The Refs Review The Play: Fifth Circuit Tightens The Rules For Self-Employment Taxes On Partnership And LLC Owners

Our January 2026 eAlert explained the Fifth Circuit Court of Appeals’ decision in Sirius Solutions L.L.L.P. v. Commissioner, 165 F.4^th 374 (5^th Cir. 2026) (Sirius I), which was good news for pass-through owners because it could reduce their self-employment taxes. The Fifth Circuit has revisited Sirius I in K Alain, L.L.L.P. v. Commissioner, full text available here (the taxpayer had changed its name, but we’ll still call this decision Sirius II) and moved to a less pro-taxpayer position (though still not as far as the IRS wanted). While the taxpayer in this case still technically “won” (it gets another chance to argue its case in the lower court), the modified decision makes it harder for business owners to claim they don’t owe self-employment taxes on their share of business earnings. Below we explain the Sirius II decision, what to expect in future court cases and what steps partnerships and LLCs might still take to reduce self-employment tax.

What does Sirius II say that Sirius I didn’t?

As we explained in our prior eAlert, Sirius I was pro-taxpayer because it adopted a clear-cut rule: Pass-through owners with limited liability under state law were “limited partners” under Internal Revenue Code (Code) section 1402(a)(13) and therefore not subject to self-employment tax under that statute, and the inquiry stopped there so that an owner’s role in management and operations wasn’t relevant. This overturned the Tax Court, which had used a “functional” test whereby only owners that functioned solely as passive investors could be “limited partners” without self-employment tax liability under Code section 1402(a)(13).

The government complained that Sirius I created an obvious loophole: A company owner could be completely hands-on, running every aspect of the business, but still avoid self-employment taxes by having a state law limited liability shield. (In fact, the partners in Sirius I controlled everything in their partnership’s business and never disputed that in the litigation.) In Sirius II, the Fifth Circuit did address these concerns and reconsidered its position. However, the Fifth Circuit didn’t move all the way to the Tax Court’s strict “functional” test which was what the IRS wanted. Rather, the Fifth Circuit adopted a middle-ground “significance” test which looks at how involved a pass-through owner is in the business. If the owner’s role is “significant” then he or she is not a “limited partner” under section 1402(a)(13) and therefore must pay self-employment tax.

What is the future litigation landscape post-Sirius II?

The Sirius II decision, like Sirius I before it, covers only in the Fifth Circuit (Texas, Louisiana and Mississippi). Taxpayers in other states can still try to use the Sirius II approach, but the IRS will likely keep fighting to use the “functional” test in other courts to create a disagreement between different federal appeals courts. When courts disagree like this (a “circuit split”), the U.S. Supreme Court often steps in to make a final, nationwide decision. As we noted before in our prior eAlert, two other cases dealing with the same issue – Denham Capital Management LP v. Commissioner and Soroban Capital Partners LP v. Commissioner – are currently on appeal to the First and Second Circuits respectively. Those appellate courts haven’t decided yet.

Key Takeaways

• “Classic” limited partnerships are probably still safe. If you’re a limited partner in a traditional limited partnership under state law, you should still qualify as a “limited partner” for tax purposes and avoid self-employment tax under Sirius II. Here’s why: In a classic limited partnership and as our prior e-alert notes, limited partners lose the limited liability shield if they get involved in management like a general partner. So limited partners in these structures typically stay hands-off anyway, which means they’re unlikely to have the kind of “significant” involvement that would trigger self-employment tax under Sirius II’s new test.
• Owners of LLCs and similar entities might have reason to worry. If you own part of a limited liability partnership (LLP), limited liability limited partnership (LLLP) or limited liability company (LLC), you might face problems. As our prior eAlert notes, these structures let you keep your liability protection even if you’re heavily involved in running the business. Under the old Sirius I rule, that liability protection alone might have shielded you from self-employment tax, but that rule changed under Sirius II. Now you need to ask: Is my role in managing the business “significant”? If so, you’ll owe self-employment tax.
• Figure out what “significant” means for your situation. Sirius II didn’t clearly define what counts as “significant” involvement. For guidance, one might look at the IRS’s proposed rules from 1997. Those rules say you’re not a limited partner if you have the authority to sign contracts for the business or if you worked in the business for more than 500 hours in a year. While these proposed rules don’t define “significant” exactly, they give you a useful starting point for evaluating your own situation. Note that the IRS also uses the 500-hour-per-year test in determining whether a business owner is “passive” under Code section 469, which limit the ability of “passive” owners to reduce their taxes using business losses.
• Keep watching for new court decisions. Even though Sirius II backed away from a simple liability-only test, the legal battle isn’t over. Watch for decisions in the Denham and Soroban cases from the First and Second Circuits. If either court adopts the IRS’s stricter “functional” test, we’ll have a “circuit split” which could push the issue to the Supreme Court for a final answer. Worth noting here: Sirius II reflected the government’s position.
• Consider filing for a refund. If you followed the IRS’s strict “functional” test and paid self-employment tax, you might be able to get some money back by filing a refund claim under Sirius II. But act quickly – you typically have a deadline of three years after you filed your return. And, even if the IRS denies your refund request, filing the claim protects your right to keep fighting for it later.