On Jan. 16, the U.S. Court of Appeals for the 5th Circuit issued an opinion in Sirius Solutions, L.L.L.P. v. Commissioner holding that the “limited partner” exemption from self-employment tax under Section 1402(a)(13) applies to partners in limited partnerships that have limited liability under state law. In doing so, the 5th Circuit reversed the Tax Court and rejected the position of the IRS that the limited partner exemption applies only to passive investors under a functional analysis test. This is a significant development for fund managers who rely on the limited partner exemption.
Sirius represents the first appellate decision discussing the limited partner exemption since the Tax Court held that a functional analysis is required to evaluate eligibility under Section 1402(a)(13), even for individuals who are limited partners under state law. While the partnership in Sirius was engaged in business consulting, the court’s reasoning could apply to any state law limited partnership, regardless of the type of activity it performs.
Additional cases challenging the Tax Court’s functional analysis test for limited partner status involving fund managers are pending in other circuits, including those involving Soroban Capital Partners (2nd Circuit) and Denham Capital Management (1st Circuit). If either of those circuits rules in favor of the IRS, causing a split in circuits, the Supreme Court may decide to weigh in on the question.
In the meantime, the decision in Sirius likely provides additional comfort to fund managers and other service providers who have relied on their status as limited partners under state law to apply the limited partner exemption, particularly in the 5th Circuit.
The 5th Circuit defined limited partners for Section 1402(a)(13) purposes as members of state law limited partnerships that have limited liability. The court expressly declined to rule whether members of limited liability companies (LLCs), limited liability partnerships (LLPs) or other types of state law entities may qualify for the limited partner exemption.
Grant Thornton insight:
The Tax Court and IRS generally have applied a single test for purposes of the limited partner exemption for all entities classified as partnerships for U.S. federal tax purposes, regardless of their entity type under state law. Fund managers and other service providers holding interests in entities such as LLCs and LLPs and their tax advisors should address the implications of this ruling on their status as limited partners for purposes of Section 1402(a)(13). Grant Thornton will continue to monitor this and other pending cases across the country.
Contacts:
National Tax Leader, Partnership Tax Solutions
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Julie is a principal in Partnership Tax Services with Grant Thornton’s Chicago office. She focuses on partnership compliance and consulting services and has provided tax services to a variety of clients over her nearly 20 years of public accounting experience.
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Washington National Tax Office
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Grace Kim has more than 20 years of experience in the area of partnership taxation, which includes IRS, law firm and accounting firm positions. Her diversified experience includes working on a broad range of structuring and operational issues in a variety of industries and areas.
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