The Tax Navigator – Sirius Solutions LLP v. Commissioner: What’s a Limited Partner for Self-Employment Tax?

Join Sean Muller, The Tax Navigator, as he unpacks a taxpayer-friendly Fifth Circuit ruling that rejects the IRS’s functional test and clarifies when limited partners, including those who provide services, may be exempt from self-employment tax.

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Detailed Description of The Tax Navigator – Sirius Solutions LLP vs. Commissioner: What’s a Limited Partner?

00:00:00
Sean: So, we had a big case last Friday that got settled in the Fifth Circuit. The majority opinion dealt with Sirius Solutions, and it dealt with whether a limited partner is subject to self-employment tax.

00:00:13
Sean: There were two other cases that are in the First and Second Circuits right now that were settled by the Tax Court that were not taxpayer-friendly. And they basically subjected limited partners to self-employment tax. Some of these numbers are quite large.

00:00:27
Sean: And so, we thought that the tide was really turning and they were going to this functional test. So, I’m going to read the section that has been dealt with this forever. It’s been around forever.

00:00:38
Sean: And the ruling says, “There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707.”

00:00:51
Sean: So really what’s happened here is this functional test is that if it looks like a duck, it is a duck, regardless of if we call it a bird. That’s what happened in the other two cases.

00:01:02
Sean: And so, they looked at these partners in a partnership and they said, “You’re providing significant services to the partnership. I don’t care if they call you a limited partner. You’re not a limited partner, so all of your income is subject to self-employment tax.” So, they applied this functional test.

00:01:15
Sean: This Fifth Circuit case was also a Tax Court case and was dependent on what had already been settled. So, they made it un-taxpayer friendly, IRS won, go to the Fifth Circuit, they appeal the case again.

00:01:31
Sean: Two of the three judges in the case said this functional test doesn’t work. We are looking to the strict state law definition of a limited partner. So, a limited partner in a limited partnership can be treated with limited not to be self-employment tax.

00:01:48
Sean: The three things they looked at was the IRS regulations — or sorry, IRS instructions — to their form for many, many years that talked about this exact definition.

00:02:01
Sean: And so, if you’re a limited partner, you’re not subject to self-employment tax. The Social Security Administration doesn’t give you credit for your self-employment earnings if you’re a limited partner. So, they looked at the Social Security Administration that came to a different opinion.

00:02:21
Sean: The big part of this case here is the other cases focused on “as such.” And so, when they looked at that and said, the substance of reform, I don’t care if you say you’re a limited partner, are you truly a limited partner, which means you’re a passive investor in order to get this exclusion.

00:02:29
Sean: The Fifth Circuit looked at the next section we talked about with guaranteed payments. And so, their position was that the IRS and the treasury — actually, Treasury — when they wrote the rules, they envisioned a situation where a limited partner could actually provide services to the partnership because they made reference to a guaranteed payment.

00:02:49
Sean: And so, their question was, why would you have a definition about guaranteed payments that implies that you allow to do services? If you wanted it to be only passive investors, not to be the self-employment tax, you should have written it as such.

00:03:05
Sean: So, two of the three judges wrote that. It’s a very taxpayer-friendly rule.

00:03:09
Sean: We really thought over the last couple of years that this limited partner “loophole,” that’s been called was really going to go out the window and you’re really going to have to look to see walks like a duck, it is a duck.

00:03:20
Sean: But this provides more clarity that at least in the Fifth Circuit, you can continue to treat a limited partner as a limited partner, not to be self employment tax.

00:03:29
Sean: Very interesting ruling for sure and more to come around that.

This episode of The Tax Navigator was recorded prior to publication. Some references or updates discussed may reflect information current as of the recording date.