Two recent federal circuit court decisions have significantly limited the application of the “limited partner exception” to U.S. federal self-employment tax, with important implications for private equity sponsors and other investment management businesses. In Soroban Capital Partners LP v. Commissioner and K Alain, L.L.L.P. v. Commissioner (formerly Sirius Solutions, L.L.L.P. and referred to here as Sirius), the Second and Fifth Circuits each concluded that limited partner status under state law is not by itself sufficient to exclude a partner’s distributive share of partnership income from self-employment tax.

Although the two courts articulated somewhat different standards, both focus on whether a partner participates in managing or running a partnership’s business. A third appeal, Denham Capital Management LP v. Commissioner, remains pending before the First Circuit.

Background: The Limited Partner Exception

Section 1401 of the Internal Revenue Code imposes a tax on an individual’s self-employment income, which generally includes the individual’s distributive share of trade or business income of a partnership in which the individual is a partner. For high-earning individuals, the tax on self-employment income is 3.8%, though the actual cost is somewhat mitigated because a portion of the tax is treated as a deductible business expense of the partnership.

Section 1402(a)(13) of the Code—the “LP Exception”—excludes “the distributive share of income or loss of a limited partner, as such,” from U.S. federal self-employment tax. However, the Code does not define “limited partner, as such.” Historically, IRS partnership return instructions have described a limited partner principally by reference to limited liability. Many taxpayers have interpreted the LP Exception similarly, treating partners with limited liability as limited partners for this purpose, regardless of their level of participation in the partnership’s business.

The IRS has challenged this interpretation in recent years, including in Soroban, Sirius and Denham, arguing that the LP Exception was intended to protect passive, investment-type returns rather than earnings attributable to a partner’s active participation in a business.

Soroban: A Functional Analysis

The dispute in Soroban arose from the IRS’s examination of an investment management firm’s 2016 and 2017 tax returns. Soroban Capital Partners, a Delaware limited partnership, excluded from its reported net earnings subject to self-employment tax approximately $141.5 million of income allocated to its three principals, each of whom was a state-law limited partner. The individuals received separate guaranteed payments for their services to the partnership, which were included in self-employment income.

In November 2023, the Tax Court ruled in favor of the IRS, holding that the LP Exception does not apply to a partner “who is limited in name only.” The Tax Court adopted a functional analysis drawn from prior cases that emphasized an individual’s actual activities and the economic source of their income and extended that analysis to state-law limited partnerships. In doing so, the Tax Court rejected Soroban’s argument that status as a state-law limited partner alone was sufficient to satisfy the LP Exception.

In a subsequent 2025 decision applying the functional analysis to the facts, the Tax Court concluded that the Soroban principals, who essentially managed and ran Soroban Capital Partners, did not qualify for the LP Exception. The principals worked full-time for Soroban, managed portfolio investments, participated in governing committees and exercised substantial managerial control over the business.

On September 17, 2026, the Second Circuit affirmed the Tax Court’s decision, holding that the Soroban principals were not “limited partners, as such.” Examining the meaning of “limited partner” at the time Congress enacted the statute, the Second Circuit concluded that, in addition to having limited liability, a limited partner must not run, manage or otherwise control the partnership’s business. The Second Circuit opinion does not provide guidance on what constitutes impermissible management or control for this purpose.

Sirius: A “Significant Role” Test

Sirius involved Sirius Solutions, a Delaware limited liability limited partnership operating a business consulting firm. As in Soroban, the IRS challenged Sirius Solutions’ treatment of its limited partners’ distributive shares for the 2014 through 2016 tax years. Following the Tax Court’s 2023 decision in Soroban, the parties in Sirius stipulated that Sirius’ limited partners would not qualify for the LP Exception under the Tax Court’s functional analysis. In February 2024, the Tax Court ruled in favor of the IRS, thereby allowing Sirius to appeal the underlying legal standard.

On January 16, 2026, a divided Fifth Circuit panel initially rejected Soroban and its functional analysis and held that a limited partner for purposes of the LP Exception was a partner in a state-law limited partnership who had limited liability. In reaching its conclusion, the majority relied on dictionaries contemporaneous with the LP Exception’s enactment and legacy IRS and Social Security Administration materials.

In August 2026, in a surprising development following the government’s petition for rehearing en banc, the Fifth Circuit withdrew its January 2026 opinion and issued a substituted opinion. While still purporting to reject Soroban’s passive-investor standard, the new opinion held that a limited partner for purposes of the exclusion from federal self-employment taxes is “a partner who plays no significant role in managing or running a business.” The Fifth Circuit provided little guidance on how to apply the “significant role” standard or what level of participation crosses the line into management of the business.

The Fifth Circuit vacated the Tax Court’s decision in Sirius and remanded for further proceedings under the new standard, without determining whether the Sirius limited partners qualified for the LP Exception.

Denham: A Pending Appeal

Denham is the remaining pending appellate case addressing the LP Exception.

Denham Capital Management, an investment management partnership, challenged IRS adjustments for its 2016 and 2017 tax years. The Tax Court ruled against Denham in December 2024, applying the functional analysis established in Soroban. Denham appealed to the First Circuit in April 2025, and oral argument took place on February 5, 2026. The First Circuit’s opinion is still pending.

Implications for Private Equity Sponsors

In addition to the pending opinion in Denham, the taxpayers in either Soroban or Sirius could still petition the Supreme Court for review. However, while the final verdict on the scope of the LP Exception remains pending, the outlook for taxpayers in managerial roles seeking to rely on the LP Exception appears increasingly unfavorable.

As noted above, neither Soroban nor Sirius provides meaningful guidance on when participation in business decisions crosses into impermissible management, control or running of the business. Though both cases are clear that state-law limited partner status alone is insufficient to establish eligibility for the LP Exception, they also acknowledge that a limited partner may participate in certain non-managerial aspects of a business and still benefit from the LP Exception.

Although the Fifth Circuit’s standard differs from the Second Circuit’s in looking to whether a limited partner has a “significant role” in running a partnership’s business, in practical terms the opinions appear closely aligned. The distinction between the two standards may be more significant for partners whose activities fall short of clearly running or managing the business.

In connection with 2026 tax reporting, taxpayers—especially in the Second and Fifth Circuits—will need to assess whether their participation reaches the impermissible levels described in Soroban and Sirius. This determination must be made both by individual partners and by the partnership itself, which will need to decide whether to report income on Schedule K 1 as subject to self-employment tax. Sponsors with individuals relying on the LP Exception should review the roles, responsibilities and compensation arrangements of those individuals. Potential problem areas include where a limited partner has operational authority, manages personnel, has authority to legally bind the entity, controls core investment or service decisions or is held out internally or externally as responsible for operating the business.

With two federal appellate courts now requiring an examination of a limited partner’s managerial role, formal limited partner status alone appears increasingly unlikely to support the LP Exception.

The pending First Circuit decision in Denham, together with potential further appellate proceedings in Soroban and Sirius, may provide further clarity on the boundaries of each Circuit’s LP Exception standard. For now, however, the principal message for sponsors is that the availability of the LP Exception increasingly appears to depend not only on a partner’s classification under state law, but on what that partner actually does within the limited partnership.

 

Private Equity Report Fall 2026, Vol 26, No 3