Tag Archives: tax-exempt investors

Fifth Circuit Reverses LP Self-Employment Tax Exclusion

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August 18, 2026

A recent withdrawal and replacement of a Fifth Circuit ruling may impact certain investment fund managers’ ability to claim exemption from self-employment tax under Internal Revenue Code (“Code”) Section 1402(a)(13) on their distributive shares of management fee income.

As discussed in our previous January 2026 client alert, the Fifth Circuit delivered a significant win for investment fund managers organized as limited partners. The court overruled a Tax Court opinion and held that if a partner is classified as a limited partner under state law, their share of partnership income is exempt from self-employment tax. The IRS argued that the exemption should only apply to passive partners, but the Fifth Circuit disagreed. This was cautiously viewed as significant support for the position that a limited partner’s share of management fee income would be exempt from self-employment tax.

However, on August 13, 2026, the Fifth Circuit panel withdrew its January opinion and replaced it with a new one. The revised ruling adopts a narrower definition of limited partner that depends on the partner’s role in running the business. Under this new standard, partners who are actively managing the partnership’s business may not qualify as limited partners for self-employment tax purposes, even if state law identifies them as such. The case has been remanded for further proceedings under this new standard, and similar cases are pending in the Second and Third Circuits.

With those appeals pending, it is possible there may not be a unified rule until this matter is before the U.S. Supreme Court. It is unknown how those cases will resolve and whether they will hinder limited partners’ ability to claim an exemption from self-employment taxes under Code Section 1402(a)(13).

What This Means for Limited Partners

The self-employment tax exemption is now at risk for limited partners receiving distributive shares of income through an investment manager organized as a limited partnership. The exemption will turn on whether a limited partner is actively engaged in the business of the investment manager, but the standard for active participation is not yet clearly defined.

For other equity holders in investment managers not organized as limited partnerships (e.g., LLCs), the tax posture is likely unchanged, and their distributive share will remain subject to self-employment tax.

This is an extremely fact-specific inquiry, and we recommend fund managers be aware of developments in the law.

For additional information, please reach out to CFM Tax Practice Chair Kevin Leiske or associate Miles B. Anderson.

Hedge Fund UBTI (unrelated business taxable income)

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Hedge fund investors are always cognizant of the potential tax consequences of an investment into a hedge fund.  One of the issues which a hedge fund manager should be aware of is the concept of unrelated business taxable income or UBTI.

What is UBTI and why is it important?

As it relates to a tax-exempt investor in a hedge fund, UBTI is debt financed income derived by the hedge fund which does not relate to the activities of the tax-exempt investor.  As hedge funds are “flow through” vehicles, the designation of income as UBTI flows through the tax-exempt investor.  This is important because the tax-exempt investor must pay tax (called the unrelated business income tax or UBIT) on that portion of the income received by the fund which is UBTI.  UBTI is generally going to be taxed at a 35% rate.
Is there a way to get around UBTI?

There are two ways to make sure that tax-exempt investors do not receive any UBTI.  The first and most obvious is to make sure that the fund will use no leverage.  Because this might not be an option for some hedge funds, and because these funds would like to receive assets from tax-exempt entities, another option is for the fund to create an offshore hedge fund (either through a side by side structure or a master feeder structure).  In these structures that income does not “flow-through” to the investors like with the domestic hedge fund, but rather the income is paid to the investors through a dividend which is generally not taxable to a tax-exempt organization.  Using an offshore structure in this manner is often described as using a “blocker” because the UBTI is blocked out.

Do short sales give rise to UBTI?

Short sales alone do not give rise to UBTI.  The IRS has specifically provided guidance to the hedge fund community on this issue.  Please see Revenue Rule 95-8.  However, if a hedge fund borrowed money to engage in the short sale, this would probably give rise to UBTI.  If the fund utilizes short sales and engages in no leverage activities, then the there will likely be no UBTI with regard to the short sales.

What are the tax code provisions dealing with UBTI?

The following are links to the tax code dealing with UBTI:

Section 511 – provides for a tax on UBTI

Section 512 – defines UBTI and provides for the pass through treatment of UBTI to tax-exmpt investors in a fund (see 512(c))

Section 513 – provides a definition for “unrelated trade or business.”

Section 514 – provides additional definitional support for determining the amount of UBTI under section 512.