Editor’s note: This article was first published on Nov. 17, 2025. Since then, the Fifth Circuit has issued two opinions addressing the limited-partner exception to self-employment tax under IRC § 1402(a)(13). The court’s January 2026 opinion was taxpayer-friendly and focused on state-law limited liability. The court later withdrew that opinion and issued a substitute opinion on Aug. 12, 2026, adopting a narrower, management-based standard. The Aug. 12, 2026 substitute opinion is now the operative Fifth Circuit decision.

Core point: A partner who significantly manages or runs the business should not assume that a state-law limited-partner designation protects their distributive share from self-employment tax and Medicare tax.

Update Aug. 17, 2026: Fifth Circuit Withdraws January Opinion And Narrows The Limited-Partner SE Tax Exception

On Aug. 12, 2026, the Fifth Circuit withdrew its January 2026 opinion in Sirius Solutions L.L.L.P. v. Commissioner and issued a substitute opinion under the caption K Alain LLLP v. Commissioner. Although the court denied the government’s petition for rehearing en banc, it abandoned the broad state-law test described in our Jan. 25 update below.

The January opinion held that limited liability under state law was sufficient for a partner to qualify for the self-employment tax exclusion under IRC §1402(a)(13). The substitute opinion instead defines a limited partner as “a partner who plays no significant role in managing or running a business.” Therefore, state-law limited-partner status alone is no longer sufficient in the Fifth Circuit; courts must examine the partner’s actual role in the business.

However, the Fifth Circuit did not fully adopt the Tax Court’s passive-investor test in Soroban. The court concluded that a limited partner may participate in some non-managerial business activities without losing the exclusion. Its new dividing line is managerial versus non-managerial activity—not simply active versus passive participation or material versus non-material participation under the passive-activity rules.

This flip-flop substantially narrows the taxpayer-friendly January decision and creates a new factual question: When does a partner’s involvement become a “significant” role in managing or running the business? Active partners who manage a hedge fund, private equity firm, registered investment adviser (RIA), or professional services management company should not assume that their state-law LP designation protects their distributive share from SE tax. Partners engaged only in non-managerial activities may have a stronger argument for the exclusion, although the extent of that protection remains uncertain.

Under the Tax Court’s Golsen rule, the substitute decision directly governs Tax Court cases appealable to the Fifth Circuit, which covers Texas, Louisiana, and Mississippi. Appeals involving Denham Capital Management and Soroban Capital Partners remain pending in the First and Second Circuits, respectively. Until the appellate courts, Congress, or Treasury provide greater clarity, relying on limited-partner status to avoid both SE tax and NIIT remains uncertain and potentially risky. An S-corporation management-company structure continues to offer a more established approach to managing payroll and Medicare taxes, subject to reasonable-compensation requirements.

The Jan. 25, 2026 update below is retained as a historical record of the Fifth Circuit’s original ruling. That opinion was withdrawn and replaced on Aug. 12, 2026, as explained in the update above. It is no longer controlling law.

Update Jan. 25, 2026: Fifth Circuit Rejects IRS Functional Test—Limited Impact Outside Three Southern States

In Sirius Solutions L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. Jan. 16, 2026), the Fifth Circuit Court of Appeals vacated a Tax Court decision involving the limited-partner exception to self-employment tax under IRC §1402(a)(13). The court held that qualification for the exception turned on limited liability under state law—not on whether the partner was a passive investor or materially participated in the business.

In doing so, the Fifth Circuit rejected the functional, passive-investor test applied by the IRS and the Tax Court in Soroban Capital Partners and Denham Capital Management. Instead, the court relied on the statutory text and the historical meaning of “limited partner.” In a footnote, the court expressly reserved the question of how—or whether—its reasoning would apply to interests in other entities, such as LLPs and LLCs.

The Fifth Circuit covers Texas, Louisiana, and Mississippi. Under the Tax Court’s Golsen rule, the Tax Court would have been required to follow Sirius in cases appealable to that circuit. Outside the Fifth Circuit, the Tax Court could continue applying the functional, substance-over-label analysis reflected in Soroban, Denham, and Castigliola.

This geographic limitation was important because many hedge-fund management companies operate outside the Fifth Circuit, particularly in the Second Circuit, which includes New York and Connecticut; the Ninth Circuit, which includes California; and the Third Circuit, which includes Delaware. Consequently, the original Sirius decision did not alter the enforcement environment for most hedge-fund managers, who remained exposed to IRS challenges and unfavorable Tax Court precedent when relying on limited-partner status to avoid SE tax.

Even under the original Sirius ruling, planning based solely on limited-partner classification remained uncertain outside the Fifth Circuit. For management companies seeking a more durable approach to Medicare tax exposure, an S-corporation management structure continued to offer a more established and defensible solution without depending on unresolved statutory gaps in IRC §§1402 and 1411.

Original Blog post on Nov. 17, 2025: Executive Summary

The IRS has recently cracked down on hedge-fund, private-equity, and professional-service management companies that tried to use limited partner status to avoid the 3.8% Medicare-related tax on management-company profits. In several high-profile cases—including Soroban, Denham, and Castigliola—the Tax Court held that partners who actively manage the business are not “true” limited partners under §1402(a)(13) and therefore cannot use LP status to sidestep self-employment (SE) tax.

This white paper explains the structural gap in the tax code that created this issue, why management-company partners fall into the gray zone between SE tax and the Net Investment Income Tax (NIIT), and how the courts and IRS now apply a functional test that looks at what partners actually do, not what their partnership interest is called.

For fund managers, RIAs, and active partners in management companies, the takeaway is clear:
LP status alone does not shield active partners from SE tax, carried interest remains NIIT income, and S-Corporations are the only reliable structure for reducing Medicare taxes.

The paper also clarifies how these rules affect TTS traders, Section 475 income, and investor-level LPs.

White paper: In recent years, several hedge-fund, private equity, and professional service management companies attempted to use limited partner classifications to reduce or avoid the 3.8% Medicare-related tax on management company income. The IRS challenged these positions, and the Tax Court repeatedly ruled that active service partners were not “true” limited partners for purposes of the §1402(a)(13) self-employment (SE) tax exclusion.

This article explains how the statutory gap arose, why management company partners fall into it, how recent cases have resolved these disputes, and what today’s fund managers and traders should understand when structuring their entities.

Partnership tax rules can produce unexpected results when older definitions collide with modern fund structures. The idea of an “active limited partner” highlights this problem. Under IRC §1402(a)(13), a limited partner’s distributive share is generally not subject to self-employment (SE) tax.

At the same time, income from a business in which a taxpayer materially participates is not subject to the Net Investment Income Tax (NIIT) under IRC §1411. When a partner is legally designated as a limited partner but actively participates in the management company, these two rules conflict with the management company’s ordinary income being treated neither as SE income nor NIIT income.

Who This Affects

• This issue directly applies to partners in management companies—hedge fund managers, RIAs, private equity sponsors, and professional service partnerships.
• It applies less to sole-proprietor traders with TTS and Section 475, whose trading income is not SE income under long-standing IRS guidance. Trading gains are subject to NIIT.
• Investors in hedge funds and private equity funds can benefit from this content, too. 

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Key Lessons

• Active managers cannot rely on LP status to avoid SE tax.

• Carried interest is always NIIT income—never SE income.

• TTS/475 traders avoid SE tax but still owe NIIT.

• S-Corporations are the only well-established way to reduce Medicare taxes.

• IRS and Tax Court apply a substance-over-label “functional test.”

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Primer on Self-Employment (SE) Tax

SE tax includes Social Security (12.4%) up to an inflation-adjusted wage base ($176,100 for 2025), and uncapped Medicare (2.9%) taxes, totaling 15.3% on net earnings from self-employment. For employees, there are similar payroll taxes: employees pay half of the Social Security and Medicare taxes, and employers pay the other half. 

Two Paths for the 3.8% “Medicare” Tax

The 2010 Affordable Care Act (ACA) created two parallel mechanisms for imposing a 3.8 percent Medicare-related tax on investment income of high-income taxpayers:

• The Self-Employment Medicare Tax (2.9% base + 0.9% Additional Medicare Tax = 3.8%) applies to net earnings from self-employment — active trade-or-business income under IRC § 1402.

• The Net Investment Income Tax (NIIT) (3.8%) applies to unearned or passive income such as capital gains, Section 475 ordinary income for traders, interest, dividends, rents, and Schedule K-1 investment profits under IRC § 1411. NIIT also applies to passive activity income and loss from pass-through entities and investment and trading companies.

• The NIIT is calculated on the lesser of net investment income (NII) or the amount your MAGI exceeds thresholds: $200,000 for singles, $250,000 for married filing jointly. These thresholds are not indexed for inflation. 

• Example: a single filer with $500,000 of net trading gains (NII) and MAGI of $600,000. The NIIT threshold for a single filer is $200,000. 
  Calculation: MAGI $600,000, NII $500,000, Threshold (Single): $200,000
  Amount MAGI exceeds threshold: $600,000 − $200,000 = $400,000

  The NIIT is owed on the lesser of:
  •NII: $500,000, MAGI excess: $400,000
  So, the taxable amount for NIIT is $400,000.
  NIIT owed: $400,000 × 3.8% = $15,200.

Congress intended that no income should escape both Medicare taxes — a principle reflected in the legislative history of §§ 1402(a), 1411, and ACA regulations. In practice, however, the statutory definitions sometimes leave a gap for active limited partners.

Earned income should be subject to SE tax, and unearned income should be subject to NIIT. Understanding how Congress drew the line between earned and unearned income helps explain why the limited-partner exception exists.

The Limited-Partner Exception

IRC § 1402(a)(13) excludes a limited partner’s distributive share of partnership income (other than guaranteed payments for services) from net earnings from self-employment.

This rule — dating to the 1954 Code — was designed for passive investors in state-law limited partnerships. It assumes such partners do not materially participate in operations and therefore should not owe self-employment tax. The ACA’s NIIT was not started until 2013.

The “Active Limited Partner”

Modern hedge-fund and private-equity management companies, as well as law firms, blur this distinction. Many managers hold limited-partner (LP) interests for liability protection yet actively manage the business daily.

Partners who materially participate in the partnership’s business but hold only limited-partner interests under state law fall into a statutory gray area:

• Under § 1402(a)(13), their distributive share is excluded from SE income because limited partners are not considered to earn SE income unless they receive guaranteed payments for services.
• Under § 1411(b) and Treas. Reg. § 1.1411-4(g)(7)(i), non-passive participation income is excluded from NIIT, which was set up to catch passive activity pass-through and investment income.

This overlap can leave ordinary business income neither SE income nor passive activity NIIT income. I next discuss how hedge fund and private equity firms deal with this issue, as these were the types of companies that recently lost in tax court over it. 

Management Company LP vs. Fund LP: Why the Distinction Matters

In all major cases involving the limited partner exclusion—Soroban, Denham, and Castigliola—the individuals claiming §1402(a)(13) exclusion were owners of the management company (Castigliola is a law firm), not passive investors in a hedge fund or private equity fund LP.

The management company is the entity that provides investment advisory, trading, or portfolio management. Its income—management fees, incentive allocations, and operational revenue (for the law firm)—derives from the partners’ active services.

By contrast, investor fund LPs hold pooled capital and generate investment returns, including capital gains, Section 475 trading income, dividends, interest, and Section 1256 gains.

These investor LPs are the intended beneficiaries of §1402(a)(13), which excludes passive investment income from SE tax. However, this fund LP income is subject to NIIT for the passive investors. 

This distinction is critical: the §1402(a)(13) exclusion was designed for passive investor LPs, not partners in service‑providing management companies.

Courts consistently look to the partner’s functional role, not their state‑law label. When an individual materially participates in generating the partnership’s business income, the limited‑partner exclusion does not apply—even if their interest is titled as a limited‑partner interest under state law.

Treasury and IRS Awareness

The Treasury Department acknowledged this coordination problem in the preamble to the Final NIIT Regulations (T.D. 9644, 2013), promising future guidance to reconcile §§ 1402 and 1411. Over a decade later, no such guidance has been issued.

Chief Counsel Advice 201436049 and Proposed Reg. § 1.1402(a)-2 (62 Fed. Reg. 1702, January 13, 1997) both indicate that the term “limited partner” in §1402(a)(13) should be interpreted more narrowly than its state‑law label. These authorities emphasize evaluating what a partner actually does in the business, not just how their interest is titled.

However, neither source definitively resolves how the SE‑tax exclusion applies when a partner is legally a limited partner but materially participates in the partnership’s operations.

Cases such as Castigliola v. Commissioner, T.C. Memo 2017-62, reinforce this functional approach. In Castigliola, law firm partners who were legally designated as limited partners were nevertheless treated as engaged in a trade or business for SE tax purposes because they actively provided services and materially participated in the operations.

The decision makes clear that the substance of a partner’s activities, rather than the state‑law title attached to their interest, governs the application of the SE‑tax rules. Still, the broader issue remains unsettled because the Treasury has not issued comprehensive regulations coordinating §1402(a)(13) with the NIIT rules under §1411.

📊 Management Company vs. Fund LP — Structural Diagram

The management company is a service business. The fund LP is the investment vehicle.

Management Company (LP or LLC)
• Provides investment advisory + management services
• Earns management fees + incentive/performance allocations (carried-interest)
• Partners are service providers
• Income is business income (SE-tax analysis applies)
• Carried-interest in capital gains, Section 475 trading income, and portfolio income are subject to NIIT, not SE tax

⬇️ Manages ⬇️

Fund LP / Master Fund / Feeder Fund
• Pools investor capital
• Generates investment income (capital gains, interest, dividends)
• LPs are passive investors
• Income is investment income (NIIT applies)

📘 Case-Law Spotlight: How Courts Treat “Active Limited Partners” in Fund Managers

🟦 Soroban Capital Partners LP v. Commissioner (2024)

• Soroban Capital Partners LP is the management company/RIA, not the hedge‑fund investment vehicle. It earns management fees and incentive allocations and manages multiple fund entities.
• Individuals classified as limited partners of the management company were full-time investment professionals responsible for generating the firm’s advisory and management‑company income.
• They claimed the §1402(a)(13) limited partner exclusion to avoid SE tax on their box one ordinary business income.
• Tax Court held they were not limited partners “as such” under §1402(a)(13) because they were active service partners in the management company.
• Their distributive shares of ordinary business income were subject to self-employment tax.
• See “Sec. 1402(a)(13) and limited partnerships,” The Tax Adviser, March 1, 2024 (Beavers emphasizes a functional test—partners who are “limited in name only” do not qualify for the §1402(a)(13) exclusion).

🟦 Denham Capital Management LP v. Commissioner (2024)

• Denham Capital Management LP is the management company, not the private‑equity fund vehicle. It serves as the General Partner (GP) and investment adviser to a family of sector-focused investment funds.
• Partners labeled as limited partners were actively engaged in investment advisory, due diligence, portfolio management, and operational oversight.
• IRS challenged the use of §1402(a)(13), arguing these partners were materially participating in a financial‑services business.
• Tax Court applied Soroban, concluding these individuals were not limited partners “as such” because they were service partners in the management company.
• Result: their distributive shares of management‑company ordinary income were included in net earnings from self-employment, even though the entity was organized as a Limited Partnership (LP).

Key Principle from Both Cases

A partner’s functional role and actual services, not their state‑law title, determine whether the §1402(a)(13) limited‑partner exclusion applies.

📘 Call-Out: “Limited in Name Only” — Functional Test Explained

Beavers (The Tax Adviser, March 2024) emphasizes that §1402(a)(13) must be applied using a functional test. A partner qualifies as a “limited partner” only if they are genuinely passive in the partnership’s operations.

If the partner provides services, manages operations, or materially participates in generating revenue, they are “limited in name only,” and the §1402(a)(13) exclusion does not apply. This principle aligns with the holdings in Soroban, Denham, and Castigliola, which all rejected limited partner labeling when the partners were active service providers.

📘 Call-Out: When a Fund Management Company Has Box One Income — TTS and Section 475 Only

Most hedge funds do not qualify for Trader Tax Status (TTS) because their trading activity does not rise to the level of an active trading business. Without TTS and a Section 475 election, gains remain capital gains reported in K-1 boxes 8–13, not box one ordinary business income/loss.

A hedge fund investment vehicle reports box one ordinary business income only if it:

1. Qualifies for TTS, and
2. Elects Section 475(f) mark-to-market (MTM) accounting. When a hedge fund uses Section 475 MTM accounting, its trading gains are ordinary income.

Section 475 trading gains are not earned income subject to SE tax; instead, they are unearned income subject to NIIT.

TTS trading business expenses in box 1 reduce SE income for purposes of SE tax. It’s quirky: TTS business expenses are treated as SEI, and Section 475 ordinary income and capital gains are NII.

IRS Tax Topic 429 states, “gains and losses from selling securities as a trader aren’t subject to self-employment tax.” Traders are not considered to be in the trade or business of providing services. Expert treatises make clear that traders with trader tax status, even when reporting ordinary income under Section 475 MTM, do not pay SE tax on that income, distinguishing them from dealers and other service businesses.

Section 475 ordinary income is subject to NIIT under §1411. A Section 475(f) election is available only to traders who qualify for TTS, and TTS, by definition, requires self-directed, active trading. 

Even though TTS traders conduct an active business, the NIIT law explicitly treats trading in financial instruments as investment activity for NIIT purposes. Regardless of the taxpayer’s material participation in a TTS fund LP, TTS/475 income remains NIIT income.

In short, TTS/Section 475 income is always NIIT income because NIIT classifies trading in financial instruments as investment activity—even when the taxpayer is conducting an active trading business.

Carried Interest and the NIIT

Carried interest is a profit interest that allocates a portion of the fund’s investment gains to the managing partner. It is categorically different from:

• Management company box one ordinary business income (the management fee), and

Carried interest income retains its underlying character at the fund level and is reported in K-1 boxes 8–13. These items include:

• Long‑ and short-term capital gains,
• Qualified dividends,
• Interest income, and
• Section 1256 contract gains or losses,

Under IRC §1411(c)(1)(A)(iii) and Treas. Reg. §1.1411‑4(a)(1)(iii), these categories of income are always included in net investment income (NII). This rule applies regardless of whether the partner is:

• A limited partner or general partner,
• Active or passive,
• Involved in investment management or not.

Because carried interest flows from investment activity and not services, it is:

• Always subject to the 3.8% NIIT, and
• Never subject to SE tax.
• It doesn’t work to claim an “active limited partnership”; it’s NII either way.

In the classic “2 and 20” compensation structure, the management company charges a 2% management fee. It receives a 20% incentive allocation (carried interest) of the fund’s investment income (usually based on new-high-net profits).

The IRS has periodically challenged carried interest as a disguised incentive fee, and some members of Congress have frequently proposed legislation to repeal or further limit carried-interest treatment. Understanding these dynamics is essential when analyzing how carried interest interacts with NIIT and SE tax.

The OBBBA did not change or extend the carried-interest rules created under the TCJA. The three-year holding period under IRC §1061 remains in place, and none of the proposed tightening measures made it into the final bill. As a result, carried interest continues to receive long-term capital gains treatment under the TCJA rules, and OBBBA leaves the existing regime unchanged for private-equity and fund managers.

Even active fund managers pay NIIT on carried interest. The only income potentially affected by the “active limited partner” issue is ordinary business income from the management company or General Partner entity.

Choice of Entity for Traders and Hedge Funds

Entity selection determines how a hedge fund manager’s compensation flows through the tax system.

Many hedge funds adopt a classic structure:

• A fund LP or LLC that holds investor capital and generates portfolio gains; and
• A GP/management company responsible for investment management and business operations.

Managers commonly participate in the fund in two separate capacities:

• Through the GP entity, receiving management‑company income and performance allocations; and
• Sometimes, as personal investors holding a limited‑partner interest in the LP. Many managers invest personal capital to demonstrate commitment to investors, although the amounts vary widely, and some managers do not invest personally at all.

When managers do invest personally, they may receive a separate investor K-1 reporting only investment results—capital gains, dividends, interest, and Section 1256 gains—never management fee income or carried interest allocations.

Separately, the GP/management company—whether an LLC taxed as a partnership or an S‑Corporation—issues its own K-1 to the manager for GP-level business income. This K-1 is distinct from and unrelated to any investor-level K-1.

(As always, legal entity selection involves governance and liability considerations. Managers should seek counsel experienced in fund law in their state of residence.)

📘 Call-Out: GP / S‑Corporation Election for Payroll‑Tax Optimization

Electing S‑Corporation status at the GP/management‑company level enables managers to:

• Pay themselves reasonable compensation, subject to payroll taxes, and
• Receive remaining S‑Corp profits free from Social Security and Medicare taxes.

For S-Corp management businesses, many practitioners use a 25–50% benchmark when evaluating reasonable compensation, but the IRS requires pay to reflect fair market value for services performed.

Remaining profits distributed as S‑Corp dividends are not subject to payroll tax, offering substantial savings compared to partnerships, where active limited partners face increasing scrutiny and SE tax exposure.

This widely accepted planning strategy allows owners to reduce Medicare taxes by receiving income in the form a distributions rather than wages. This method offers a clear, established, and IRS-tested approach to managing payroll‑tax exposure. 

It’s a different matter for trading S-Corps eligible for TTS; they don’t have underlying earned income and therefore don’t need reasonable compensation. They use officer compensation to unlock health and retirement plan deductions.

The Bottom Line

Partner Type	SE Tax	NIIT	Notes
Passive limited partner	❌	✅	Investor LP portfolio income and capital gains are subject to NIIT
Active general partner	✅	❌	Business income is subject to SE tax
Active limited partner (stat. gap)	✅*	❌	*Disputed position under current law

See CCA 201436049 and T.D. 9644 (2013) for IRS and Treasury recognition of unresolved issues. Congressional or regulatory guidance is pending.

Guaranteed payments for services remain subject to SE tax regardless of partner status or participation level.

Outlook

Until Treasury finalizes regulations harmonizing §§ 1402 and 1411, high-income partners who actively manage funds yet hold limited-partner interests occupy a legally ambiguous zone. Practitioners should carefully evaluate both state-law entity status and material participation, as future guidance may reclassify such income for SE or NIIT purposes.

For hedge-fund managers, traders, and their advisors, the safest approach is to treat active management-company income as SE income. Using limited-partner status to avoid SE and NIIT remains risky under the current law.

Disclaimer:
This article is for educational discussion only and not individualized tax advice. It summarizes federal tax law as of 2025 and provides no assurance of outcome in any particular case. Consult your tax advisor about your own entity classification, self-employment exposure, and NIIT obligations.

Sources and Citations

1. Denham Capital Management LP v. Commissioner (T.C. Memo 2024-114)
Full opinion (PDF): https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2024/12/tc-memo-2024-114.pdf
KPMG summary: https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2025/01/tnf-kpmg-report-denham-january-2025.pdf

2. Soroban Capital Partners LP v. Commissioner (161 T.C. 310 (2023))
EisnerAmper overview: https://www.eisneramper.com/insights/tax/soroban-capital-case-1402-a-13-exclusion-1223/
Gibson Dunn analysis: https://www.gibsondunn.com/tax-court-determines-that-limited-partners-are-not-necessarily-exempt-from-self-employment-tax-limits-of-limited-partner-exception/

3. Castigliola v. Commissioner (T.C. Memo 2017-62)
Case summary (Current Federal Tax Developments): https://www.currentfederaltaxdevelopments.com/blog/2017/4/10/tax-court-rejects-limited-partner-claim-in-professional-service-firm

4. NIIT Final Regulations (T.D. 9644, 2013)
Federal Register summary: https://www.federalregister.gov/documents/2013/12/02/2013-28409/net-investment-income-tax

5. IRS Chief Counsel Advice 201436049
Primary source (IRS PDF): https://www.irs.gov/pub/irs-wd/201436049.pdf
Tax Adviser summary: https://www.thetaxadviser.com/issues/2015/jan/tax-clinic-08-jan-2015/