A recent Fifth Circuit decision, Sirius Solutions LLLP v. Commissioner, brought welcome news for the investment funds industry. In Sirius, the Fifth Circuit held that the Self-Employment Contributions Act ("SECA") "limited partner exception" does not require a partner to be a "passive investor," as the IRS and the Tax Court had previously indicated. Instead, a taxpayer qualifies for the limited partner exception if it is "a limited partner in a state-law limited partnership that is afforded limited liability."
Section 1402(a)(13) generally exempts the distributive share of partnership income allocable to a "limited partner, as such," from self-employment tax, but the term "limited partner" is not defined. In several recent Tax Court cases, the Tax Court adopted the IRS's passive investor standard and reasoned that a "functional analysis" should be applied to assess whether state law limited partners act like passive investors. The Tax Court accordingly ruled that certain state law limited partners were not passive investors and so not eligible for the limited partner exception because, among other activities, they managed portfolios, monitored and hedged transactions, and executed trades.
In rejecting the Tax Court's functional analysis approach, the Fifth Circuit instead focused on the statutory text and ordinary meaning of "limited partner" at the time of the limited partner exception's enactment. In support thereof, the Fifth Circuit referenced historic instructions in IRS forms that defined limited partners according to the existence of limited liability and not the activities conducted by those partners. As a further argument against the passive investor standard, the Fifth Circuit cited the limited partner exception's statutory text, which explicitly contemplates limited partners rendering services to a partnership without losing their ability to rely on the limited partner exception.
The Sirius decision represents the first U.S. federal appellate court decision on the limited partner exception. Two other similar cases are currently pending before the First and Second Circuits, as discussed here and here. While the Sirius decision is binding on taxpayers in the Fifth Circuit, it is not binding in other jurisdictions. Taxpayers in the Fifth Circuit may consider revisiting their structures against the Sirius test, bearing in mind that Sirius applies only to limited partnerships, and the opinion specifically states that it does not discuss whether members of another entity, such as a limited liability partnership or limited liability company, may also qualify for the limited partner exception. Taxpayers in other jurisdictions should continue to monitor the outstanding appellate cases.
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