Limited Partners and Self-Employment Tax: What Alabama Business Owners Should Know
Developments through October 8, 2026
A limited partner who works in the partnership’s business may still qualify for the self-employment tax exclusion on their share of partnership profits. Recent appellate decisions focus on the partner’s role in managing or running the business, although the courts do not articulate identical standards. The decisions offer a narrower path to the exclusion than the Fifth Circuit’s January 2026 opinion initially suggested.
In January, the Fifth Circuit’s decision in Sirius Solutions appeared to offer a broad taxpayer victory based on limited liability under state law. The court subsequently withdrew that opinion and replaced it, and the Second Circuit has now ruled as well. Business owners and investment managers who relied on the January decision should revisit their analysis. For Alabama businesses, neither decision is binding, and the Tax Court’s own standard generally applies.
The statutory rule
A partner’s share of partnership trade or business income generally enters the calculation of net earnings from self-employment, whether or not the income is distributed. Section 1402(a)(13) excludes the distributive share of a qualifying limited partner, but preserves self-employment tax treatment for guaranteed payments compensating that partner for services.
The exclusion concerns self-employment tax. It does not exempt partnership profits from income tax. The statute does not define “limited partner,” leaving courts to determine who qualifies.
The Fifth Circuit’s revised approach
In Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), the Tax Court adopted a functional analysis focused on whether a partner acted as a passive investor. A state-law limited partner designation did not resolve the question.
The Fifth Circuit initially rejected that approach. On August 12, 2026, however, it replaced its January opinion in the same litigation, now captioned K Alain, L.L.L.P. v. Commissioner.
The replacement opinion focuses on whether a partner plays a significant role in managing or running the business. It continues to reject the Tax Court’s passive-investor standard, but limited liability alone no longer establishes eligibility. The court vacated the Tax Court’s decision and remanded without determining whether the partners qualified.
For working partners, the distinction between providing services and managing the enterprise matters. The revised opinion suggests that a limited partner may take part in nonmanagerial aspects of the business, but it does not define what makes a role significant.
The Second Circuit’s decision
On September 17, 2026, the Second Circuit affirmed the Tax Court in Soroban. It held that a limited partner must have limited liability and must not run, manage, or control the partnership’s business. The three principals exercised managerial control, including investment responsibilities, seats on the firm’s governing committees, and personnel decisions, and their distributive shares were subject to self-employment tax.
The court acknowledged that a partner may provide some services and still qualify, provided those activities do not constitute controlling, managing, or running the business. It also suggested that its interpretation of the Fifth Circuit’s standard differed little from the Tax Court’s approach.
Whether the Fifth Circuit’s significant-role threshold produces different outcomes for partners with limited managerial responsibilities remains unresolved.
What this means in Alabama
Alabama is in the Eleventh Circuit, which has not issued a controlling decision resolving this limited-partner question. For a Tax Court case appealable there, the Tax Court generally continues to apply its own Soroban analysis absent controlling appellate authority. That analysis examines whether the partner functions as a passive investor. In a partnership-level proceeding, appellate venue generally follows the partnership’s principal place of business under section 7482(b)(1), not an individual partner’s residence.
The Fifth and Second Circuit decisions may support legal arguments in an Alabama-related dispute, but neither binds the Eleventh Circuit. Alabama taxpayers should not assume that the Fifth Circuit’s revised standard governs their reporting position.
As of this post’s date, K Alain remains on remand and Denham Capital Management remains pending in the First Circuit. The boundary between permissible services and disqualifying management remains uncertain, as Morgan Lewis’s October update notes. These limited-partnership cases also should not be treated as settling eligibility for LLC members or LLP partners.
Practical steps
A partnership excluding partners’ distributive shares from self-employment tax should review the position with tax counsel. Useful questions include:
What management decisions does each partner actually make?
How are profit allocations distinguished from guaranteed payments for services?
Do the governing documents match actual business operations?
Which court’s precedent would govern a dispute?
Did any reporting position or proposed refund claim rely on the withdrawn January opinion?
For a working limited partner, eligibility requires a careful connection between actual responsibilities and the governing legal standard. A title in a partnership agreement cannot supply that analysis.
This post provides general information, not legal or tax advice, and reading it does not create an attorney-client relationship. Consult a qualified tax professional about your own facts before acting.
Bowman Law Firm, LLC, Gene M. Bowman, Tax Attorney, Huntsville, Alabama
