Limited Partners Win Self-Employment Tax Battle, War Continues

Partners in investment funds and other partnerships have won a key court victory over whether they must pay Social Security and Medicare taxes. But the fight is far from over.

A federal appeals court’s ruling late last week makes it easier for limited partners—including many partners in hedge funds, private-equity firms, and professional-services businesses—to be exempt from paying self-employment taxes that help fund Social Security and Medicare. The US Fifth Circuit Court of Appeals ruled in favor of Sirius Solutions LLLP, a Houston consulting firm, and threw out a US Tax Court ruling that had sided with the IRS and its narrower view of when limited partners can be exempt.

While the ruling is binding only in the states covered by the Fifth Circuit— Texas, Louisiana, and Mississippi—cases involving very similar issues are still pending in two other federal appeals courts. If one or both of those courts sides with the government, that would create a split among circuits that may well prompt the US Supreme Court to decide the issue.

The Fifth Circuit ruling is “much anticipated and certainly impactful,” but it “does not end the debate,” said Jennifer Breen, a partner at Morgan, Lewis & Bockius LLP.

“I almost certainly think that the Supreme Court will take this up,” said Jerry Musi, a tax partner at RSM US LLP.

Sirius and its advocates argue that the exemption has long been interpreted the way Sirius did, and that the IRS has tried to change course. “This ruling brings clarity back to a part of the tax code that never should have been controversial in the first place,” said Mary McNulty, a partner at Holland & Knight who represents Sirius, in a statement.

Some criticized the decision. The ruling “would effectively allow wealthy taxpayers to elect out of paying employment taxes on labor income,” Miles Johnson, a senior attorney adviser at the Tax Law Center at New York University’s School of Law, said in a statement. Other courts “should resist the Fifth Circuit’s interpretation,” he said.

A Treasury spokesperson couldn’t be reached for comment on the Fifth Circuit ruling.

Limited Partner Definition

Under the tax code, limited partners’ share of income from a partnership is excluded from the earnings used to calculate self-employment tax. But Sirius Solutions and the IRS clashed on the definition of a “limited partner” who qualifies for the exemption.

The law says only that a “limited partner, as such” is eligible. In Sirius’s view, that means any limited partner who has limited liability under state law. In the IRS’s view, that means only limited partners who are “passive investors,” rather than active participants in a partnership’s business.

The Tax Court agreed with the IRS. But the Fifth Circuit overruled the Tax Court, in a 2-1 ruling on Jan. 16, relying on the dictionary to declare that a limited partner is “a partner in a limited partnership that has limited liability.”

Miri Forster, a partner at Eisner Advisory Group LLC, said the ruling “represents a significant victory” for taxpayers, “although not necessarily the final one. A key question remains: Will other circuits follow suit?”

The First Circuit and Second Circuit also have pending cases before them over the self-employment tax exclusion for limited partners. The First Circuit case involves Denham Capital Management LP; the Second Circuit case involves Soroban Capital Partners LP. Those appeals aren’t as far along as the Sirius case; they haven’t had oral arguments yet.

Walter Schwidetzky, a law professor at the University of Baltimore, predicted those circuits “will not find the panel’s decision persuasive and rule for the IRS,” causing a split. It didn’t seem to bother the Fifth Circuit that partners in a consulting business like Sirius weren’t paying any self-employment taxes, he said, describing the ruling as “not a great outcome for taxpayers writ large.”

The self-employment tax issue has also attracted attention because Democrats accused Treasury Secretary Scott Bessent during his confirmation hearing of using the exemption at the hedge fund he founded before joining the government, benefiting him by hundreds of thousands of dollars a year.

According to a memo compiled by Democratic staff on the Senate Finance Committee, Bessent’s interest in Key Square Group LP, the hedge fund he founded, was structured to avoid self-employment taxes. President Donald Trump’s transition team said at the time of the confirmation hearing that Democrats didn’t show Bessent violated the law and were being “subjective” in interpreting the tax code. The Fifth Circuit ruling essentially sides with Bessent’s position.

Democrats should “close this loophole” when they’re back in control of Congress “so ultra-wealthy partners like Scott Bessent can no longer skip out on paying their fair share into Medicare,” Sen. Ron Wyden (D-Ore.), the ranking Democrat on the Senate Finance Committee, said in a statement Tuesday.

The case is Sirius Sols. LLLP v. Commissioner, 5th Cir., No. 24-60240, 1/16/26