- The Second Circuit’s Soroban decision and the Fifth Circuit’s Alain decision focus on a partner’s actual activities, holding that limited partners generally cannot exercise managerial control and still qualify for the self-employment tax exception.
- The rulings make it more difficult to rely solely on state-law limited partner status and limited liability, requiring many partnerships to apply a functional analysis of partner roles, responsibilities, and participation in the business.
- Partnerships should reassess self-employment tax positions for 2026 returns. Partnership agreements, organizational structures, and documentation of partner activities may become increasingly important, particularly for investment managers, professional services firms, and other partnerships with active limited partners.
The Second Circuit Court of Appeals has ruled in Soroban Capital Partners v. Commissioner, No. 25-2250 (2nd Cir. 2026), that several partners did not qualify for the limited partner exception from self-employment tax because they “exerted managerial control” over the partnership.
The decision comes on the heels of the Fifth Circuit’s opinion in K Alain L.L.L.P. v. Commissioner (formerly Sirius Solutions, L.L.L.P. v. Commissioner), which similarly ruled that a limited partner “cannot play a significant role in managing or running a business.” (See our related Alert: Fifth Circuit Overturns Tax Court on Limited Partner Self-Employment Tax Exemption.)
Together, the opinions provide important new guidance on how a functional analysis should apply to determine when partners qualify for the exception from self-employment tax based on their activities for the partnership.
The emphasis on managerial control in both decisions potentially offers a slightly more favorable standard than that outlined by the Tax Court, which generally seeks to determine whether partners are “akin to passive investors.” Partnerships might be able to use the circuit courts’ guidance to establish themselves as limited partners even if they provide services for the partnership. Taxpayers can consider adding specific terms to partnership agreements and contemporaneously documenting activities to support their positions.
At the same time, the cases make it harder for taxpayers to continue to take the position that a limited partner in a state-law limited partnership qualifies for the limited partner exception based solely on the state-law designation without regard to their activities.
The issue is complex, and the standards could vary based on jurisdiction. The law is also still evolving, with Alain remanded to the Tax Court for application of the Fifth Circuit’s holding and another major case still pending in the First Circuit.
BDO Insight
Many partnerships could benefit from reexamining this issue for their 2026 returns. Others might need to apply a functional analysis for the first time, particularly investment managers, service partnerships, professional services partnerships, and partnerships with active individual limited partners that took positions solely based on state-law designations and limited liability. Determinations on the issue could affect tax distributions and estimated tax payments for taxpayers as early as the fourth quarter of 2026.
Limited Partner Definition
Section 1402(a)(13) provides an exception from self-employment tax for limited partners, although the exception does not apply to guaranteed payments for services. There is no definition of a limited partner in the statute or final regulations, creating a persistent source of controversy. The Tax Court has established a “passive investor” standard, which hinges on a partner’s roles and responsibilities in the partnership. The Tax Court uses a “functional analysis” to determine whether partners “control a business” or are “generally akin to passive investors” based on all the facts and circumstances.
Taxpayers across several circuits have challenged the Tax Court’s position. The Fifth Circuit rejected the Tax Court’s passive investor standard in Sirius. In its initial opinion in January 2026, the circuit court held that state-law limited partners in a limited partnership qualified for the exception based on their limited liability, regardless of their activities in the partnership.
The same three-judge panel in the Fifth Circuit then withdrew the original opinion and issued a revised version in August. Under the new opinion, a limited partner is one “who plays no significant role in managing or running a business.” The Fifth Circuit concluded that “some participation is allowed, so long as the partners do not exercise control over the business,” distinguishing between managerial and nonmanagerial activities.
The Fifth Circuit did not apply its standard to the facts in the case, instead remanding the case to the Tax Court to make the determination.
The new Second Circuit decision in Soroban applies a relatively similar standard, finding that limited partners cannot “exert managerial control” or “exercise control and managerial authority.” The court also noted that it agrees with the Fifth Circuit’s holding that limited partners can provide services or have participation in a partnership, “so long as the activities in question do not constitute controlling, managing, or running the business.”
BDO Insight
The Second Circuit also confirmed that the issue is a partnership-level item, although the Soroban case was a TEFRA partnership-level proceeding, not a proceeding covering a BBA partnership.
Distinction in Standards
Despite the similar standards established by the two decisions, the Fifth Circuit made clear that it considered its opinion a rejection of the Tax Court’s passive investor standard, while the Second Circuit upheld the Tax Court’s conclusion. In practical terms, the Fifth Circuit standard still appears to require a similar functional analysis to the Tax Court’s based on the activities of partners, and the Second Circuit even noted that it found “little daylight” between the Fifth Circuit position and the Tax Court’s holding (and presumably between the Tax Court’s standard and its own).
Although all three standards may be directionally similar, the holdings in the Fifth and Second Circuits appear slightly more permissive than the way the Tax Court has applied its passive investor standard. Both Alain and Soroban make clear that a limited partner can still provide services as long as those services are not managerial.
The slight variations in standards among the three courts potentially create differences in how taxpayers should apply a functional analysis depending on the jurisdiction. A decision on the same issues remains pending in the First Circuit in Denham Capital Management LP v. Commissioner.
Also, taxpayers can still potentially apply the rules under regulations proposed in 1997 under long-standing IRS administrative guidance that provides that the IRS will not challenge a taxpayer position applying proposed regulations consistently and in full.
Following the Fifth Circuit’s substituted decision, taxpayers have significantly less appellate support for a position based solely on state-law limited partner status and limited liability.
Next Steps
Partnerships should potentially reassess positions, given the evolving standards. The determinations are highly fact-specific and could require significant analysis. Partnerships that previously did not satisfy the Tax Court’s passive investor standard could explore qualifying under the Fifth and Second Circuit rationales, which allow limited partners to perform some activities. Taxpayers can consider taking proactive steps to support those positions, such as structuring changes, adding specific terms to partnership agreements, and documenting partner activities. There might also be opportunities to rely on the 1997 proposed regulations.
Partnerships that took a favorable position based solely on state-law limited partner status and limited liability should reevaluate whether enough support remains for that position, or if functional analyses and further planning are warranted.
Standards could apply slightly differently depending on jurisdiction, and the outstanding Denham case could still affect the landscape. Taxpayers should not wait to consider the issue. Although most 2025 partnership returns were filed by September 15, changes in position could affect tax distributions and estimated tax payments in the coming months.
Please visit BDO’s Partnership Tax Services page for more information on how BDO can help.