9th Circuit Opines on TEFRA Small Partnership Exception’s Application to Disregarded Entities and Punts on Issue of Deference Given to Revenue Rulings

Today Treasury re-released regulations under the new partnership audit regime, and that is a reminder that TEFRA is on its way out, putting pressure on me and my Saltzman/Book colleagues to finish our new chapter on partnership audits. Despite the new regime, courts, taxpayers and IRS still wrestle with TEFRA, which, given its complexity, will still produce developments for the blog and the treatise for the foreseeable future. Those developments include technical TEFRA issues, as here, but also broader issues of importance to tax procedure, including the degree of deference that courts should give to revenue rulings and when disregarded entities under the check the box regulations are not to be disregarded for all purposes.

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Last week the 9th Circuit in Seaview Trading v Commissioner considered one nook and cranny of TEFRA, the Section 6321 small partnership exception that applies when the partnership has “10 or fewer partners each of whom is an individual . . . , a C corporation, or an estate of a deceased partner.”

In Seaview, the father and son partners each held their interest in a partnership via single member LLCs that were organized under Delaware law. IRS audited the partnership and under TEFRA issued a final partnership administrative adjustment (FPAA) disallowing partnership losses relating to the 2001 year. The statute of limitations had long passed on the father and son’s individual 2001 tax returns if the TEFRA rules were not applicable. The son, on behalf of the partnership, filed a petition in Tax Court claiming that the FPAA was invalid because the partnership was exempt from TEFRA due to its qualifying for the small partnership exception. The Tax Court disagreed, and the Ninth Circuit, on appeal, affirmed the Tax Court. In so doing, it expounded on the relationship between State and Federal law and the deference given to revenue rulings.

In this brief post I will explain the issue and summarize the appellate court’s opinion.

As most readers know, the check the box regulations under Section 7701 disregard a solely owned LLC unless the owner elects otherwise. Regulations under Section 6321 provide that the small partnership TEFRA exception “does not apply to a partnership for a taxable year if any partner in the partnership during that taxable year is a pass-thru partner as defined in section 6231(a)(9).” TEFRA, at Section 6321(a)(9), defines a pass-thru partner as any “partnership, estate, trust, S corporation, nominee, or other similar person through whom other persons hold an interest in the partnership.” Section 6321(a)(9) predates the LLC and like entity explosion of the late 20th century, and there are no Treasury regulations that define LLCs and the like as a pass-thru partner.

The partnership in Seaview argued that under the check the box regulations, the LLCs that held the partnership were treated as sole proprietorships of their respective individual owners, and that consequently they could not constitute pass-thru partners within the meaning of the TEFRA regulations.

Despite the absence of regulations that address the issue of how interests held through single member LLCS are treated under the small partnership exception, the IRS, in Revenue Ruling 2004-88, specifically considered that issue. The revenue ruling held that a partnership whose interest is held through a disregarded entity ineligible for the small partnership exemption because a disregarded entity is a pass-thru entity.

In reaching its conclusion that the small partnership exception did not apply, the 9th Circuit addressed how much deference it should give to the IRS’s revenue ruling. The opinion notes that there is some uncertainty on the degree of deference to informal agency positions like revenue rulings. The court explained that in Omohundro v. United States the 9th circuit has generally given Skidmore deference to them. On the other hand, it noted that under the 2002 Schuetz v. Banc One Mortgage Corp., the 9th Circuit had given greater Chevron deference to an informal HUD agency position, and that there is some tension between the circuit’s approach in Schuetz and its approach in Omohundro.

It avoided having to resolve the tension between Omohundro and Schuetz by finding that the Service position in the revenue ruling was correct even when applying the less deferential Skidmore standard. The Skidmore test essentially means that courts defer to the position if it finds it persuasive. As the opinion describes, factors that courts have considered in analyzing whether a position is persuasive include the position’s thoroughness, agency consistency in analyzing an issue and the formality associated with the guidance.

The taxpayers in Seaview essentially hung their hat on the revenue ruling’s rather brief discussion of the sole member LLC issue, but the court nonetheless found the ruling persuasive and also consistent with other cases and less formal IRS counsel opinions that likewise considered the application of the small partnership exception to disregarded entities.

For those few readers with an appetite for TEFRA complexity, I recommend the opinion, but in a nutshell the court agreed with the Service approach that looked first to how the statute’s language did not reflect a Congressional directive to limit the exception to only listed entities. As the opinion discussed, Section 6321(a)(9) defines a pass thru partner as a “partnership[s], estate[s], trust[s], S corporation[s], nominee[s] or [an]other similar person through whom other persons hold an interest in the partnership.” Noting that the statute itself contemplates its application beyond the “specific enumerated forms” the question turns on “whether a single- member LLC constitutes a “similar person” in respect to the enumerated entities.”

The opinion states that “Ruling 2004-88 holds that the requisite similarity exists when ‘legal title to a partnership interest is held in the name of a person other than the ultimate owner.’ ” That line drawing, in the 9th Circuit view, was persuasive, and the revenue ruling had in coming up with the approach cited to and briefly discussed cases that supported the IRS position, including one case where a custodian for minor children was not a pass thru partner because he did not have legal title and another case where a grantor trust was a pass thru partner because it did hold legal title.

One other point, the relationship between state and federal law, is worth highlighting. The taxpayers gamely argued that the IRS view impermissibly elevated state law considerations to determine a federal tax outcome. The court disagreed:

But the issue here is not whether the IRS may use state-law entity classifications to determine federal taxes. Rather, the question is whether an LLC’s federal classification for federal tax purposes negates the factual circumstance in which the owner of a partnership holds title through a separate entity. In other words, state law is relevant to Ruling 2004-88’s analysis only insofar as state law determines whether an entity bears the requisite similarity to the entities expressly enumerated in § 6231(a)(9)—that is, whether an entity holds legal title to a partnership interest such that title is not held by the interest’s owner.

Conclusion

The Bipartisan Budget Act (BBA) new rules for partnership audits begin for returns filed for partnership tax years beginning in 2018. As partners and advisors navigate the uncertain waters of a new BBA partnership audit regime, TEFRA and its complexity will be with us for some time.

The BBA regime has opt out procedures for partnerships that have 100 or fewer qualifying partners. Essentially the statute states that all partners must be individuals,  C corporations, or any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner. While silent on the treatment of disregarded entities, the BBA statute also states that Treasury and IRS by “regulation or other guidance” can prescribe rules similar to the rules that define the category of qualifying partners. 

Proposed Treasury regulations under the BBA were in limbo but earlier today Treasury re-released regulations that provide guidance for the new regime. The proposed BBA regulations specifically address disregarded entities. Despite comments in response to an earlier notice asking Treasury to allow disregarded entities to be treated as qualifying partners, the proposed regulations do not include disregarded entities as qualifying partners and the preamble specifically states that Treasury declined to do so because “the IRS will face additional administrative burden in examining those structures and partners under the deficiency rules.”

The upshot is that for under both TEFRA and likely BBA disregarded entities holding interests in a partnership mean that the general partnership audit rules will apply.

 

 

 

 

Tenth Circuit Holds Partner Can Raise Reasonable Cause Defense in Partner Proceeding

TEFRA holds a special place in my tax procedure loving heart. Working with a recently-married colleague of mine (who did the heavy lifting), we rewrote the content on TEFRA in Saltzman and Book a couple of years ago. Digging deeply into its nooks and crannies, we dutifully update it now, while at the same time preparing to write fresh content on the new regime ushered in by the Bipartisan Budget Act of 2015.

Lest I whine too much about Congress replacing TEFRA after putting all that time in, it will still have relevance for many years. There are still plenty of unresolved TEFRA issues that courts are struggling with, including one that the Tenth Circuit tackled this week in McNeill v US. That case involved the question as to which party, the partnership or the managing partner, could raise a reasonable cause/good faith penalty defense. The penalty arose from the disallowance of losses in a shelter that artificially shifted losses from non-US partners, who contributed low value high basis securities, to retiring executive McNeill, who contributed some cash but had many millions in gains he was looking to offset with the other parties’ unusable losses.

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One of the issues we struggled with/wrote about in Saltz/Book was the reasonable cause/good faith defense, and in particular who (the partnership or the partner) is the proper party to make that argument. There are a number of cases that essentially now stand for the proposition that the reasonable cause/good faith defense may be a partner- or partnership-level defense, depending on who is asserting it. So, while a partnership as a pass through entity is not a taxpayer in the sense that it has no separate income tax liability, it does, often through its managing partner, have the ability to raise at the partnership level a reasonable cause/good faith defense.

In  McNeill, in a federal district court in Wyoming, the government successfully argued that since the partnership in an administrative proceeding had consented to the penalties then McNeill, as the managing partner, was precluded from arguing in a partner level proceeding from raising a separate partner-level reasonable cause good faith defense. This was not based on judicial preclusion doctrines such as issue or claim preclusion; rather, the district court looked to TEFRA itself and in particular Section 6230(c)(4), and the interplay of the second sentence and third sentence in the statute.

The second sentence states that “the determination under the final partnership administrative adjustment or under the decision of the court (whichever is appropriate) concerning the applicability of any penalty . . . which relates to an adjustment to a partnership item shall also be conclusive.” The next sentence states that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.”

McNeill appealed, and at the Tenth Circuit the government argued that the issue was resolved by the second sentence, i.e., that penalty determinations “must be conclusive not just against the partnership itself but also against the managing partner in any later partner level refund action.” The circuit court found some appeal in that argument but not enough to carry the day:

It’s an argument that is sound as far as it goes but one that doesn’t go quite far enough. It fails to account for the statute’s very next and last sentence, which expressly says that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.” Here, then, Congress pretty clearly seemed to contemplate a regime in which any partner may assert any “partner level defenses” that may apply. And by statute the reasonable cause/good faith defense appears to be one available at the partner level: after all, it applies when (among other things) the “taxpayer” can show he acted in good faith and (again) under TEFRA it is usually the partner who is the taxpayer. Id. § 6664(c)(1).

(emphasis added)

Parting Thoughts

There is more in the opinion, including a spirited dissent that essentially adopts the district court’s reasoning, the majority’s discussion as to why the government’s efficiency argument might have been misguided, and a walk-through of precedents that while not on point support the Tenth Circuit’s conclusion. The opinion is also noteworthy though for it suggests that if there were a judicial proceeding on the merits of the penalty defense (as opposed to just an administrative determination) then the government could have argued that issue preclusion would prevent the managing partner from raising a separate defense.

I also note that in many instances the analysis as to reasonable cause/good faith as to the partnership and managing partner overlaps so much that the difference may not matter much on the merits. Lawyers and accountant letters attempting to justify the tax position likely do not differ that much in terms of recipient, especially as here there was very little space between the managing partner and the partnership itself. Yet the majority opinion suggests that were differing opinion letters, and McNeill will now be able to get the lower court to look at those. The result is not quite a clean victory, but it at least gets him in the door.

 

Summary Opinions — For the last time.

This could be our last Summary Opinions.  Moving forward, similar posts and content will be found in the grab bags.  This SumOp covers items from March that weren’t otherwise written about.  There are a few bankruptcy holdings of note, an interesting mitigation case, an interesting carryback Flora issue, and a handful of other important items.

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  • Near and dear to our heart, the IRS has issued regulations and additional guidance regarding litigation cost awards under Section 7430, including information regarding awards to pro bono representatives. The Journal of Accountancy has a summary found here.
  • The Bankruptcy Court for the Southern District of Florida in In Re Robles has dismissed a taxpayer/debtor’s request to have the Court determine his post-petition tax obligations, as authorized under 11 USC 505, finding it lacked jurisdiction because the IRS had already conceded the claim was untimely, and, even if not the case, the estate was insolvent, and no payment would pass to the IRS. Just a delay tactic?  Maybe not.  There is significant procedural history to this case, and this 505 motion was left undecided for considerable time as there was some question about whether post-petition years would generate losses that could be carried back against tax debts, which would generate more money for creditors.  This became moot, so the Court stated it lacked jurisdiction; however, the taxpayer still wanted the determination to show tax losses, which he could then carryforward to future years (“establishing those losses will further his ‘fresh start’”).  The Court held that since the tax losses did not impact the estate it no longer a “matter arising under title 11, or [was] a matter arising in or related to a case under title 11”, which are required under the statutes.
  • The Tax Court in Best v. Comm’r has imposed $20,000 in excess litigation costs on an attorney representing clients in a CDP case. The Court, highlighting the difference in various courts regarding the level of conduct needed, held the attorney was “unreasonable and vexations” and multiplied the proceedings.  Because the appeal in this case could have gone to the Ninth Circuit or the DC Circuit, it looked to the more stringent “bad faith” requirements of the Ninth Circuit.  The predominate issue with the attorney Donald MacPherson’s conduct appears to have been the raising of stated frivolous positions repeatedly, which the Court found to be in bad faith.
  • And, Donald MacPherson calls himself the “Courtroom Commando”, and he is apparently willing to go to battle with the IRS, even when his position may not be great…and the Service and courts have told him his position was frivolous. Great tenacity, but also expensive.  In May v. Commissioner, the Tax Court sanctioned him another seven grand.
  • The Northern District of Ohio granted the government’s motion for summary judgement in WRK Rarities, LLC v. United States, where a successor entity to the taxpayer attempted to argue a wrongful levy under Section 7426 for the predecessor’s tax obligation. The Court found the successor was completely the alter ego of the predecessor, and therefore levy was appropriate, and dismissal on summary judgement was proper.
  • I’m not sure there is too much of importance in Costello v. Comm’r, but it is a mitigation case. Those don’t come up all that frequently.  The mitigation provisions are found in Sections 1311 to 1314 and allow relief from the statute of limitations on assessment (for the Service) and on refunds (for taxpayers) in certain specific situations defined in the Code.  This is a confusing area, made more confusing by case law that isn’t exactly uniformly applied.  The new chapter 5 of SaltzBook will have some heavily revised content in this area, and I should have a longer post soon touching on mitigation and demutualization in the near future.  In Costello, the IRS sought to assess tax in a closed year where refunds had been issued to a trustee and a beneficiary on the same income, resulting in no income tax being paid.  Section 1312(5) allows mitigation in this situation dealing with a trust and beneficiary.  There were two interesting aspects of this case, including whether the parties were sufficiently still related parties where the trust was subsequently wound down, and whether amending a return in response to an IRS audit was the taxpayer taking a position.
  • The First Circuit has joined all other Circuits in holding “that the taxpayer must comply with an IRS summons for documents he or she is required to keep under the [Bank Secrecy Act], where the IRS is investigating civilly the failure to pay taxes and the matter has not been referred for criminal prosecution,” and not allowing the taxpayer for invoking the Fifth Amendment. See US v. Chen. I can’t recall how many Circuit Courts have reviewed this matter, but it is at least five or six now.
  • The District Court for the District of Minnesota in McBrady v. United States has determined it lacks jurisdiction to review a refund claim for taxpayers who failed to timely file a refund request, and also had an interesting Flora holding regarding a credit carryback. The IRS never received the refund claim for 2009, which the taxpayer’s accountant and employee both testified was timely sent, but there was not USPS postmark or other proof of timely mailing, so Section 7502 requirements were not met.  Following an audit, income was shifted from 2009 to other years, including 2008.  This resulted in an outstanding liability that was not paid at the time the suit was filed, but the ’09 refund also generated credits that the taxpayer elected to apply to 2008.  The taxpayers also sought a refund for 2008, arguing the full payment of the ’09 tax that created the ’08 credit should be viewed as “full payment”, which they compared to the extended deadline for refunds when credits are carried back.  The Court did not find this persuasive, and stated full payment of the assessed amount of the ’08 tax was needed for the Court to have jurisdiction over the refund suite under Flora.  Sorry, couldn’t find a free link.
  • The IRS lost a motion for summary judgement regarding prior opportunity to dispute employment taxes related to a worker reclassification that occurred in prior proceeding. The case is called Hampton Software Development, LLC v. Commissioner, which is an interesting name for the entity because the LLC operated an apartment complex.  The IRS argued that during a preassessment conference determining the worker classification the taxpayer had the opportunity to dispute the liability, and was not now entitled to CDP review of the same.  The Court stated the conference was not the opportunity, as the worker classification determination notice is what would have triggered the right under Section 6330(c)(2)(B), and such notice was not received by the taxpayer (there was a material question about whether the taxpayer was dodging the notice, but that was a fact question to be resolved later).  The Hochman, Salkin blog has a good write up of this case, which can be found here.
  • The IRS has issued additional regulations under Section 6103 allowing disclosure of return information to the Census Bureau. This was requested so the Census could attempt to create more cost-efficient methods of conducting the census.  I don’t trust the “Census”.  Too much information, and it sounds really ominous.  That is definitely the group in Big Brother that will start rounding up undesirables, and now they have my mortgage info.
  • The Service has issued Chief Counsel Notice 2016-007, which provides internal guidance on how the results of TEFRA unified partnership audit and litigation procedures should be applied in CDP Tax Court cases. The notice provides a fair amount of guidance, and worth a review if you work in this area.
  • More bankruptcy. The US Bankruptcy Court for the Eastern District of Virginia has held that exemption rights under section 522 of the BR Code supersede the IRS offset rights under section 533 of the BR Code and Section 6402.  In In Re Copley, the Court directed the IRS to issue a refund to the estate after the IRS offset the refund with prepetition tax liabilities.  The setoff was not found to violate the automatic stay, but the court found the IRS could not continue to hold funds that the taxpayer has already indicated it was applying an exemption to in the proceeding.   There is a split among courts regarding the preservation of this setoff right for the IRS.  Keith wrote about the offset program generally and the TIGTA’s recent critical report of the same last week, which can be found here.

 

 

Summary Opinions — Catch Up Part 1

Playing a little catch up here, and covering some items from the beginning of the year.  I got a little held up working on a new chapter for SaltzBook, and a supplement update for the same.  Both are now behind us, and below is a summary of a few key tax procedure items that we didn’t otherwise cover in January.  Another edition of SumOp will follow shortly with some other items from February and March.

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  • In CCA 201603031, Counsel suggests various procedures for the future IRS policy and calculations for the penalty for intentional failure to file electronically.  The advice acknowledges there is no current guidance…I wrote this will staring at my paper 1040 sitting right next to my computer.  Seems silly to do it in pencil, and then fill it into the computer so I can file electronically.
  • This item is actually from March.  Agostino and Associates published its March newsletter.  As our readers know, I am a huge fan of this monthly publication.  Great content on reducing discharge of indebtedness income and taxation.  Also an interesting looking item on representing real estate investors, which I haven’t had a chance to read yet, but I suspect is very good.
  • The IRS has issued a memo regarding its decision to apply the church audit restrictions found under Section 7611 (relating to exemption and UBI issues) to employment tax issues with churches also.
  • Panama Papers are all the rage, but I know most of you are much more interested in Iggy Azalea’s cheating problems (tax and beau).  Her Laker fiancé was recorded by his teammate bragging about stepping out and she had a sizable tax lien slapped against her for failure to pay.  She has threatened to separate said significant other from reproductive parts of his body, but it appears she has approached the tax debt with a slightly more level head, agreeing to an installment agreement.
  • I’m a rebel, clearly without a cause.  I often wear mismatched socks, rarely take vitamins, and always exceed the speed limit by about 6 MPH.  But, professionally, much of my life is about helping people follow the rules.  In Gemperle v. Comm’r, the taxpayers followed the difficult part of the conservation easement rules, and obtained a valid appraisal of the value, but failed to follow the simple rule of including it with his return.  Section 170(h)(4)(B)(iii) is fairly clear in stating the qualified appraisal of the qualified property interest must be included with the return for the year in question.  And, the taxpayers failed to bring the appraiser to the hearing as a witness, allowing the IRS to argue that the taxpayer could not put the appraisal into evidence because there was no ability to cross examine.  In the end, the deduction was disallowed, and the gross valuation misstatement penalty was imposed under Section 6662(h) of 40%.  The Section 6662(a) penalty also applied, but cannot be stacked on top of the 40% penalty pursuant to Reg. 1.6662-2(c).  The Court found that there was no reasonable cause because the taxpayer failed to include the appraisal on the return, so, although relying on an expert, the failure to include the same showed to the Court a lack of good faith.  Yikes! Know the rules and follow them. It is understandable that someone could get tripped up in this area, as other areas, such as gift tax returns, have different rules, where a summary is sufficient (but perhaps not recommended).
  • The Shockleys are fighting hard against the transferee liability from their corporation.  Last year we discussed their case relating to the two prong state and federal tests  required for transferee liability under Section 6901.  In January, the Shockleys had another loss, this time with the Tax Court concluding they were still liable even though the notice of transferee liability was incorrectly titled and had other flaws.  Overall, the Court found that it met and exceed the notice requirements and the taxpayer was not harmed.
  • The Tax Court, in Endeavor Partners Fund, LLC v. Commissioner, rejected a partnership’s motion for injunction to prevent the IRS from taking administrative action against its tax partner.  The partnership argued that allowing the IRS to investigate the tax matters partner for items related to the Tax Court case (where he was not a party) would “interfere with [the Tax] Court’s jurisdiction” because the Service could be making decisions on matters the Court was considering.  The Court was not troubled by this claim, and held it lacked jurisdiction over the matters raised against the tax matters partner, and, further, the partnership’s request did not fall within an exception to the Anti-Injunction Act.
  • Wow, a financial disability case where the taxpayer didn’t lose (yet).  Check out this 2013 post by Keith (one of our first), dealing with the IRS’s win streak with financial disability claims.  Under Section 6511(h), a taxpayer can possibly toll the statute of limitations on refunds with a showing of financial disability.  From the case, “the law defines “financially disabled” as when an “individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment … which has lasted or can be expected to last for a continuous period of not less than 12 months,” and provides that “[a]n individual shall not be considered to have such an impairment unless proof of the existence thereof is furnished in such form and manner as the Secretary may require.””  I’ve had some success with these cases in the past, but I also had my ducks in a row, and compelling facts.  So, not something the IRS would want to argue before a judge.  The Service gets to pick and choose what goes up, which is why it wins.  In LeJeune v. United States, the District Court for the District of Minnesota did not grant the government’s motion for summary judgement, and directed further briefing and hearing on whether the taxpayer’s met their administrative requirements.
  • Another initial taxpayer victory, which could result in an eventual loss, but this time dealing with TFRP under Section 6672.  In Hudak v. United States, the District Court for the District of Maryland dismissed the IRS’s motion for summary Judgement, finding that a jury could determine that a CFO (here Mr. Mules) was not a responsible person with the ability to pay.  The CFO admitted he knew the company wasn’t complying with its employment tax obligations, and knew other creditors were being paid.  He alleged, however, that he lacked the ability (as CFO) to make the required payments…seems like an uphill battle.  He could win though, as the contention is that the owner/CEO/President (Mr. Hudak) made those decisions, had that authority, and misled the CFO to believe the payments were made.  Neither side will likely be able to put much past the Court in this matter, as Judge Marvin Garbis is presiding (he who authored various books on tax, including Cases and Materials on Tax Procedure and Tax Fraud and Federal Tax Litigation).

 

Important New Partnership Audit Rules Change Taxation of Partnerships

Today’s guest post is written by attorneys from the San Antonio office of Strasburger & Price LLP, a Texas based firm with a strong tax practice area. Farley P. Katz is a partner at Strasburger who focuses his practice on civil and criminal tax controversies. He has written a variety of tax articles including The Art of Taxation: Joseph Hémard’s Illustrated Tax Code, 60 Tax Lawyer 163 (2007) and The Infernal Revenue Code, 50 Tax Lawyer 617 (1997). Joseph Perera represents clients on a variety of federal and state tax matters. Before joining Strasburger, he worked in the National Office of the Office of Chief Counsel. Katy David is a partner at Strasburger who counsels clients on tax matters, including federal income taxation and state margin and sales taxation.  We welcome these first time guest bloggers who provide an explanation of the new law impacting partnership tax procedures.  I always hoped that if I waited long enough I would not have to learn TEFRA.  Keith 

On November 2, 2015, the Bipartisan Budget Act of 2015 (BBA) became law. Buried in the BBA are new rules replacing the long-standing Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Electing Large Partnership rules that previously governed partnership audits. These new rules turn established partnership tax law on its head.

Under BBA rules, if a partnership understates its income or overstates its deductions, it is subject to income tax. Not only can the partnership owe income tax, the tax will not be based on the income for the year in question, but instead on one or more prior years’ income. Consequently, the economic burden of the tax could be borne by partners who had no interest in the partnership when the income was generated. Conversely, if a partnership overstated its income in a prior year, the benefit of correcting that overstatement will accrue to the current partners, not those who were partners in the earlier year. Finally, if a partnership elects out of the new provisions (assuming it is eligible), the IRS will no longer be able to conduct a centralized audit controlling each partner’s distributive share, but will instead have to audit each partner individually.

The BBA rules apply to partnership returns filed after 2017, although a partnership may elect to have these rules apply to returns filed before 2018. Not only will these new rules vastly complicate the audit of partnerships that elect out, but they will also require that virtually every partnership in existence consider electing out or revising its partnership agreement to address BBA.

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Who is subject to BBA?

All partnerships are subject to the new rules unless they elect out. Although TEFRA excluded partnerships with 10 or fewer individual (excluding NRAs), C corporation or estate partners, BBA has no such automatic exception. As a result, all partnerships are now covered: even those with as few as two individuals, family limited partnerships, LLCs treated as partnerships for tax purposes, and tiered partnerships. The only excluded partnerships are those that are eligible to elect out and do so on a timely basis.

What does BBA do?

BBA is similar to TEFRA in many respects. Like TEFRA, it requires that all items of income, loss, deduction or credit be determined at the partnership level. Like TEFRA, BBA provides that a partner’s tax return is consistent with the K-1 the partnership issued, unless the partner files a notice of inconsistent treatment. If a partner fails to file the notice, the IRS may treat any underpayment of tax resulting from the partner taking an inconsistent position as a mere mathematical or clerical error and assess the tax without issuing a deficiency notice.

Like the Tax Matters Partner under TEFRA, BBA’s “Partnership Representative” (who does not have to be a partner) is the point of contact for the IRS and can bind the partnership. Unlike TEFRA, however, BBA provides that all tax attributable to adjustments (called the “imputed underpayment”) is assessed against and collected from the partnership, along with interest (determined from the due dates for the reviewed years) and penalties. Also unlike TEFRA, BBA provides that penalties are exclusively determined at the partnership level; there is no partner-level defense. 

How does BBA calculate an underpayment?

Under BBA the years audited are called the “reviewed years,” and the year in which an audit becomes final is called the “adjustment year.” The imputed underpayment is determined by adding together or “netting” all adjustments to items of income, gain, loss and deduction and multiplying the result by the highest tax rate in effect for the reviewed years under section 1 (individuals) or section 11 (corporations). The imputed underpayment is calculated without regard to the nature of the adjustments; all positive or negative adjustments to capital gains, losses, whether long or short term, items of ordinary income or other types of income or loss, are netted. Nor does it appear to matter that items might be subject to restrictions on deduction at the partner level such as the “at risk” or “passive activity” limitations. If the audit adjusts tax credits, those adjustments are taken into account.

Changes in partners’ distributive shares are treated differently and are not netted. For example, if an audit reallocates income from one partner to another, BBA counts only the increase in income, not the decrease, and adds the increase to the partnership underpayment. This treatment will result in phantom income and tax to the partnership even though it does not change the net income reported on the Form 1065.

What if there would be less tax if the adjustments flowed through to the partners?

In many circumstances, the imputed underpayment will be less overall if the adjustments flowed through to the partners. For example, a partner might have a net operating loss that could absorb an adjustment. BBA provides that Treasury shall issue procedures allowing partners to elect to file amended returns for the reviewed years (i.e., the audited years). If the amended returns take into account all adjustments made, and if the tax is paid, then the adjustments will be removed from the partnership level adjustment. Reallocations of distributive shares will be removed only if all the partners affected file amended returns.

Treasury also will issue rules to reduce the partnership level tax rate without requiring amended returns from the partners in certain situations, such as where there are tax-exempt partners. A similar rule will apply lower tax rates if the adjustment includes ordinary income to a C corporation partner (which would pay a lower tax than an individual partner would) or if the adjustment includes capital gain or qualified dividends to an individual partner. Finally, Treasury may issue regulations that make other modifications to the imputed underpayment in similar circumstances.

A partnership seeking to reduce its imputed underpayment under this provision must supply supporting documentation to the IRS within 270 days of issuance of a Proposed Partnership Adjustment.

Can a partnership elect to make the partners liable for the adjustments?

A partnership may elect to have the adjustments shown in a Final Partnership Adjustment (FPA) flow through to its partners. The partners’ tax for the year of the election will be increased by the amount their tax in the reviewed years would have increased based on their distributive share of the adjustments made. In addition, the tax will include any tax that would have resulted from those adjustments in the years after the reviewed year and before the election year. All tax attributes, such as basis, will be affected by these adjustments.

The partnership must elect this flow-through within 45 days of issuance of the FPA. If it makes the election, the partnership will not be liable for any tax. Although the statute is unclear, it appears that the partnership can still contest the FPA in court.

The effect of this election is similar to a TEFRA adjustment, but instead of actually imposing tax in the earlier years, it imposes a tax in the year of the election. In addition to the tax, partners will liable for any penalties and interest, but the interest rate is increased by two percentage points and runs from the earlier years that generated the liability.

What if an audit reduces the tax reported?

If a partnership audit reduces the income originally reported or increases the net loss originally reported, these changes will constitute adjustments for the adjustment year (audit year) and will flow through to the partners for that year.

As under TEFRA, partnerships that have over reported their income may file an Administrative Adjustment Request (AAR), but the IRS will treat any decrease in income or increase in loss as occurring in the year the AAR is filed. If the partnership determines it underpaid its tax, it may file an AAR, but payment of tax is due on filing.

TEFRA provided that the Tax Matters Partner could file an AAR on behalf of the partnership or that any other partner could file an AAR on the its own behalf. However, under BBA, only the partnership can file an AAR; a partner no longer may file its own AAR.

Who can elect out? 

Partnerships with 100 or fewer partners can elect out, if the partners are all individuals (including NRAs), C corporations, foreign entities that would be treated as C corporations if they were domestic, or estates of deceased partners. An S corporation also may qualify, if it identifies all of its shareholders to the IRS. In that event, each of the S corporation’s shareholders counts as a partner for purposes of the “100 or fewer partners” test. A partnership that has even one partner that is itself a partnership cannot elect out, nor does it appear that a partnership could elect out if it has a trust as partner. Although TEFRA contained a provision that a husband and wife counted as one partner for the similar “10 or fewer” rule, BBA contains no such exception. 

How does a partnership elect out?

An election applies to one year only and must be made in a timely filed return for that year. The partnership must identify all the partners to the IRS and give the partners notice of the election.

What happens if a partnership elects out?

If a partnership elects out of BBA, the consistency provisions no longer apply. As a result, each partner may take an inconsistent position regarding partnership items reported on its K-1, without providing notice to the IRS of the inconsistent position.

If a partnership elects out, the IRS still could audit the partnership, but it must make all tax adjustments at the partner level. Accordingly, it would have to issue 30-day letters or notices of deficiency to the individual partners. We expect many partnerships that were subject to TEFRA to elect out of BBA, which will put the IRS in a bind. If the IRS issues a taxpayer a notice of deficiency and the taxpayer petitions the Tax Court, the IRS ordinarily is barred from issuing another deficiency notice if it later discovers additional adjustments. Accordingly, if a partnership elects out of BBA and the IRS makes adjustments on audit, it will have to decide whether to fully audit the returns of the partners (significantly increasing its workload) or issue notices of deficiency and thereby risk losing the opportunity to make further adjustments to those returns.

What are the procedural rules for audits? 

The procedural rules are similar to those under TEFRA. The IRS must give notice of the beginning of the audit. The IRS, however, is required to give notice of any Proposed Partnership Adjustment and then must wait at least 270 days before issuing a FPA. The 270 days gives the partnership time to produce documentation supporting lower tax rates for an imputed underpayment. The IRS must wait 90 days after issuing the FPA before assessing, and—if the partnership timely petitions in court—the IRS must wait until the decision is final to assess. Petitions in Tax Court do not require pre-payment, but a partnership filing in district court or the Claims Court requires payment of the estimated imputed underpayment.

There are, however, a number of procedural differences between BBA and TEFRA. For example, BBA requires that the IRS issue a Proposed Partnership Adjustment, which has legal consequences, whereas TEFRA did not require that an analogous 60-day letter be issued. TEFRA also provided that any partner could participate in the audit and many could bring suit, whereas BBA provides that only the partnership may take those actions. TEFRA also provided procedures by which the IRS or a partner could convert partnership items to partner-level items, effectively opting out of TEFRA, but BBA contains no such provisions. TEFRA provided that if an AAR is filed and the IRS did not act on it, the taxpayers could bring a suit in court, whereas BBA provides for such suit only if the IRS issues an FPA, apparently leaving taxpayers without remedy.

Statute of limitations 

BBA provides that an adjustment generally must be made (presumably “assessed”) within 3 years from the later of (1) the date the partnership return for the reviewed year was filed, (2) the due date for that return, or (3) the date the partnership filed an AAR for the year. However, if the partnership timely submitted documentation to support a reduced tax rate, the adjustment may also be made within 270 days of the date all such documentation was submitted, plus any extensions of time given to submit. Finally, even if the partnership did not request a reduced tax rate, an adjustment also will be timely if made within 270 days of the date a Proposed Partnership Adjustment was issued. An adjustment made within any of these periods is timely, and the partnership can extend the time to make the adjustment. The periods also are extended in other situations. If the amount of unreported income exceeds 25 percent of the gross income of the partnership for the reviewed year, the IRS has 6 years to make the adjustment. Moreover, if the partnership did not file a return or filed a fraudulent return, there is no limitation.

Will there be guidance? 

The BBA rules make fundamental changes in the tax treatment of partnerships and raise a multitude of new questions. Treasury has been directed to issue regulations, and the IRS is expected to issue additional guidance. Nevertheless, the rules undoubtedly will result in much confusion and litigation in the coming years.

What should partnerships do now? 

The BBA raises a number of issues that taxpayers should consider. Among them is whether partnership agreements need to be revised to address the BBA. Some partnerships, for example, might consider provisions that require electing out of the BBA (if that is possible). Under the BBA, the economic consequences of a tax audit of a given year or years will accrue in a subsequent year when the partnership might have different partners. Taxpayers might consider provisions addressing such possibilities and providing for appropriate tax sharing or allocation provisions. In any event, taxpayers using partnerships for businesses or investments and persons buying or selling partnership interests need to be aware of these provisions and should consult with their tax advisors.

Summary Opinions for 9/21/15 to 10/2/15

Running a little behind on the Summary Opinions.  Should hopefully be caught up through most of October by the end of this week.  Some very good FOIA, whistleblower, and private collections content in this post.  Plus fantasy football tax cheats, business on boats, and lots of banks getting sued.  Here are the items from the end of September that we didn’t otherwise write about:

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  • Let’s start with some FOIA litigation. The District Court for the District of Columbia issued two opinions relating to Cause of Action, which holds itself out as an advocate for government accountability.  On August 28th, the Court ruled regarding a FOIA request by Cause for various documents relating to Section 6103(g) requests, which would include all request by the executive office of the Prez for return information, plus all such requests by that office that were not related to Section 6103(g), and all requests for disclosure by an agency of return information pursuant to Sections 6103(i)(1), (2), & (3)(A).   The IRS failed to release any information pursuant to the last two requests, taking the position that records discussing return information would be “return information” themselves, and therefore should be withheld under FOIA exemption 3.  There are various holdings in this case, but the one I found most interesting was the determination that the request by the Executive Branch and the IRS responses may not be “return information” per se, which would require a review by the IRS of the applicable documents.  Although the petition was drafted in broad terms, this Washington Times article indicates the plaintiff was seeking records regarding the Executive Branch looking into them specifically, presumably as some type of retaliation.

In a second opinion issued on September 16th, in Cause of Action v. TIGTA, Judge Jackson granted TIGTA’s motion for summary judgement because after litigation and in camera review, the Court determined none of the found documents were responsive.  This holding was related to the same case as above, but the IRS had shifted a portion of the FOIA request to TIGTA.  Initially, TIGTA issued a Glomar response, indicating it could not confirm or deny the existence (I assume for privacy reasons, not national defense).  The Court found that was inapplicable, and TIGTA was forced to do a review and found 2,500 records, which it still withheld.  Cause of Action tried to force disclosure, but the Court did an in camera review and found the responsive records were not actually applicable.

  • That was complicated.  Now for something completely different.  This HR Block infographic is trying to get you all investigated for tax fraud.  In summary, 75 million of the 319 million people in America play fantasy football, and roughly none are paying taxes on their winnings.  If you click on the infographic, we know you are guilty.  Thankfully, my teams this year are abysmal, so I won’t be committing tax fraud…my wife on the other hand has a juggernaut in our shared league…To all of our IRS readers, please ignore this post.
  • Now a couple whistleblower cases.  In Whistleblower One 10683W v. Comm’r, the Tax Court held that the whistleblower was entitled to review relevant information relating to the denial of the award based on information provided by the whistleblower.  The whistleblower had requested information relating to the investigation of the target, the disclosed sham transaction, and the amounts collected, but the IRS took the position that certain items requested were not in the Whistleblower Office’s file, and were, therefore, beyond the scope of discovery (denied, but we don’t have to explain ourselves).  The Court disagreed and found the information was relevant and subject to review by the whistleblower.  Further, the IRS was not unilaterally allowed to decide what was part of the administrative record.  Another case that perhaps casts a negative light on how the IRS is handling the whistleblower program.
  • On September 21st, the District Court for the Middle District of Florida declined a pro se’s request for reconsideration of a petition for injunctive relief against the IRS to force it to investigate his whistleblower claim in Meidinger v. Comm’r (sorry couldn’t find a free link to this order).  Mr. Meidinger likely knew the court lacked jurisdiction, and this was the purview of the tax court —  Here is a write up by fellow blogger, Lew Taishoff, on Mr. Meidinger’s failed tax court case.  Lew’s point back in 2013 on the case still rings true:  “But the administrative agency here has its own check and balances, provided by the Legislative branch.  There’s TIGTA, whose mission is ‘(T)o provide integrated audit, investigative, and inspection and evaluation services that promote economy, efficiency, and integrity in the administration of the internal revenue laws.’ Might could be y’all should take a look at how the Whistleblower Office is doing.”  The tax court really can’t force an investigation, but TIGTA could put some pressure on the WO to do so.  After taking a shot at the IRS, I should note I know nothing of the facts in this case, and Mr. Meidinger may have no right to an award, and TIGTA has flagged various issues in the program.  It just doesn’t feel like significant progress is being made.
  • I found Strugala v. Flagstar Bank  pretty interesting, which dealt with a taxpayer trying to bring a private action under Section 6050H.  Plaintiff Lisa Strugala filed a class action suit against Flagstar Bank for its practice of reporting, and then in future years ceasing to report, capitalized interest on the borrower’s Form 1098s.  Flagstar Bank apparently had a loan that allowed borrowers to pay less than all the interest due each month, resulting in interest being added to the principal amount due.  At year end, the bank would issue a 1098 showing the interest paid and the interest deferred.  In 2011, the bank ceased putting the deferred interest on the form.  Plaintiff claims that the bank’s practice violated Section 6050H, which only requires interest paid to be included.  The over-reporting of interest, she claims, causes tens of thousands of tax returns to be filed incorrectly.  Further, upon the sale of her home, Strugala believed that the bank received accrued interest income that it didn’t report to her.  A portion of the case was dismissed, but the remainder was transferred to the IRS under the primary jurisdiction doctrine.  The Court found the IRS had not stated how the borrower should report interest in this particular situation, and that it should determine whether or not this was a violation.  In addition, Section 6050H didn’t have a private right under the statute.  I was surprised that this was not a case of first impression.  The Court references another action from a few years ago with identical facts.  However, perhaps I shouldn’t not have been, as this is somewhat similar to the BoA case Les wrote about last year, where taxpayers sued Bank of America alleging fraudulent 1098s had been issued relating to restructuring of mortgage loans.
  • The Tax Court has held in Estate of John DiMarco v. Comm’r, that an estate was not entitled to a charitable deduction where individual beneficiaries were challenging the disposition of assets.  Under the statute, the funds have to be set aside solely for charity, and the chance of it benefiting an individual have to be  “so remote as to be negligible.”  Here, the litigation made it impossible to make that claim.
  • My firm has a fairly large maritime practice, which makes sense given our sizable port in West Chester, PA (there is not actually a port, but we do a ton of maritime work).  That made me excited about this crossover tax procedure and maritime  Chief Counsel Advice dealing with Section 1359(a).  Most of our readers probably do not run across Section 1359 too frequently.  Section 1359 provides non-recognition treatment for the sale of a qualifying vessel, similar to what Section 1031 does for like kind real estate transactions.  This applies for entities that have elected the tonnage tax regime under Section 1352, as opposed to the normal income tax regime.  In general, the replacement vessel can be purchased one year before the disposition or three years afterwards.  But, (b)(2) states, “or subject to such terms and conditions as may be specified by the Secretary, on such later date as the Secretary may designate on application by the taxpayer.  Such application shall be made at such time and in such manner as the Secretary may by regulations prescribe.”  Those regulations do not exist.  The CCA determined that even though the regulations do not exist, the IRS must consider a request for an extension of time to purchase a replacement vessel, as the Regs are clearly supposed to deal with extensions by request.
  • From The Hill, another article against the IRS use of private collection agencies.

 

 

 

Summary Opinions for August 1st to 14th And ABA Tax Section Fellowships

Before getting to the tax procedure, we wanted to let everyone know the application for the ABA Tax Section fellowships is now open.  Here is a link to the release regarding the applications and the Christine A. Brunswick Public Service Fellowships.   Here is another link regarding the process, which also highlights recent winners.   I’ve had the pleasure of meeting many of the recipients, and it is an esteemed group providing amazing services thanks to the ABA Tax Section.

A few quick follow ups to some items from last week.  We had a wonderful post from Robin Greenhouse on the BASR Partnership case dealing with the statute of limitations and fraud of the tax preparer, which can be found here.  Ms. Greenhouse and Les were both also quoted in a story on the topic for Law360, which can be found here (may be behind a subscription wall, sorry).  Keith posted on the Ryscamp case, which dealt with jurisdiction to review a determination that a taxpayer’s position is frivolous.  Keith was also quoted about the case in the Tax Notes article, which can be found here (also behind subscription wall, sorry again).

Here are some of the other tax procedure items we didn’t otherwise cover:

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  • We flagged earlier in the month that Congress has overturned Home Concrete with the new Highway Bill.  The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 has a few other changes to tax procedure laws.  Probably the biggest news is that partnerships and s-corps will need to file tax returns three months and fifteen days after the close of their tax years (for calendar filers, that will be March 15).  This is a change for partnerships, but not s-corps.  C-corporations, however, will not have to file until four months and fifteen days after the close of the tax year (April 15 for calendar year filers).  The goal of this is to get k-1s to individuals prior to the April 15 filing deadline.  I assume c-corps were pushed back a month on work flow concerns for preparers.  The act also revised the extended due dates for various types of returns.  In addition, next year, FBARs will be due April 15, and there will be a possible six month extension.
  • The District Court for the District of New Jersey decided a lien priority case where a bank recorded a mortgage regarding a home equity line of credit (HELOC), some portion of which may have been withdrawn after a federal tax lien was filed.  In US v. Balice, the bank argued that the withdrawal date of the funds on the HELOC was irrelevant and state law directed that the date related back to the original recording date (the Court declined to offer an opinion about whether or not this is the actual NJ law).  The government argued that federal law applied, which held first in time is first in right, but only to the extent the funds were already withdrawn.  The Court held that state law defined the property rights, but federal law governed the lien priority.  Under federal the federal statute, the security interest was only perfected when the funds were actually borrowed.  See Section 6323(a).
  • The IRS has issued two important Revenue Rulings in the international arena.  The first outlines the procedures for making competent authority requests.  The second is for taxpayers seeking advanced pricing agreements, and can be found here.
  • Jack Townsend on his Federal Tax Procedure blog has a discussion of Sissel v. US Dept. HHS, where the majority, concurring and dissenting opinions all review the Originations Clause of the Constitution and its application to Obamacare.
  • I unabashedly praised John Oliver’s sultry singing about the IRS with Michael Bolton previously in our pages.  In that ditty, Oliver pointed out we should be hating on Congress, not the IRS.  Peter Reilly over at Forbes makes a good point that in Oliver’s new IRS bit, he should probably be complaining about Congress again and not the IRS about the lack of church audits (check out Section 7611, which is Congress’ doing).
  • Service issued guidance to its new international practice unit on transactions that might generate foreign personal holding company income under subpart F.  Caplin & Drysdale have coverage here.
  • The Tax Court seems to have just thrown an assist to the Service in Summit Vineyard Holdings v. Comm’r, holding that an individual had apparent authority to execute an extension for the statute of limitations, even though the individual lacked actual authority.  The Court somewhat saved the Service, because it probably should have known that the TMP was a different entity in the year in question, as it had been informed of the switch.  The Court noted the auditing agent had very limited TEFRA knowledge (I’m not sure that excuses the IRS from properly following the rules).  The agent had the manager of the then current TMP sign, instead of the TMP for the year in question.  There appears to be somewhat of a split on this, but the Court determined that the Ninth Circuit (where the appeal would lie) would apply state law and find apparent authority based on the evidence and actions taken by the individual.  Saved by the Court!  Based on the facts, it does not seem that unfair though, as the individual was the manager of both TMPs, and it seems like he also thought he was properly executing the paperwork and extending the SOL.
  • In Chief Counsel Advice, the Service has concluded it can only apply the Section 6701 aiding and abetting penalty one time against a person who submitted false retirement plan application documents.  This is the case even though multiple documents could be submitted with fraudulent information, and even though it could result in an understatement for the plan and each participant.
  • The Service has also released PMTA 2015-11, which outlines the application of the penalty under Section 6662A(c) for taxpayers who failed to disclose participation in listed transactions involving cash value life insurance to provide welfare benefits.  This is a very specific issue, so I won’t go into much detail, but the guidance is fairly thorough and provides good insight into the Service’s thoughts on the matter.
  • And another Section 7434 case.  I wrote about the Angelopolous case earlier in the week, which dealt with who was the “filer” of the information return.  In US v. Bigley, the District Court for the District of Arizona reviewed whether an employee’s claim against his employer for false returns was time-barred.  The suit was well past the six year statute, and the employee clearly had knowledge over the last year.  Section 7343(c) outlines the statute of limitations, and states the statute is the later of six years or one year after the return is discovered by exercise of reasonable care.    The Court found that the employee received the information returns upon filing, so the six year statute clearly applied, and it would be impossible to have the one year statute in that situation.  The actual language is “1 year after the date such fraudulent information return would have been discovered by exercise of reasonable care.”  I wonder if it would be possible to create a larger fraudulent scheme, whereby the recipient would receive the information return but not realize it was fraudulent until a later date.  Would the one year statute then apply?
  • My brother-in-law just got a Ph.D. (congrats Alex! I doubt he will ever read this).  In honor of that esteemed accomplishment, here is an infographic highlighting all kinds of negative financial and other statics related to Ph.Ds.  I make no assurances to the veracity of the graphic’s claims, and I am generally in favor of graduate degrees, but I found the stats interesting.