Fifth Circuit Withdraws Prior Opinion and Adopts a Management Standard for the Self-Employment Tax Exception Under Code Section 1402(a)(13)

Background

A partner’s distributive share of a partnership’s trade or business income is generally subject to self-employment tax. Code Section 1402(a)(13) creates an exception to this general rule for the distributive share of a “limited partner, as such.” The Code does not define “limited partner” for this purpose. The Tax Court, applying a “functional analysis test,” has held that the exception in Code Section 1402(a)(13) does not turn on whether a partner is a limited partner under state law, but rather applies only to a partner who functions as a “passive investor.”

On January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit rejected the Tax Court’s functional analysis test and held that the term “limited partner” means a partner who, under state limited partnership law, has limited liability status in a limited partnership (the Prior Opinion). 

Following the issuance of the Prior Opinion, the government petitioned the Fifth Circuit for rehearing en banc. On August 12, 2026, the Fifth Circuit denied rehearing en banc, treated the petition as one for panel rehearing, granted it, withdrew the Prior Opinion, and substituted a new one (the New Opinion).¹  The New Opinion again vacates the Tax Court’s decision and remands the case, this time on a different reading of the term “limited partner” in Code Section 1402(a)(13).

What Changed

Under the Prior Opinion, the Fifth Circuit indicated that the determination of whether a person was a “limited partner, as such” turned on limited liability status under state limited partnership law. Under the New Opinion, the Fifth Circuit applies a different standard. Based on the court’s analysis of the “original public meaning” of what it meant to be a “limited partner” at the time the Code Section 1402(a)(13) exception was enacted, the New Opinion provides that a “limited partner, as such” is one “who plays no significant role in managing or running a business.” Thus, under the Fifth Circuit’s new standard, “some participation is allowed, so long as the partners do not exercise control over the business.” 

The New Opinion again rejected the Tax Court’s “passive investor” test but did not decide whether the taxpayer’s limited partners satisfied the standard in the New Opinion.

Unaddressed Issues

The New Opinion leaves several questions unresolved, including:

• Whether an individual may hold, directly or indirectly, the dual status of general partner as to part of the individual’s interest in a partnership (through which the individual manages and runs the business of the partnership), and limited partner as to a different portion of the individual’s interest in a partnership.
• Whether an individual’s role and responsibilities as an employee of an affiliate of a partnership bear on whether the individual is considered to play a significant role in managing or running the partnership’s business in the individual’s capacity as a limited partner in the partnership.
• Whether members of limited liability companies and other legal entities classified as partnerships for U.S. federal income tax purposes, but not formed as state law limited partnerships, may qualify as Code Section 1402(a)(13) limited partners if they are not limited partners as a matter of state law, but nevertheless do not play a significant role in managing or running the entity’s business.

Other Pending Appeals and Potential Circuit Split

Appeals from decisions applying the Tax Court’s functional analysis test are also pending in the First and Second Circuits. The Prior Opinion was the first opinion by a circuit court of appeals to address the Tax Court’s functional analysis test. The Fifth Circuit’s unusual decision to withdraw that opinion and adopt a different standard adds uncertainty to an already unsettled area of federal income tax law. The New Opinion, however, continues to reject the Tax Court’s functional analysis test. If either the First or Second Circuit sustains that test, that court will create a circuit split. The Supreme Court may be more likely to grant a petition for certiorari if such a split arises.