An appellate court ruling has recently clarified how limited partnership is treated for self-employment tax purposes, pushing back on a narrowed IRS definition and offering greater certainty for emerging managers and business founders.
If you are starting an investment management firm or another closely held business, you have likely been advised to structure your ownership as a limited partnership, often with a 1% general partner (GP) and a 99% limited partner (LP) interest. The reason is simple, yet strategic: under longstanding tax law, income allocated to an LP is generally not subject to self-employment (SE) tax.
The Internal Revenue Service (IRS) has challenged this approach for years, asserting that “limited partners” who are materially involved in business operations should not receive “passive” tax benefits. However, a recent ruling from the U.S. Court of Appeals for the Fifth Circuit has provided meaningful clarity, and a measure of reassurance, to business owners navigating limited partnership structures.
The Stakes and the Savings: Why Structure Matters
Self-employment tax effectively replaces Social Security and Medicare taxes for individuals who are not classified as employees. It currently applies at 15.3% on the first wage base (Social Security) plus 2.9% for Medicare, with an additional Medicare surtax at higher income levels. For profitable businesses, the distinction between income subject to SE tax and income exempt from it can easily amount to six or seven-figure savings over time.
The Conflict: Defining a Limited Partner
The Internal Revenue Code (IRC) provides an exception from SE tax for an LP, excluding guaranteed payments for services. However, the code does not define the term “limited partner,” an omission that has sparked decades of debate. Generally, an LP contributes capital, has limited liability, and does not participate in day-to-day management.
The evolution of business structures (including the rise of LLCs and management companies) has introduced new interpretations and debates surrounding this concept. The IRS has argued that individuals actively working in the business, those with management authority, or whose income is tied to services should not be treated as an LP for SE tax purposes.
Prior to the Fifth Circuit’s decision, courts and the IRS increasingly applied a “functional” analysis that focused on a partner’s level of involvement rather than legal status. This approach was reflected in the Tax Court’s decision in Soroban Capital Partners, which narrowed the limited partner exception by emphasizing activity rather than legal status. The Fifth Circuit’s ruling in Sirius Solutions marked a clear shift away from that approach.
The Turning Point: Recent Court Rulings
In Sirius Solutions, the Fifth Circuit Court of Appeals rejected this narrowed interpretation, holding that the statute focuses on status under state law, not day-to-day activity.* A partner in a limited partnership with limited liability may qualify for the SE tax exclusion. Congress — not the IRS — must change the rule if it believes working LPs should be taxed.
*The Fifth Circuit decision provides meaningful guidance, but the decision is binding only within that jurisdiction. Other courts are continuing to evaluate similar issues, and future rulings could either reinforce or narrow the current interpretation elsewhere.
In doing so, the court adopted a statutory interpretation of the LP exception and rejected the use of a functional or “passive investor” test to determine eligibility. This was widely viewed as a favorable outcome for taxpayers.
Structural Considerations for Today’s Managers
For founders setting up a new management company today, these rulings provide real-world guidance. From our perspective, emerging managers should continue to evaluate structuring approaches that include:
- Using a limited partnership management company structure
- Structuring ownership between 1% GP and 99% LP split
- Allocating profits primarily to the LP interest
However, guaranteed payments for services remain subject to SE tax, and the GP’s income is generally subject to SE tax. Just as important, proper facts and documentation remain critical. Documenting intentions and operations thoroughly establishes operational discipline and substantiates your entity selection, which strengthens your position with both regulators and institutional investors.
A Practical Example
Assume a new investment manager earns $2 million in net profits:
- $200,000 is paid as guaranteed payments (SE tax applies).
- $1.8 million is allocated to the LP interest.
Under current law and recent rulings, the $1.8 million allocated to the LP may not be subject to SE tax, resulting in substantial savings.
Closing Insights for Emerging Managers and Founders
The key takeaway is to structure thoughtfully, not simply to seek tax efficiency, but also to demonstrate operational and institutional maturity. This recent decision reaffirms that longstanding planning structures continue to work when properly implemented. However, as scrutiny around fund structures increases and the legal environment continues to evolve, investors and allocators are evaluating not only your tax position but also the durability and risk management underpinning your organization.
While the area is complex and unsettled nationwide, a rigorous, informed approach to structure can be a powerful tool for building a resilient, tax-efficient business from day one.
Supporting Emerging Managers and Founders
Grassi’s Financial Services advisors provide coordinated tax, assurance and advisory services designed to help emerging managers and founders navigate a highly regulated environment while building scalable businesses. Our team brings a practical, industry focused perspective to help clients manage risk as their businesses grow.
For tailored guidance on entity structure, regulatory considerations, and growth planning, connect with a Grassi advisor today.
