Virtually all of you who practice in the flow-through arena likely have been following the controversy as to who qualifies as a limited partner for purposes of the §1402(a)(13) exclusion from self-employment tax. Over the last few years, we have reported on taxpayer losses in the Tax Court cases of Soroban Capital Partners (on appeal to the 2nd Circuit) and Denham Capital (on appeal to the 1st Circuit) where the partners in a hedge fund manager and an investment manager, respectively, were shot down in reporting significant SE tax exclusions. These cases applied a “functional analysis,” and determined that because the “limited partners” controlled the partnership business and worked full-time in the business, these taxpayers essentially were acting as general partners and therefore, did not qualify for the SE tax exclusion. Essentially, the Tax Court applied what is referred to as a “passive investor” standard.

Then, on January 16, 2026, the 5th Circuit handed the taxpayer a major victory in Sirius Solutions (No. 24-60240) (now named K Alain, L.L.L.P.), a controversial two-to-one decision, where the court indicated that because the limited partners were categorized as such under state law, such partners qualified for the SE tax exclusion, notwithstanding the relevant partners were full-time, controlling persons in the partnership. This decision was applauded by some tax professionals and heavily criticized by others. Importantly, Sirius led many tax professionals to reconsider prior reporting decisions, current reporting decisions and partnership structuring decisions. Unfortunately for many taxpayers, this victory was short-lived, as yesterday the 5th Circuit vacated its original decision and replaced it with a victory for the IRS.

The 5th Circuit held that a limited partner “is a partner who plays no significant role in managing or running a business,” which certainly was not the case with the Sirius partners (or for that matter the partners in Soroban and Denham). This 5th Circuit conclusion largely was based on the definition of a limited partner when §1402(a)(13) was drafted in 1977, a time when it generally was understood that a limited partner was one who did not control the partnership’s business (although some participation was permissible). At the same time, the 5th Circuit rejected the Soroban “passive investor” standard, with the 5th Circuit indicating that the Tax Court was in error in barring “even the most minor involvement” in the partnership’s affairs as disqualifying eligibility for the limited partner SE tax exclusion. Instead, the 5th Circuit focused on the concept of “control.” However, that was it – no definition of “control” and no discussion of whether a partner could receive a return on capital and wear two hats, one as a limited partner with respect to a return on capital and one as a “general partner” with respect to services rendered. In fact, the analysis provided by the majority was only six double-spaced pages, and it focused strictly on the definition of limited partner back in 1977.

Judge Graves, who dissented in both the vacated opinion and yesterday’s opinion, expressed the view that the majority missed the mark when it focused on control and when the majority rejected the passive investor standard. Of course, what constitutes a “passive investor” is unclear. Of interest is the following observation near the end of the dissent:

So, what do we as professionals do? Certainly, income of controlling or actively involved service providers in personal service businesses will have a tough road in being classified as non-SE income, pending what we hear from the 1st and 2nd Circuits. But, what if there are partners in such businesses who have contributed significant capital, such as PE Funds that have acquired interests in CPA firms, and some of the PE Fund owners sit on the Board of Managers of the partnership – is 100% of their share of partnership income at risk? And what about the non-personal service partnerships where capital providers also are service providers – can such persons qualify for a partial SE tax exclusion? Is it an all-or-nothing standard? The 5th Circuit decision is not terribly instructive. Moreover, what approach will be taken by the IRS outside the personal service arena? Lots of questions and not a lot of answers. What we do know is that the glee felt by many taxpayers after the issuance of the original Sirius decision has been replaced with gloom.

Needless to say, Sirius and structuring considerations to maximize the SE tax exclusion will be a major topic of discussion at both of this year’s Tax Planning Forum® and Fundamentals of Flow-Through® programs. We hope that you will consider attending either or both of these virtual or in-person programs or our new Fundamentals QAS self-study program. Registration is in full swing, and we encourage you to register soon, especially if you are interested in either of our in-person programs in Las Vegas or Orlando where space is limited.