Fifth Circuit Rejects “Passive Investor” Test for Code Section 1402(a)(13) Limited Partner Exception

On January 16, 2026, the U.S. Court of Appeals for the Fifth Circuit held that the term “limited partner” in Code Section 1402(a)(13) means a partner who, under state limited partnership law, has limited liability status in a limited partnership, rather than only a partner who functions as a mere “passive investor.”¹ The court reached that conclusion by interpreting the term according to its ordinary meaning at enactment and interpreting the statute, including its separate treatment of guaranteed payments for services, as confirming that limited partners may perform services without losing limited partner status.

 

Applying that interpretation, the Fifth Circuit vacated the Tax Court’s decision, which had applied a functional analysis test that was not referenced in the statute and remanded the case for further proceedings consistent with the Fifth Circuit’s reading of the statute.

Code Section 1401 imposes tax on “self-employment income” (SECA), which is generally measured by “net earnings from self-employment.” Code Section 1402(a) generally includes a partner’s distributive share of income from a partnership trade or business in “net earnings from self-employment.” Code Section 1402(a)(13), however, excludes “the distributive share of any item of income or loss of a limited partner, as such,” while preserving self-employment taxation for certain guaranteed payments for services (by cross-reference to Code Section 707(c)).

 

The Tax Court has held in several cases that Code Section 1402(a)(13) requires a functional inquiry into whether a partner acts as a “limited partner.” Under that approach, the Tax Court ignored whether partners were treated as limited partners under state law, and instead focused on whether the partners’ time, skill, and judgment were essential to the business; whether they exercised managerial authority, served on committees, or could bind the partnership; whether they devoted material efforts to the business; how the partnership marketed the partners’ expertise to clients; and whether the partners’ distributive shares bore a meaningful relationship to capital contributions.

 

The Fifth Circuit expressly rejected the Tax Court’s functional analysis test as inconsistent with the statutory text and ordinary meaning of the term “limited partner.” The Fifth Circuit treated “limited partner” as an undefined statutory term and interpreted it by reference to ordinary meaning at the time of the statute’s enactment, concluding that the defining attribute of a limited partner for Section 1402(a)(13) purposes is limited liability in a state law limited partnership. The court rejected the Tax Court’s mere “passive investor” interpretation of the term “limited partner,” reasoning that Section 1402(a)(13) contemplates that a limited partner may perform services without losing limited partner status, and that the statute’s reference to acting as a limited partner “as such” can operate to distinguish amounts allocated to a partner in a limited partner capacity from amounts allocated to the same partner in a general partner capacity, without necessitating an activity-based test.

 

The Fifth Circuit expressly limited its holding to partners in state law limited partnerships and stated in a footnote that it was not addressing whether members of other entity types, such as limited liability partnerships or limited liability companies, may qualify for the Code Section 1402(a)(13) limited partner exception. The court also made clear that the federal meaning of “limited partner” does not depend on state law labels, but on whether state law confers the substantive attributes of a limited partnership and limited liability, with federal law then determining the tax consequences of those state-created interests.

 

The Fifth Circuit’s decision squarely conflicts with numerous Tax Court decisions, two of which have appeals pending before the First and Second Circuits. That divergence places the Fifth Circuit at odds with the analytical framework now under review in those cases, creating the potential for further development on the proper interpretation of the limited partner exception.