Congress once wrote four words into the tax code: “limited partner as such.” But then it never explained what those words meant. Even worse, they wrote these words before limited liability companies existed. Today, those four words are at the center of a legal battle moving through multiple appellate courts, and the outcome will determine whether your partnership clients owe self-employment tax on their share of income.
In Episode 32 of the Tax in Action podcast, host Jeremy Wells, EA, CPA, picks up where his previous episode on partnerships left off. He tackles two critical questions: What actually makes someone a partner under federal tax law? And which partners must pay self-employment tax on their distributive share?
The answers turn on substance rather than paperwork, and that’s where things get complicated. Since Congress never defined “limited partner as such,” and since the phrase predates LLCs entirely, the courts have split into openly conflicting camps. One camp reads it as a test of whether someone is truly a passive investor. Another looks at state-law definitions and dual-role partners. This is a genuine circuit split that could land at the Supreme Court.
Until it’s resolved, Jeremy makes clear you can’t rely on the “limited partner” label in a K-1 or operating agreement. You have to evaluate what each partner actually does. Let’s walk through how courts define who counts as a partner, why the “limited partner as such” exception is so unclear, and how this circuit split affects your clients right now.
Who Actually Counts as a Partner?
Before we can figure out who owes self-employment tax, we need to answer a more basic question: who counts as a partner in the first place? The answer has always been rooted in substance over form, and that principle causes today’s self-employment tax disputes.
Jeremy opens with a scenario you’ve likely seen. Two individuals register an LLC, each listed as a member. Under the check-the-box regulations, that’s a partnership for federal tax purposes. One member works full time in the business, keeping it running. The other contributed startup capital, works elsewhere, and rarely touches the business. They’re a classic silent partner. With equal 50% interests, the Form 1065 and K-1s report a 50/50 income split.
But are these two partners truly equal under federal tax law? One earns income through labor, while the other just wrote a check. Should the tax code treat them the same?
When the Code Said Nothing
Before 1951, the Internal Revenue Code had no definition of “partner.” This silence created disputes that reached the Supreme Court. With no statute to guide them, the courts had to define it themselves and made a decision that still shapes practice today. They largely ignored state-law labels.
“Partner” can mean one thing under state law and something different under federal tax law. The courts focused on the parties’ stated and implied intent, examining partnership agreements, contributions of capital or services, and how they actually behaved once the business was running.
Tower Sets the Standard
The first landmark case was Tower v. Commissioner (1946). The Court asked whether the individuals truly intended to join together to carry on a business and share in profits and losses. The answer, they said, depends on multiple factors, none of them individually decisive. There’s no simple checklist that automatically makes someone a partner.
The Court said an individual may be a partner if she “either invests capital originating with her or substantially contributes to the control and management of the business, or otherwise performs vital additional services, or does all of these things.”
The backstory drives the point home. Mr. Tower, following tax advice, converted his corporation to a partnership and made his wife a partner purely to shift income to her lower tax bracket. But Mrs. Tower contributed no capital, provided no services, and exercised no control. The Court saw through it and taxed the income to Mr. Tower, who actually earned it.
Culbertson Clarifies the Mess
Three years later was Culbertson v. Commissioner (1949). The Tax Court had misread Tower, treating its list of factors as rigid requirements and denying partnership status left and right. The Supreme Court pushed back, saying the Tax Court “ignores what we said is the ultimate question for decision and makes decisive what we described as circumstances to be taken into consideration.”
The real test is subjective intent: whether the parties, in good faith and with a business purpose, intended to join together in the present conduct of the enterprise.
Congress Steps In for Family Partnerships
In 1951, Congress finally added a statutory definition, now in Section 761(b). A person is recognized as a partner if they own a capital interest in a partnership where capital is a material income-producing factor, whether acquired by purchase or gift.
Congress targeted family partnerships, in which high-earning patriarchs would gift interests to lower-earning relatives to spread income into lower tax brackets while retaining control. According to the Joint Committee’s Blue Book, Congress wasn’t overriding Tower and Culbertson; it was carving out a legitimate transaction, making clear the IRS couldn’t deny partner status just because an interest came from a family member.
The Capital Interest Test
Everything circles back to the concept of capital interest, or an interest in partnership assets that would be distributable upon withdrawal or liquidation. It’s different from a mere profits interest because just sharing in earnings doesn’t cut it.
Courts apply a hypothetical liquidation test. If the partnership shut down tomorrow and sold everything, would this person get a slice of the assets? If not, are they really a partner?
The pattern of economic reality, not paperwork, determines who is a partner. And this same substance-over-form logic becomes far more contentious when we turn to self-employment tax.
The Four Words Nobody Can Define
Now we reach the phrase causing all the trouble, where ambiguity stops being academic and starts costing real money.
First, Jeremy lays down the foundational rules. Partners are treated as self-employed for tax purposes, regardless of their role. This means partners cannot be employees of their own partnership. “You should never have a partner getting both a W-2 and a K-1 from the same partnership,” Jeremy emphasizes. While there are “exceedingly rare” exceptions, the rule holds: partners don’t go on payroll. If a partner wants a fixed income for services, it flows through as guaranteed payments, not wages.
The general partner rule is unforgiving. A general partner’s distributive share is subject to self-employment tax. It doesn’t matter if the interest is passive under Section 469. It doesn’t even matter if the partnership elected out of Subchapter K under Section 761(a). As Jeremy notes, that election only affects Subchapter K. It does nothing to shield general partners from self-employment tax.
The Exception and Its Giant Hole
IRC Section 1402(a)(13) creates an escape hatch by excluding “limited partners, as such” from self-employment tax on their distributive share. But even for limited partners, guaranteed payments for services are subject to self-employment tax.
The problem is Congress never defined “limited partner as such” anywhere.
In 1997, the Treasury proposed regulations to define the term for Section 1402 purposes. The controversy was so intense that Congress imposed a moratorium on any such regulation, and that moratorium was originally set to expire on July 1, 1998. “It’s now 28 years later, and neither Congress nor the Treasury has provided any sort of update on this question,” Jeremy says.
The LLC Problem
Making everything worse, Section 1402(a)(13) was written before LLCs existed. LLC members aren’t personally liable for entity debts. That’s the whole point of limited liability, making them look like limited partners. Yet those same members often actively manage the business and provide services, making them look like general partners.
So which are they for self-employment tax purposes? The statute offers no answer. Congress wrote a rule for a world of general and limited partnerships and never updated it for the entity that now dominates small business.
Courts Split on What “Limited Partner” Means
With no definition and no regulation, the courts filled the vacuum, and they didn’t all fill it the same way.
The Tax Court’s Passive Investor Test
The first approach comes from Renkemeyer, Campbell & Weaver v. Commissioner (2011), involving a law firm. The Tax Court examined the legislative history and concluded Congress intended to “ensure mere passive investors would not receive credits toward Social Security coverage.”
On this reading, “limited partner as such” means “passive investor.” The phrase “as such” signals the exemption applies to those who operate as limited partners. Once a partner participates in operations, they’re no longer a limited partner for federal tax purposes.
The Tax Court expanded this in Soroban Capital Partners (2023), applying its “functional analysis” test. The inquiry is, does the partner functionally participate or stay out? Notably, Soroban involved a state-law limited partnership, yet the court still held that a partner labeled “limited” who acts like a general partner owes self-employment tax. Soroban is currently on appeal in the Second Circuit.
The Fifth Circuit’s State-Law Approach
The competing view comes from Sirius Solutions LLP v. Commissioner. The Fifth Circuit, which Jeremy notes “tends to be different from a lot of the other appellate courts,” rejected the passive-investor approach entirely.
Instead, the court looked at how “limited partner” was defined in legal dictionaries and by the IRS and Social Security Administration when Section 1402 was written. The court’s logic ran three ways.
First, the guaranteed-payments carve-out shows Congress expected limited partners to provide services. As the court said, “the text of the exception itself contemplates that limited partners would provide actual services to the partnership.”
Second, Congress used “passive” terminology elsewhere in the code but not in Section 1402. It used “rendered no services” in Section 1402(a)(10) just a few paragraphs above, yet chose different language in (a)(13). Why different wording for the same concept?
Third, “as such” refers to dual-status partners, or people who act as general partners sometimes and as limited partners at others, clarifying that only their limited-partner income escapes tax.
A Geographic Lottery
These approaches directly conflict. When appellate courts interpret the same federal statute in opposite ways, the natural endpoint is the Supreme Court.
Meanwhile, Jeremy flags a practical complication from the Golsen rule. The Tax Court must follow the precedent of whichever appellate circuit would hear a given case. So a partnership in the Fifth Circuit gets one result while an identical partnership elsewhere gets another. The outcomes are driven purely by geography.
The Jurisdiction Question
Jeremy also discusses Denham Capital Management, on which the First Circuit heard oral arguments in early 2024. Rather than debate what “limited partner” means, the partners argue the Tax Court lacks jurisdiction to decide this in a partnership-level audit. Under TEFRA, net earnings from self-employment are a partner-level item, since individual partners calculate their own self-employment tax.
The wrinkle is partnerships must report self-employment earnings in Box 14 of the K-1. The IRS argues that the “characterization” of income makes it a partnership item. This could add another layer to an already complex issue.
What This Means for Your Practice
Let’s return to Jeremy’s opening scenario. The member working full time is almost certainly a partner whose income is subject to self-employment tax. The capital-only member likely holds a valid partnership interest too. But under the Tax Court’s current precedent, their income probably escapes self-employment tax if they genuinely stay out of the business.
That last part is crucial. Jeremy cites Howell v. Commissioner (2012), where a married couple treated the wife’s LLC earnings as exempt from self-employment tax. But her testimony revealed she occasionally provided managerial and marketing advice to her husband. That occasional participation was enough. The Tax Court held she wasn’t a “limited partner as such,” and her earnings were subject to self-employment tax.
Key Takeaways for Tax Professionals
Jeremy leaves us with clear lessons from this uncertainty:
- Federal tax law determines partner status based on economic reality, not state-law labels. That’s the through-line from Tower and Culbertson.
- The IRS and Tax Court currently apply a functional analysis to determine if a partner is “limited” for self-employment tax purposes. But recent developments cast doubt on this approach.
- Look beyond the paperwork. The words “limited partner” on a K-1 or operating agreement won’t protect a client who functions like a general partner.
- Never combine a W-2 and a K-1 from the same partnership. Partners are self-employed; fixed compensation comes through guaranteed payments.
- Remember what’s always taxable. General partners’ distributive shares are subject to self-employment tax even if passive or if the partnership elected out of Subchapter K. Guaranteed payments to any partner for services remain subject to SE tax.
- Document everything. Track each partner’s participation, services, and management role. As Howell shows, even occasional input can trigger self-employment tax.
Until the Supreme Court resolves this circuit split, you’re advising clients under real uncertainty. The prudent response isn’t to guess which approach will win. Build positions based on what every court agrees matters, which is what each partner actually does.
For Jeremy’s complete analysis of the cases, statutory history, and practical implications, plus previews of upcoming episodes on capital accounts and special allocations, listen to episode 32 of Tax in Action.