The Fifth Circuit’s recent decision in Sirius Solutions, L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. 2026), creates a strict textualist framework for the self-employment (SE) tax exclusion under I.R.C. § 1402(a)(13) for cases that would be appealed to the Fifth Circuit Court of Appeals.
While this decision provides a safe harbor for state-law limited partners, it simultaneously dismantles the functional analysis test that Limited Liability Company (LLC) members have historically relied upon to claim the exclusion. When the strict textual definition of “limited partner” adopted in Sirius is combined with the Tax Court’s precedent in Norwood v. Commissioner, a dangerous syllogism emerges: LLC members, lacking the specific state-law title required by the Fifth Circuit, may default to the general rule of inclusion regardless of their participation levels.
The General Rule of Inclusion: The Norwood Principle
To understand the risk posed by Sirius, one must first revisit the baseline established in Norwood v. Commissioner, T.C. Memo 2000-84. In that case, the Tax Court addressed the SE tax liability of a general partner in a medical supply partnership who spent only 41 hours on partnership matters during the tax year. The taxpayer argued that because his interest was passive, his distributive share should be exempt from SE tax.
The Tax Court rejected this argument, establishing a bright-line rule: unless a partner falls within the specific statutory exception for limited partners, their distributive share of trade or business income is subject to SE tax under Section 1402(a). The court held that the taxpayer’s “lack of participation in or control over the operations of [the partnership] does not turn his general partnership interest into a limited partnership interest”.
Crucially, Norwood established that for partners falling outside the specific Section 1402(a)(13) exception, economic reality regarding participation is irrelevant. The court stated: “That petitioner spent a minimal amount of time engaged in the operations of [the partnership] is irrelevant to this determination… [The distributive share is] subject to the taxes imposed by section 1401 on self-employment income… regardless of whether [the partner’s] involvement is passive or active”.
The Sirius Trap: Narrowing the Exception to State-Law Labels
Prior to Sirius, LLC members navigated the Norwood inclusion rule by arguing that, functionally, they occupied a position analogous to limited partners. However, the Fifth Circuit’s decision in Sirius Solutions ostensibly forecloses this “functional equivalent” argument by insisting on a strict adherence to the text of the 1977 statute.
In Sirius, the Fifth Circuit held that the “limited partner” exception applies only to a specific legal status. The Court declared: “When § 1402(a)(13) says ’limited partner,’ it is referring to a limited partner in a state-law limited partnership that has limited liability”. The opinion emphasizes that the “touchstone of a ’limited partner’ in 1977 was limited liability”, but inextricably links this liability protection to the specific entity format of a limited partnership.
While the Sirius court noted in a footnote that “we do not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception”, the logic of the opinion presents a severe obstacle for LLC members. The Court expressly rejected the Tax Court’s approach of inquiring into the “functions and roles” of the partners. Instead, the Fifth Circuit vacated the lower court’s decision because it relied on an “erroneous passive investor rule”.
The Intersection: Why LLC Members May Be Left with No Defense
The combination of Norwood and Sirius leaves LLC members in a statutory void.
First, under Sirius, an LLC member cannot claim the Section 1402(a)(13) exclusion based on the plain text. An LLC member is not a “limited partner in a state-law limited partnership”. The Norwood court explicitly addressed the necessity of proper form, stating: “A limited partnership must be created in the form prescribed by State law”. Since an LLC is not a limited partnership under state law, the member fails the threshold definition established by the Fifth Circuit.
Second, the “functional analysis” escape hatch has been welded shut. In the past, an LLC member might have argued, “I act like a limited partner, so treat me as one.” However, Sirius explicitly condemns the IRS and Tax Court for applying a test that balances an “infinite number of factors in performing its ’functional analysis test’”. If the Fifth Circuit refuses to look at the “functions and roles” of a partner to grant the exclusion to a state-law limited partner, it is difficult to see how they would apply a functional test to grant the exclusion to an LLC member who lacks the requisite statutory title.
The Consequence: Irrelevance of Participation Level
If an LLC member cannot qualify as a “limited partner” under the Sirius definition, they revert to the general rule of Section 1402(a). Here, Norwood dictates the outcome.
In Norwood, the court held that because the taxpayer was not a limited partner, his income was subject to SE tax “regardless of whether [his] involvement is passive or active”. The court explicitly stated that the “passive activity rules under section 469 have no application in this case” regarding SE tax liability.
Norwood based its decision on the logic that the general rule of the first paragraph of IRC §1402(a) tells us partners pay self-employment tax on income from a trade or business carried on the partnership. It states:
(a) Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member (emphasis added);…
To avoid this result, a partner needs to look to the exceptions found enumerated in the remainder of IRC §1402(a), of which IRC §1402(a)(13) provides the limited partner exception found in this case.
While the Tax Court in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 TC 137, effectively reversed the Norwood analysis as applied to LLCs, the Fifth Circuit panel clearly states that the functional analysis the court turned to in Renkemeyer is not an appropriate inquiry to define the “limited partner, as such” in IRC §1402(a)(13).
Therefore, applying the Sirius logic to an LLC member results in the following position:
- The LLC member is not a “limited partner” because they are not in a state-law limited partnership.
- The LLC member cannot use a “functional analysis” to prove they are a limited partner, as that test is erroneous.
- Without the Section 1402(a)(13) exclusion, the member is subject to the general rule of Section 1402(a).
- Under the general rule (Norwood and the plain text of IRC Section 1402(a)’s first paragraph), the member’s distributive share is fully subject to SE tax, even if they spent zero hours working for the entity.
Conclusion
While Sirius Solutions is a victory for traditional limited partnerships, it creates a high-stakes environment for LLCs electing partnership taxation. By defining “limited partner” strictly by reference to state-law limited partnerships and rejecting functional inquiries, the Fifth Circuit may have inadvertently subjected all LLC members to the Norwood regime: automatic SE tax liability on all trade or business income, regardless of whether the member is a passive investor or an active manager. As the Sirius court noted, “state law creates legal interests… but the federal statute determines when and how they shall be taxed”. Without the specific state-law interest of a “limited partnership,” LLC members currently lack a judicially recognized shield against self-employment tax in the Fifth Circuit.
Prepared with assistance from NotebookLM.
Ed Zollars CPA's Blog 