Second, Fifth Circuits address “limited partner” self-employment tax exception

Recent circuit court rulings continue to interpret the meaning of the “limited partner” exception for purposes of the self-employment tax.

Background

Section 1402(a)(13) of the Internal Revenue Code of 1986 (Code), as amended, provides that the “distributive share of any item of income or loss of a limited partner” is excluded from the self-employment tax imposed under Code Section 1401. The exact meaning of “limited partner” has been the subject of ongoing litigation.

Soroban and K Alain

On September 17, 2026, the US Court of Appeals for the Second Circuit unanimously affirmed the US Tax Court’s decision in Soroban Capital Partners LP v. Commissioner, holding that partners who run, manage, or otherwise exercise managerial control over a partnership’s business do not qualify as “limited partners” for purposes of the limited partner exception to self-employment tax under Code Section 1402(a)(13), and therefore are subject to self-employment tax on their partnership earnings.

The Second Circuit first rejected the taxpayer’s argument that the topic was ineligible for review under the Tax Equity and Fiscal Responsibility Act (TEFRA) partnership tax audit regime in effect for the tax years at issue. The Second Circuit then analyzed the historical meaning of “limited partner” and concluded that in 1977, when Congress enacted Code Section 1402(a)(13), the ordinary meaning of the term referred to a partner with both limited liability and limited involvement in managing the business. Although the Second Circuit recognized that “merely providing services does not necessarily equate to running the business,” it did not specify when permissible services or participation in a partnership crosses the line into management, control, or running the business. In Soroban, the individuals in question also had the titles of managing partner and chief investment officer, co-managing partner, and head of trading and risk management and were members (either directly or through disregarded entities) of the investment manager’s general partner. Limited partners in personal service partnerships should be forewarned that the Second Circuit did not view such roles as being consistent with a Code Section 1402(a)(13) limited partner.

The standard articulated by the Second Circuit generally aligns with the recently re-issued decision of the US Court of Appeals for the Fifth Circuit in K Alain L.L.L.P. v. Commissioner, which held that a limited partner is a “partner who plays no significant role in managing or running a business.” In reaching such formulation, the Fifth Circuit withdrew and replaced its January 2026 opinion in Sirius Solutions, L.L.L.P. v. Commissioner, which had adopted a formalistic, state-law-focused definition of “limited partner” as a partner in a limited partnership with limited liability. Thus, both Soroban and K Alain move away from a purely legal-status-based definition and toward an inquiry that also focuses on the partner’s actual role in relation to the business.

As with Soroban, K Alain leaves substantial uncertainty as to what activity would render a partner ineligible for the statutory “limited partner” exception. While the Second Circuit ruled that the taxpayers were not Code Section 1402(a)(13) limited partners, the Fifth Circuit remanded its case to the Tax Court to make this determination. Notably, on September 18, 2026, the Internal Revenue Service urged the Tax Court to apply the Second Circuit’s Soroban standard in a filing involving its case against Point72 Asset Management, L.P. On September 28, 2026, K Alain petitioned the Fifth Circuit for an en banc review, requesting that the Fifth Circuit revoke its new, “unworkable” standard and go back to the earlier decision’s legal-based standard; accordingly, there may be further delay in getting judicial clarity in the Fifth Circuit.

The same issues regarding the application of the self-employment tax exception and the meaning of “limited partner” under Code Section 1402(a)(13), as well as whether the matter is eligible for review under the TEFRA partnership tax audit regime, are currently before the US Court of Appeals for the First Circuit in Denham Capital Management LP v. Commissioner. A decision in Denham could further shape the developing circuit-level guidance on this issue.

Members of investment management companies should consider how the recent decisions in K Alain and Soroban impact their 2025 tax returns, 2026 estimated tax positions, and eventually their 2026 tax returns. With respect to the 2025 tax year, persons who timely requested an extension to file Form 1040 generally have until October 15, 2026, to file. Because K Alain and Soroban were issued after the close of the 2025 tax year but before the October 15, 2026, extended filing deadline, taxpayers filing on extension should evaluate whether those decisions affect any position to exclude a limited partner’s distributive share of partnership income from self-employment tax.

The McDermott difference

Please contact your McDermott Will & Schulte tax lawyer(s) to discuss specific planning considerations and potential consequences of these decisions, including:

• Whether, in light of the current legal landscape, it is reasonable to take the same position on a 2025 return as that taken on a 2024 return
• The relevance of specific economic, governance, and operational arrangements to the limited partner exception, including arrangements in which certain individuals are involved in aspects of the management company’s business but do not have decision-making authority for the management of the firm
• The potential impact of the recent circuit court decisions on taxpayers located outside the Second Circuit (Connecticut, New York, and Vermont) or Fifth Circuit (Louisiana, Mississippi, and Texas)
• Structuring considerations for existing management companies and for newly formed management companies