was not compensation for the performance of services.^[8] The grossing up of NESE would have enabled the partner to qualify for additional social security benefits. Thus, Code § 1402(a)(13) carves out a limited partner’s distributive share of partnership income from the definition of NESE.

Proposed Regulations
Over time, however, as national incomes approached and then exceeded the Social Security cap described above, the focus of the government changed. The IRS, instead of seeking to prevent individuals from including partnership income in their Social Security base, wrote rules that curtailed the ability of limited partners to exclude partnership income from NESE. Specifically, in January 1997, the IRS proposed regulations that generally would have prevented partners (including limited liability company (LLC) members) who provided more than 500 hours of service to a partnership from being treated as “limited partners” for Code § 1402(a)(13) purposes. However, in August 1997, Congress imposed a one-year moratorium preventing the Treasury from adopting regulations dealing with the employment tax treatment of limited partners.^[9] The moratorium expired on July 1, 1998. Treasury never adopted the 1997 Proposed Regulations even after the 1997 moratorium expired. Accordingly, the 1997 Proposed Regulations did not become effective.

Judicial Authorities
Several cases addressed whether the limited partner exception applies to other limited liability entities, such as LLCs and limited liability partnerships (LLPs). These cases uniformly hold that the limited partner exception only applies to LPs. For example, in Renkemeyer, Campbell & Weaver, LLP,^[10] the taxpayers at issue were attorney-members of a Kansas LLP engaged in the practice of law. Each LLP member was provided with the same liability protection as a limited partner. The LLP reported business revenues from its law practice on IRS Forms 1065 for the relevant tax years, but no portion of those revenues was included on the law firm’s tax returns as NESE. The IRS asserted that the attorney-partners’ distributive shares of the law firm’s business income for the relevant tax years was subject to self-employment tax. The court found for the IRS because the attorney-partners were not “limited partners” under Code § 1402(a)(13).^[11]

Code § 1411 and the Medicare Tax
Code § 1411 generally imposes a 3.8% Medicare tax (the Medicare Tax) on net investment income (NII) of U.S. individuals, trusts and estates. The term “NII” is defined for this purpose to mean any income falling into one of the following three categories (net of allocable expenses):

• Income from interest, dividends, annuities, royalties and rents, except when those items are derived in the ordinary course of a trade or business not described in category 2;
• Other gross income derived in a trade or business involving trading in financial instruments or commodities, or from an active trade or business in which the taxpayer is passive (for example, income from the taxpayer’s investment in a business activity in which (s)he does not materially participate); and
• Net gain from the disposition of property, except when that property is held in a trade or business not described in category 2.

The Medicare Tax will apply to a trade or business if it is (i) a passive activity with respect to the taxpayer within the meaning of Code § 469 (the “passive activity loss” or “PAL” rules) or (ii) a trade or business of trading in financial instruments or commodities, as defined in Code § 475(e)(2). Even if a taxpayer is active in a trade or business, (s)he will have NII from non-business derived interest, dividends, annuities, royalties, rents and capital gains, minus allocable deductions. Code § 1411 does not define the term “trade or business.” The proposed regulations under Code § 1411 specify that an activity is passive with respect to a taxpayer if it is (i) a trade or business within the meaning of Code § 162, and (ii) that trade or business is a passive activity within the meaning of Code § 469 as to the taxpayer.^[12]

Notwithstanding some convoluted statutory language, the basic operation of the NII Tax to passive income, including interest and rents, is clear. Code § 1411(c)(1) starts by treating these items of passive income as subject to the NII Tax. It then, however, provides a carve-out for such items of passive income if they are derived in a trade or business which is other than a passive activity or the trading of financial instruments or commodities. Code § 1411(c)(2). Accordingly, if a taxpayer derives interest income in a trade or business that is neither a passive activity nor the trading of financial instruments, interest and rents should not be subject to the NII Tax.

Treasury Regulation § 1.1411-5(c) provides the only direct IRS guidance on the NII Tax “exception to the exception” for income derived in the business of trading financial instruments. This regulation contains a broad definition of financial instruments but does not offer any guidance on when a taxpayer should be treated as a trader in such instruments for purposes of the NII Tax. Accordingly, taxpayers are required to look to other authorities in determining whether their activities constitute trading. Many taxpayers took the position that income earned from a carried interest in a private fund was attributable to management services and not the trading of financial instruments. Accordingly, these taxpayers were able to avoid the application of the NII Tax on their share of such income.

Soroban and Denham Upended the Statutory Analysis
The IRS was successful in overturning the statutory analysis briefly described above through its victory in the Soroban decision. Many tax practitioners (including this writer) found the basis for the Tax Court’s decision to be extremely tenuous. Specifically, the Tax Court first noted that the NESE limited partner exception in Code § 1402(a)(13) only applied when the income was allocated to the limited partner as such.^[13]The court then went on a linguistic journey to interpret those two words in a manner concluding that if a person was a general partner and held a LP interest or received a guaranteed payment, no portion of the income and gains allocated to such person would be considered to have been allocated to them as a limited partner. The Tax Court decided Denham, supra, a year later. The court in Denham described the approach taken in Soroban, supra, as the “functional approach.” The Tax Court again concluded that the LP exception from NESE taxes should be limited to persons who did not also hold general partner interests or receive guaranteed payments.

The Fifth Circuit Decision in Sirius Solutions
The Fifth Circuit eviscerated the so-called functional analysis employed by the Tax Court in the Soroban and Denham decisions. The opinion begins with a simple premise: A person is a limited partner in a LP if they enjoy limited liability. It confirmed this conclusion with reference to how “limited partner” was defined in dictionaries at the time that Code § 1402(a)(13) was enacted. The Fifth Circuit also noted that instructions accompanying IRS forms used the same definition for over 40 years and noted that the IRS’s instructions as who was a limited partner “did not have some hidden, narrower reading than the rest of the Tax Code.” When the IRS did amend its definition of limited partner in 2022, it did not contradict its earlier definition. The Social Security Administration (SSA) also used the same definition.

The Fifth Circuit rejected the IRS and Tax Court’s premise that a limited partner must be a mere passive investor. The court held that the rules for guaranteed payments would be superfluous if a person could be treated as a limited partner only if they did not provide services. The court also held that the functional analysis test would require substantial analysis to be performed by every limited partner which would require “an army of lawyers and accountants – and a whole lot of luck.” The Fifth Circuit also applied a more plausible interpretation to the phrase “as such” in Code § 1402(a)(13). It held that the phrase distinguished between amounts allocated or paid to a person who was both a limited and general partner.

^{[1] The phrase “social security taxes” used in text refers to self-employment taxes imposed by Code § 1402(a)[i] and the Medicare Tax imposed on net investment income (NII) by Code § 1411.}

^{[2] 161 TC 310 (2023), aff’d aft. rehearing TC Mem. 2025-52.}

^{[3] Some of the more notable challenges include cases docketed against Point 72 Asset Management LP (Dkt. No. 12752-23) and Summit Rock Advisors LP (Dkt. No. 9713-25) and Valinor Management LP (Dkt. No. 9716-25).}

^{[4] See Denham Capital Management LP v. Commissioner, T.C. Memo. 2024-114.}

^{[5] Decision No. 24-60240 (Jan. 16, 2026).}

^{[6] Sirius utilized a stipulation to avoid litigating in the Tax Court. The stipulation enabled the taxpayer to appear directly to the Fifth Circuit without having an adverse Tax Court decision rendered against it.}

^{[7] Rev. Rul. 69-184, 1969-1 C.B. 256.}

^{[8] See H.R. Rep. No. 95-702(I), pp. 40-41 (1977) (“This is to exclude for coverage purposes certain earnings which are basically of an investment nature.”).}

^{[9] H.R. 2014 Sec. 734 (1997) on Sec. 935 “Moratorium on certain Regulations,” Taxpayer Relief Act of 1997, P.L.}

^105-34.

^{[10] 136 TC 137 (2011).}

^{[11] The taxpayers in Renkemeyer claimed their respective interests in the law firm shared the characteristics of LP interests because (i) their interests were designated as LP interests in the law firm’s organizational documents and (ii) the partners enjoyed limited liability pursuant to Kansas law. Hence, they argued, their distributive shares of the law firm’s business income qualified for the Code § 1402(a)(13) exception. The Tax Court distinguished general partners from limited partners by explaining that “[g]eneral partners typically have management power and unlimited personal liability [, whereas] limited partners lack management powers but enjoy immunity from liability for debts of the partnership.” The court held the attorneys were not limited partners because their LLP interests did not prevent them from participating in the management of the LLP. See also Howell, TC Memo 2012-303, Castigliola, TC Memo 2017-62 (Member-managers of professional LLC not limited partners) and CCA 201436049 (believed to have been issued with respect to Soroban Capital Partners).}

^{[12] The determination of whether an item of gross income allocated to a taxpayer from a pass-through entity, such as a partnership or an S corporation, is derived from a trade or business in which the taxpayer materially participates is made at the taxpayer (individual, estate or trust) level in accordance with the general principles of Code § 469.}

^{[13] Emphasis in opinion, but not in the statute.}