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.
read more...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.
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The court addressed peripherally some issues under Section 7701(a), pursuant to which the disregarded entity regulations [DRE Regs] were issued. I thought the court could have gone further and held that Section 7701(a)’s introductory language didn’t authorize the DRE Regs to overrule the pre-existing TEFRA regime where, as here, it was pretty clear that the pre-existing regime, including Rev. Rul.2004-88, properly and definitively interpreted Congressional intent behind § 6231(a)(9). Under Section 7701(a), terms defined in the numbered subparagraphs of Sec. 7701(a) – including -(2) and -(3), which encompass the DRE regime – only apply “where not otherwise distinctly expressed or manifestly incompatible with the intent thereof.” The statutory language relevant to the case was ““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.” The position asserted by the taxpayers was “manifestly incompatible with the intent” of Sec. 6231(a)(9), as previously interpreted by the Revenue Ruling, which apparently had not been withdrawn or designated as no longer applicable.