New Court Decision Can Ease Self-Employment Taxes on Partnership and LLC Owners

This January, the Fifth Circuit Court of Appeals in Sirius Solutions L.L.L.P. v. Commissioner reversed a pro-IRS decision by the United States Tax Court and eased the burden of self-employment tax for passive owners in partnerships and LLCs. However, the IRS is likely to continue auditing this issue and try to impose higher self-employment tax on partnerships and LLCs outside the Fifth Circuit, to obtain a pro-IRS decision from another appellate court which would tee up a final decision by the U.S. Supreme Court. We explain below what self-employment taxes are, how they apply to partnerships and LLCs, how the Sirius decision changes their landscape and steps that partnerships and LLCs can take to reduce them.

What is self-employment tax?

Self-employment taxes are how “self-employed” individuals (e.g., sole proprietors and service providers in law, medical, consultancy or other partnerships) pay into the federal retirement and healthcare systems. They include

• Old Age, Survivors and Disability Insurance (OASDI, a/k/a Social Security) which is 12.4% on a fixed amount of earnings per year adjusted for inflation ($184,500 for 2026) and
• Medicare, which is 2.9% on the first $200,000 of earnings and 3.8% on the rest per year.

Self-employment taxes are on top regular income taxes and can be costly. (For W-2 employees, these components are split between employer and employee contributions.)

How is it applied to partnerships and LLCs?

Sirius Solutions addressed Internal Revenue Code (Code) section 1402(a)(13) which says that earnings subject to self-employment tax exclude the pass-through share of income “of a limited partner, as such”. This statute was enacted in 1977, when there were only two types of partnerships under state laws: general and limited. Under state laws, each partner in a general partnership has management powers the same as any other partner and shares in the liability for the debts of the partnership (in addition to having liability for the partner’s own wrongful acts). In a limited partnership under state laws, however, only the general partners have full management authority and liability for partnership debts, whereas the “passive” limited partners have sharply less authority and liability for partnership debts. A limited partner may lose that limited liability shield by participating in management along with general partners, so it is important to document and operate limited partnerships so that limited partners do not step over that line.

Since 1977, the playing field has expanded for co-owners wanting to conduct a business through a pass-through entity (as opposed to a corporation) and we now have limited liability partnerships (LLPs), limited liability limited partnerships (LLLPs) and limited liability companies (LLCs). These new entities blur the lines between “active” and “passive” owners, allowing owners to actively participate in management and operations without losing limited liability protection. For example:

• California allows formation of LLPs. Only licensed professionals (g., attorneys, accountants and architects) can use an LLP and participate in management while limiting liability so long as clients are protected from malpractice (e.g., through insurance and/or deposit funded by the partners).
• California does not provide for formation of LLLPs, but Delaware (where the company in Sirius Solutions was formed) and Texas (where it operated) do. An LLLP offers liability protection to all partners (general and limited), unlike “traditional” limited partnerships where general partners are personally liable.
• Most states, including California, allow an LLC to be managed by its members (like a general partnership is managed by all its partners) or by one or more managers (like general partners managing a limited partnership or directors managing a corporation). In either case, however, an LLC member does not have personal liability for the LLC’s debts except in narrow circumstances (g., the member’s own wrongdoing).

Code section 1402(a)(13) is almost 50 years old and has not kept up with these new entities. To try to plug the gaps, the IRS in 1997 proposed (but never adopted) regulations (available here) (Proposed Regs) applying a “facts and circumstances” test to whether a person was a “limited partner” under Code section 1402(a)(13). This test went beyond the question of whether the person had limited liability and scrutinized the person’s actual role in the company (e.g., whether he or she had the power to contract for the entity or participated in the company’s business for more than 500 hours during a year).

What Sirius was about

Sirius Solutions, L.L.L.P. (Sirius) was a consultancy firm formed as an LLLP in Delaware and operating out of Houston and Dallas. A corporate entity served as the general partner and five individuals were limited partners. The IRS, auditing and applying the Proposed Regulations’ approach, concluded that the individuals were not “limited partners” under section 1402(a)(13) because of their involvement in Sirius’ management and operations and imposed self-employment tax on them all. The Tax Court upheld the IRS’s decision and applied a similar “facts and circumstances” test which went beyond the question of whether the limited partners had limited liability under state law. In doing so, the Tax Court followed its prior decisions in Denham Capital Management LP v. Commissioner and Soroban Capital Partners LP v. Commissioner.

On Sirius’s appeal, the Fifth Circuit reversed the Tax Court. The Fifth Circuit ruled that, under the plain words of section 1402(a)(13), their meaning under a legal and “dictionary” sense and the IRS’ own tax return instructions, limited liability under state law was the beginning and end of whether an individual was a “limited partner” for self-employment tax purposes. Additional inquiry into the individual’s role in management or operations was improper. (Implied but not stated in the decision was that any “fixes” were up to Congress by amending and updating section 1402(a)(13) and not the IRS’ job.)

This decision governs only in the Fifth Circuit (covering Texas, Louisiana and Mississippi only). Outside, taxpayers can proceed under this decision but the IRS can (and does) assert its contrary position in the Proposed Regs, as upheld by the Tax Court. Practitioners believe that the IRS will continue arguing its position and seek a split in the federal circuits which would land this matter before the U.S. Supreme Court for a final decision. In this regard, the Tax Court’s Denham and Soroban decisions are on appeal to the First and Second Circuits respectively.

Key takeaways?

• Monitor developments. Pay particular attention to what the First and Second Circuits do in Denham and Soroban. If either circuit (or another one) rules for the IRS, the resulting “circuit split” could land before the Supreme Court.
• Exercise caution. If you rely on Sirius outside the Fifth Circuit (Louisiana, Mississippi or Texas), the IRS can and will pursue a contrary position in an audit (and even in those three states the U.S. Supreme Court can always reverse Sirius).
• Document and structure. If limited partnership, LLC, LLP or LLLP owners with limited liability are participating in management and/or performing extensive services, then an IRS attack becomes more likely.
• Manager-managed LLCs. Consider structuring LLCs to be manager-managed and compensating managers through a fee subject to self-employment tax separate from LLC pass-through income.
• Protective refund claims. An LLC or partnership owner that followed the IRS’s position and paid self-employment tax might seek a refund under Sirius but there is a deadline (usually, 3 years after the return was filed). Even if the IRS says “no”, the taxpayer avoids blowing past the limitations period.

Jurisdictional considerations. Be aware of differences in local laws when forming and operating entities across state lines For example, the Sirius owners formed an LLLP in Delaware and could operate as such in Texas. California, however, does not provide for the formation of LLLPs but may allow a foreign LLLP to operate if it registers with the California Secretary of State.