In a 2-1 decision, the U.S. Court of Appeals for the Fifth Circuit on January 16 rejected the Tax Court’s interpretation of the self-employment tax (SECA) exemption for limited partners in state law limited partnerships in Sirius Solutions LLLP v. Commissioner. The appeal concerned Sirius’s federal tax returns from 2014, 2015, and 2016.
Appeals of Tax Court memorandum decisions addressing identical issues for two investment managers are pending in the First Circuit (Denham) and Second Circuit (Soroban). The cases to date have centered around the disagreement on the interpretation of “limited partner” in the Section 1402(a)(13) SECA tax exemption, with the IRS and prior Tax Court decisions arguing that the term “limited partner” for purposes of the statutory exemption means a “passive investor” in a limited partnership. The statute does not define “limited partner.”
The Tax Court, following its November 2023 precedential Soroban decision, had held that a functional analysis was required to determine whether the “limited partners” were passive investors or were “limited” in name only and, in fact, actively engaged in the business and thereby ineligible for the exemption.
The Fifth Circuit rejected the Tax Court’s interpretation, stating, “in any complex statutory dispute, the best course is to follow the statute’s plain text. When § 1402(a)(13) says ‘limited partner,’ it is referring to a limited partner in a state-law limited partnership that has limited liability.”
Fifth Circuit Opinion
The Tax Court had previously rejected Sirius’s challenges to its interpretation of limited partner, reasoning that it was bound by its 2023 decision in Soroban. In that decision, the Tax Court held that for purposes of the Section 1402(a)(13) exception, the term “limited partners” only “refer[s] to passive investors.”
In the Fifth Circuit’s decision in Sirius, the Court of Appeals stated that the Tax Court’s and the IRS’s interpretation that a “limited partner is a mere ‘passive investor[]’ in a limited partnership … fails for three reasons.” The court looked at contemporaneous dictionary definitions of “limited partner” from around 1977, when Section 1402 was adopted, and the one characteristic they all had in common was limited liability. They also observed that if Congress wished to only exclude passive investors from the SECA tax, it could have easily written an exception to do so at the time, noting references to “passive investment income” or “passive income” show up over 25 times across several provisions enacted around this time.
The Fifth Circuit also noted that for 45 years the IRS issued tax return instructions interpreting “limited partner” as a partner with limited liability in a limited partnership. The court then referenced the U.S. Supreme Court’s 2024 Loper Bright decision, noting that “agency interpretations are ‘especially useful in determining the statute’s meaning’ if those interpretations are ‘issued contemporaneously with the statute at issue, and … have remained consistent over time.’”
The dissenting viewpoint acknowledged the significance of agency interpretations but argued that the majority opinion did not establish why tax form filing instructions constituted the agency’s interpretation of “limited partner” in Section 1402(a)(13). The Fifth Circuit’s majority opinion responded to the dissent that the instructions appear to be textbook agency interpretations; that the IRS reviews its statutory mandate; creates instructions in light of those goals; publishes them; and then holds taxpayers to account if the taxpayers fail to follow them.
The majority observed, “What’s more, embracing the dissent’s logic would mean that even parties who followed the clear text of federal tax law and the instructions on a tax form would still lose if the IRS were to change its interpretation.”
The Fifth Circuit did not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception.
Takeaways for Fund Managers
The Fifth Circuit’s interpretation in Sirius helps provide clarity on SECA’s applicability to limited partners, but it is currently limited to taxpayers in the Fifth Circuit (Texas, Louisiana, and Mississippi). Fund managers in the jurisdiction of the Fifth Circuit may want to evaluate their current management structure in light of this taxpayer favorable decision.
The asset management community will continue to monitor appeals in the First Circuit for a private equity manager (Denham) and in the Second Circuit for another investment manager (Soroban). It’s unclear when decisions in these cases will be published, and it’s also unclear how these circuits may rule. A split circuit result is possible, potentially prompting the Supreme Court to take up the issue. Congress could also clarify the definition of “limited partner” but there’s no clear indication that it intends to do so.
Please visit BDO’s Partnership Tax Services page for more information on how BDO can help.