LLC and Partnership Owners: A New Court Test Could Change Your Self-Employment Tax
If you own an LLC, partnership, LLP, or LLLP, a new Fifth Circuit decision may affect how much of your business income is subject to self-employment tax.
On August 12, 2026, the Fifth Circuit issued its revised opinion in K Alain, L.L.L.P. v. Commissioner. The court introduced a new way to evaluate whether a partner qualifies for the limited-partner exception under Internal Revenue Code Section 1402(a)(13).
The key question is no longer only:
Does this owner have limited liability under state law?
The new question is:
Does this owner play a significant role in managing or running the business?
That change matters. It may affect active owners who receive partnership income but have been treating that income as exempt from self-employment tax.
I will walk through what changed, what remains uncertain, and what you can review now. The goal is simple: clearer records, better questions, and less stress at tax time.
The basic rule under Section 1402(a)(13)
Self-employment tax generally applies to income earned from carrying on a trade or business.
The tax helps fund Social Security and Medicare. For many business owners, it applies to income from active work in the business.
Section 1402(a)(13) provides an exception. It excludes a qualifying limited partner’s distributive share of partnership income from net earnings subject to self-employment tax.
There is an important exception to that exception.
Certain guaranteed payments made for services can still be subject to self-employment tax. In simple terms, an owner may receive:
A distributive share of business income.
A guaranteed payment for services.
Both.
The tax treatment may differ for each type of payment.
This is why your operating agreement, ownership records, payment structure, and actual work in the business all matter.
What happened in K Alain?
The case involved Sirius Solutions LLLP, a consulting business with operations in Houston, Dallas, and London. The partnership allocated ordinary business income to its limited partners.
For employment tax purposes, the partnership treated the income as excluded under the limited-partner exception.
The IRS disagreed. The IRS argued that the partners were active in the business and should pay self-employment tax on their distributive shares.
The Tax Court agreed with the IRS. It applied a functional approach based on earlier cases, including Soroban Capital Partners LP v. Commissioner. Under that approach, the limited-partner exception generally applied only to partners functioning as passive investors.
The Fifth Circuit first took a different position in January 2026. Its original opinion focused heavily on state-law status and limited liability.
That opinion suggested that a partner in a state-law limited partnership with limited liability could qualify for the exception even if the partner was active in the business.
The court later withdrew that opinion.
In the revised K Alain decision, the Fifth Circuit adopted a middle-ground test. It held that a limited partner is a partner who does not play a significant role in managing or running the business.
You can review the Fifth Circuit’s opinion and a helpful summary from EY Tax News.
How the new test differs from the Tax Court’s approach
The Tax Court’s approach has been stricter.
It has generally asked whether the partner functions as a passive investor. Under that view, a partner who performs meaningful services or participates in the business may not qualify for the limited-partner exception.
The Fifth Circuit rejected that complete-passivity approach.
The court indicated that a limited partner may participate in some nonmanagerial activities without automatically losing the exception. Simply providing some services does not necessarily mean the owner is subject to self-employment tax on the entire distributive share.
At the same time, the Fifth Circuit rejected a liability-only test.
Limited liability by itself is not enough.
The new test focuses on the partner’s actual role in the enterprise:
A partner who plays no significant role in managing or running the business may qualify.
A partner who plays a significant management or operational role may not qualify.
Some participation may be allowed.
Total passivity is not required.
Limited liability does not automatically settle the question.
This is the middle ground.
As Sullivan & Cromwell explains, the revised opinion turns on the role partners play in the enterprise rather than only on their state-law liability status.
What does “significant” mean?
This is the part that remains unsettled.
The Fifth Circuit did not create a precise numerical test. It did not say that a certain title, number of hours, or percentage of ownership automatically determines the result.
The Tax Court must apply the new standard to the facts of the case on remand. That future decision may provide more guidance.
For now, I would review the facts surrounding your role. Helpful questions include:
1. Do you make management decisions?
Consider whether you:
Set business strategy.
Approve budgets.
Direct employees or contractors.
Choose vendors.
Set pricing.
Approve major purchases.
Manage client relationships.
Decide which services the business offers.
These activities may suggest a management role.
2. Do you have authority to act for the business?
Review whether you can:
Sign contracts.
Open or close bank accounts.
Borrow money.
Hire or fire employees.
Bind the company to agreements.
Represent the business with customers or suppliers.
Formal authority is not the only factor. It is still an important part of the overall picture.
3. How much time do you spend working in the business?
Track your actual involvement.
Review calendars, project records, emails, invoices, meeting notes, and time logs. The IRS’s 1997 proposed regulations are not binding law, but they offer possible reference points. Those proposed rules discussed factors such as contract-signing authority and working more than 500 hours in a year.
That does not mean 500 hours is now a bright-line rule under K Alain. It is not.
It does mean that your time commitment can help show whether your role is limited or significant.
4. What does your operating agreement say?
Your agreement may describe you as a limited partner or LLC member. That label matters, but it may not control the tax result by itself.
Compare the agreement with what actually happens.
If the document describes a passive owner but the owner runs daily operations, that difference deserves attention. Good tax planning starts with records that match reality.
Which owners may face the most exposure?
The decision may be especially important for owners of:
LLCs taxed as partnerships.
Limited liability partnerships.
Limited liability limited partnerships.
Service partnerships.
Consulting firms.
Professional practices.
Investment or management businesses with active owners.
These structures can allow an owner to keep liability protection while also participating heavily in the business.
That combination is now more important to review in the Fifth Circuit.
A “classic” limited partnership may present a different fact pattern. Traditional limited partners often have limited management rights and remain separate from daily operations.
Still, every structure is different. The legal name of the entity does not answer the tax question by itself.
Also, not every LLC owner falls under this specific analysis. A single-member LLC may be treated as a disregarded entity for federal tax purposes. An LLC may also elect to be taxed as an S corporation or C corporation.
Your federal tax classification matters. So does the way you receive income.
The circuit split is not resolved
K Alain is binding within the Fifth Circuit. That includes federal tax cases in:
Texas.
Louisiana.
Mississippi.
Outside the Fifth Circuit, the issue remains unsettled.
The Tax Court has used its functional approach in cases such as Soroban and Denham. Appeals involving those cases are pending in the Second and First Circuits.
This creates the possibility of a circuit split. A circuit split happens when federal appeals courts reach different conclusions on the same legal issue.
The Fifth Circuit has now adopted a significant-role test. The Tax Court has applied a stricter passive-investor analysis. Other appellate courts may adopt one of these approaches or create another.
The issue may eventually reach the U.S. Supreme Court. For now, owners should avoid assuming that one court’s approach applies automatically nationwide.
This analysis from Nossaman provides additional context on the Fifth Circuit’s decision and the pending appeals.
What should you do now?
You do not need to panic or make a rushed change.
Start with an organized review.
Gather these records
Operating agreement and amendments.
Ownership and capital account records.
Profit and loss allocations.
Guaranteed payment records.
Payroll records.
Management resolutions.
Bank signing authority.
Contracts signed during the year.
Time records and calendars.
Job descriptions.
Emails showing operational responsibilities.
Prior tax returns and workpapers.
Separate income types
Identify how much income you received as:
A distributive share.
A guaranteed payment.
Wages.
A management fee.
Another form of compensation.
The limited-partner exception does not automatically protect every payment made to an owner.
Document your role accurately
Write down what you do. Include both management duties and nonmanagerial work.
Do not rely only on your title. Titles can be broad. Actual responsibilities are more useful.
Ask your tax professional focused questions
Ask:
Is my entity taxed as a partnership for federal purposes?
Which income items may be subject to self-employment tax?
Does my role appear significant under the Fifth Circuit’s approach?
How does the Tax Court’s passive-investor approach affect my position?
Do I need to change estimated tax payments?
Should we consider a protective refund claim for prior years?
What records should I maintain going forward?
A careful review can turn an uncertain issue into a manageable plan.
Keep your books ready for the conversation
Tax questions are easier to answer when your books are current.
Accurate bookkeeping can help you identify:
Owner payments.
Guaranteed payments.
Distributions.
Business expenses.
Management fees.
Capital contributions.
Income allocations.
I help small-business owners keep these details organized and understandable. My approach is step by step. We focus on clear records and practical next actions.
You can also review our guide on keeping your cash flow organized. Strong bookkeeping gives you a better foundation for tax planning.
The simple takeaway
The Fifth Circuit’s K Alain decision changes the conversation for LLC and partnership owners.
Limited liability alone may not protect a partner’s distributive share from self-employment tax.
Complete passivity may not be required either.
The central question is whether the owner plays a significant role in managing or running the business.
That question depends on the facts. Your duties, authority, time commitment, income structure, and records all matter.
The law is still developing. A tax professional can help you review your position under the rules that apply to your business and location.
If your books need attention before that review, learn more about Jenni’s Business Services or schedule a consultation. I will help you bring the information into perfect order, one step at a time.
This article provides general educational information. It is not legal or tax advice. The application of Section 1402(a)(13) depends on your business structure, tax classification, income, responsibilities, and location. Please consult a qualified tax professional before changing your tax reporting, estimated payments, or refund position.
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