For decades, one piece of tax planning was treated as settled. Organize as a limited partnership or LLC, give the working owners “limited partner” interests, pay a modest guaranteed payment for services, and let the rest of the profit flow through free of the 15.3% self-employment tax. Whole law firms, investment managers, and physician groups were built on it.
That plan is now on borrowed time. A string of Tax Court decisions, an active IRS examination campaign, and a statute that was never written for modern LLCs have combined to put the Section 1402(a)(13) limited partner exception under real pressure. If you receive a K-1 from an entity you actually work in, 2026 is the year to find out where you stand.
What the Statute Actually Says
Section 1402(a)(13) excludes from net earnings from self-employment “the distributive share of any item of income or loss of a limited partner, as such,” other than guaranteed payments for services actually rendered. Congress wrote that language in 1977, when a limited partner was a passive investor who would lose liability protection if they participated in management, and when LLCs did not yet exist in the United States.
The pivotal words are as such. Taxpayers long read the exception as a status test: hold an interest labeled “limited” under state law and it applies. The IRS reads it as a functional test covering income you earn as a passive investor, not income you earn by working in the business. Treasury proposed regulations settling the point in 1997, Congress blocked them, and they have sat unfinalized ever since. Into that vacuum stepped the courts.
The Cases That Changed the Analysis
| Decision | Entity | Holding |
|---|---|---|
| Renkemeyer (2011) | Law firm LLP | Shares earned from legal services, not passive investment; SE tax applied |
| Soroban Capital Partners (2023) | Investment manager LP | State-law limited partner status is not enough; a functional analysis is required |
| Denham Capital Management (2024) | Private equity manager LP | Partners who ran the business were not limited partners “as such” |
| Soroban, on the merits (2025) | Investment manager LP | Applying the functional test, the working partners lost the exception |
The trend line is unmistakable: courts look at what a partner does, not at what the partnership agreement calls them. A circuit-level appeal is pending, but no taxpayer should count on being rescued by it.
What the Functional Analysis Weighs
- Hours devoted to the business. Full-time involvement is the most damaging fact for the exception.
- Role and authority. Signing contracts, hiring staff, setting strategy, or owning client relationships all point toward active participation.
- Source of the entity’s income. Revenue earned from the partners’ personal services rather than deployed capital looks like earnings, not return on investment.
- Capital genuinely at risk. A meaningful capital investment producing a market return is the strongest fact in the taxpayer’s favor.
- Compensation already paid. A guaranteed payment well below the market rate for the same work suggests the distributive share is disguised compensation.
Courts have not held that every LLC member owes self-employment tax. They have held that the label on your K-1 no longer answers the question.
Why LLC Members Are Exposed Too
Section 1402(a)(13) never mentions LLCs, because they did not exist when it was written. An LLC member has limited liability by default while participating fully in management, precisely the combination the 1977 statute assumed was impossible. The IRS has consistently argued that Renkemeyer’s reasoning reaches LLC members, and nothing in the recent decisions suggests otherwise. A member-manager of a profitable LLC reporting only a guaranteed payment as self-employment income is taking a position the IRS is actively examining.
That scrutiny is not hypothetical. Limited partner self-employment tax sits on the IRS compliance campaign list, and the same fact patterns surface in audits of far smaller partnerships.
The Numbers at Stake
A Three-Partner Consulting LLP
- Firm profit before partner compensation: $2.4 million, split equally.
- Reported today: a $150,000 guaranteed payment each, with the remaining $650,000 per partner treated as exempt.
- If the exception fails: the additional $650,000 is subject to 2.9% Medicare tax plus the 0.9% additional Medicare tax above the threshold, about $24,700 per partner per year, since wage-base earnings are already covered.
- Three partners, three open years: approximately $222,000 in tax, before interest and penalties.
What drives the exposure: above the Social Security wage base only the Medicare portion applies, not the full 15.3%. Below the wage base, the arithmetic is far more painful, because the 12.4% Social Security component applies as well.
The Trap on the Other Side
Escaping self-employment tax rarely means the income escapes surtax altogether. Income exempt from SE tax because the owner is genuinely passive is generally exposed to the 3.8% net investment income tax instead. Between Sections 1402 and 1411, active and passive income each carry a surtax, so the real question is which one applies, not whether you can avoid both.
What to Do Before Year-End
- Document the facts now. Record hours, roles, capital contributions, and the source of firm revenue for each owner. A functional analysis is won on contemporaneous evidence, not on a memo written after the audit letter arrives.
- Benchmark guaranteed payments. If a partner works full time for a payment well below market, raise it. The reasonable compensation logic that protects S-corp owners is the best defense available here.
- Re-examine the entity choice. For service businesses, an S corporation offers a clearer framework: pay a defensible salary, and remaining distributions escape SE tax. Our entity comparison covers the tradeoffs, including the payroll obligations that come with it.
- Separate capital from services honestly. A genuine investor class funded with real capital can still qualify. Cosmetic two-tier structures, where the same people hold both interests, have not fared well in court.
- Model the QBI interaction. Compensation changes move both self-employment tax and the Section 199A deduction, and the optimum is rarely where owners assume.
- Decide the filing position deliberately. If you keep claiming the exception, know why, keep the support, and consider whether a reserve is appropriate.
Physician Groups and Specialty Practices
Multi-physician practices organized as LLCs or LLPs are squarely in the zone. Practice income comes from the physicians’ own clinical services, the fact pattern Renkemeyer treated as fatal to the exception, and ancillary revenue from imaging or a surgery center rarely changes the character of a working owner’s share. Any practice distributing large amounts on modest guaranteed payments should have this reviewed before the next K-1 season. Our medical practice finance and tax strategy teams run that analysis together, because the answer usually changes both the tax return and the compensation formula.
The Bottom Line
The limited partner exception still exists, but it protects a narrower group than most owners believe: partners whose return comes from capital, not from their own labor. If you work in your partnership or LLC, treat it as a position that must be earned and documented each year rather than a structural given. Disciplined bookkeeping and accurate payroll records make that case far easier to defend.
Not sure whether your K-1 income is exposed? Schedule a free consultation and our CFO advisory team will run the functional analysis, quantify the exposure across open years, and recommend a structure you can defend.
