Sponsors To Consider Options in Wake of Recent Court Rulings That Narrow Limited Partner Exceptions From Self-Employment Tax

Recent decisions by two federal courts of appeals suggest a significant shift in the legal landscape for fund sponsors, management companies and independent sponsors that have relied (or considered relying) on the limited partner exception to exclude allocable shares of net fee income from self-employment tax.

On Sept. 17, 2026, the U.S. Court of Appeals for the Second Circuit issued its long-awaited decision in Soroban Capital Partners LP v. Commissioner, affirming the Tax Court and holding that the term “limited partner” under Section 1402(a)(13) of the Internal Revenue Code of 1986, as amended, requires both (1) limited liability for partnership debts and (2) a lack of participation in the management or control of the partnership’s business. While the Soroban decision is binding as a matter of law only in the Second Circuit (if and when it becomes final), the Second Circuit’s decision comes shortly after the Fifth Circuit’s Aug. 12, 2026, revised opinion in K Alain LLLP v. Commissioner (formerly known as Sirius Solutions), in which the Fifth Circuit withdrew its earlier, more taxpayer-friendly opinion and adopted a functional standard closely aligned with the Tax Court and, now, the Second Circuit.

Background

Under the Code, a partner’s distributive share of partnership income generally is subject to self-employment tax (currently 15.3% combined for Social Security and Medicare, with a 0.9% additional Medicare tax for high earners). Code Section 1402(a)(13), however, excludes from self-employment income the distributive share of a “limited partner, as such,” other than guaranteed payments for services.

When the exception was enacted by Congress in 1977, limited partners generally were understood to be passive investors. As partnership law and structures evolved over the years to allow partners with limited liability to participate in management, the statute’s failure to define “limited partner” led to litigation over whether the exception applies to active managers or only passive investors.

The Second Circuit’s Decision in Soroban

Soroban Capital Partners LP v. Commissioner involved a Delaware limited partnership that served as an investment manager to hedge funds. Its three founding principals received approximately $141.5 million in 2016 and 2017 while working full-time (about 2,300 to 2,500 hours per year) managing investments, serving on governing committees, and overseeing hiring, firing, and operations.

Soroban paid the principals material guaranteed payments, but did not report the principals’ residual distributive shares as self-employment income, claiming they were “limited partners” within the meaning of Code Section 1402(a)(13). The IRS disagreed and issued notices of adjustment. The Tax Court ruled in favor of the IRS, and Soroban appealed to the Second Circuit.

The Second Circuit held unanimously that “limited partner” under Code Section 1402(a)(13) requires both (1) limited liability for partnership debts and (2) a lack of participation in managing or controlling the partnership’s business.

The court’s review of the term’s original meaning, the statute’s “as such” language and the legislative history all pointed the court to the conclusion that limited partners should be understood to be passive investors who did not manage the business.

Because the three principals exercised full managerial control over Soroban’s operations, including working full-time, managing investments, overseeing personnel and controlling all key business decisions, the court concluded they were not “limited partners” within the meaning of Code Section 1402(a)(13). Their distributive shares were therefore subject to self-employment tax.

The Second Circuit reserved for the possibility that a partner could still play a role in the partnership and qualify as a “limited partner” under Code Section 1402(a)(13) so long as the partner’s activities do not rise to the level of controlling, managing or running the business.

The Fifth Circuit’s Revised Opinion in K Alain (Sirius Solutions)

The Second Circuit’s decision in Soroban came about a month after the Fifth Circuit came to similar conclusions in a case that initially went the other way.

In January 2026, the Fifth Circuit ruled in K Alain LLLP v. Commissioner (formerly Sirius Solutions LLLP v. Commissioner) that state-law limited partner status (i.e., limited liability alone) was sufficient to qualify for the exception under Code Section 1402(a)(13). That opinion was widely viewed as a significant win for taxpayers and prompted some fund sponsors to file refund claims.

However, on Aug. 12, 2026, the Fifth Circuit withdrew its January opinion and issued a revised decision holding that a “limited partner” under Code Section 1402(a)(13) is “a partner who plays no significant role in managing or running a business.” The Fifth Circuit did, however, acknowledge that providing some services does not automatically disqualify a partner from the exception; only “significant” management or control is disqualifying.

With the Second and Fifth Circuits aligned on a functional test, the legal landscape appears to have shifted decisively against taxpayers who relied solely on state-law limited partner status to claim the exception.

Practical Implications for Fund Sponsors and Independent Sponsors

The Second and Fifth Circuit opinions have potentially significant practical implications for fund sponsors, management companies and independent sponsors:

• The LP exception will be difficult to sustain for active principals. Fund sponsors and management company principals who actively manage investments, make business decisions or oversee operations will have to proceed with caution if they choose to claim the limited partner exception for their allocable shares of net fee income (management fees, incentive fees and similar service-related income). Both circuits now require a functional analysis of the partner’s role, not merely state-law classification.
• Fee income is the primary target. The decisions focus on income derived from management and services. Partners whose income is primarily fee-based (as is typical for fund managers, private equity sponsors and independent sponsors managing deals) are squarely within the scope of the courts’ holdings.
• Partners providing limited services may still qualify. The Second Circuit acknowledged that a partner who provides some services but does not manage or control the partnership may still qualify as a limited partner. The Fifth Circuit similarly noted that only “significant” management activity is disqualifying. However, the line between permissible and disqualifying activity remains fact-intensive and uncertain.
• Refund claims based on the original Sirius opinion should be reevaluated. Sponsors who filed protective refund claims or amended returns in reliance on the Fifth Circuit’s January 2026 opinion in Sirius Solutions should carefully reassess those positions in light of the revised opinion.
• A First Circuit decision is pending. The First Circuit heard oral argument in February 2026 in Denham Capital Management LP, which involves private equity management firm principals. A First Circuit decision could provide additional clarity, but given the Second and Fifth Circuit alignment, a different outcome may be unlikely.

Considerations and Planning Alternatives

In light of these developments, fund sponsors and independent sponsors should consider consulting with counsel on the following:

• Review current structures. Partnerships should evaluate whether principals or key individuals are relying on the limited partner exception for self-employment tax purposes and assess the risk of those positions under the current judicial framework.
• S corporation planning. One of the most commonly used alternative planning techniques is holding management company interests through an S corporation. Under this structure, a principal forms a wholly-owned S corporation to hold its management company interest; the S corporation pays reasonable compensation to the principal as an employee (subject to employer- and employee-side employment taxes); and any distributions from the S corporation to the principal as an S corporation shareholder are not subject to self-employment tax as a matter of law. This approach has been validated by courts in other contexts and does not depend on the limited partner exception. The “reasonable compensation” standard requires careful analysis to ensure the salary paid is defensible based on the facts and circumstances, but this structure offers a more reliable path than the increasingly constrained LP exception. That said, the timing for implementation of this structure and the benefits and burdens of it should be carefully discussed with tax counsel. This strategy may not be appropriate for all principals based on their individual circumstances.
• Distinguish service income from investment returns. For sponsors who earn both fee income and investment returns, careful documentation and allocation of income streams may help support an argument that at least a portion of the partner’s distributive share is earned “as” a limited partner (i.e., in a passive investment capacity). The Second Circuit’s “as such” analysis leaves this door open, but the facts and documentation must be compelling.
• Monitor ongoing developments. The First Circuit’s pending decision in Denham, future court cases, and any potential legislative or regulatory action should be monitored closely. While the current trend strongly favors the IRS’s functional approach, future guidance could further define (or narrow) the boundaries of the exception.

The Tax Team at McGuireWoods regularly advises fund sponsors, independent sponsors and management companies on self-employment tax planning, other sponsor tax planning and partnership structuring. For more information about the implications of the Soroban decision or to discuss or employ self-employment tax planning strategies, contact Andrew Chan, Sabrina Conyers or a member of your client service team.