Disguised Sales to Partnerships, BBA Centralized Audits and Due Process

Returning to look at the BBA regime, Monte Jackel examines final BBA regulations and issues relating to a partner’s gain on a disguised sale with a partnership. Les

The final BBA regulations reflect that “partnership-related items” are the items that are subject to the uniform centralized partnership audit regime. (T.D. 9844; Reg.§301.6241-1(a)(6)(ii)-vi)). These “partnership-related items” are those shown or reflected, or required to be shown or reflected, on a partnership income tax return (form 1065), or is otherwise required to be maintained in the partnership’s books and records. On the other hand, an item shown or required to be shown on an income tax return of a person other than the partnership that results from the application of the Internal Revenue Code to a partnership-related item based upon the other person’s specific facts and circumstances, including an incorrect application of the Code or taking into account erroneous facts and circumstances of that person, is not a partnership-related item.

read more...

On the surface, the distinction between non-partnership related items and partnership- related items seems clear in most cases. Examples 1 and 2 under reg. §301.6241-1(a)(6)(vi) are the most helpful in this regard. Example 1 stands for the proposition that even though an income producing event occurs between a non-partner person and the partnership, only the deduction or expense relating to the transaction, and not the income of the other person from the very same transaction, is a partnership-related item. Similarly, example 2 involves a purported loan to the partnership by a non-partner person whereby it is stated that although the treatment of the purported loan on the partnership’s return, which presumably includes whether it is debt or equity and related interest expense, is a partnership-related item, the treatment of the purported loan in the hands of the other person, which also presumably includes a debt versus equity determination, is not a partnership-related item. Further, that appears to be the case if the persons in examples 1 and 2 were instead partners of the transferee partnership. For example, if there was a disguised sale under reg. §1.707-3, the tax effects of a purchase must clearly be reported on the partnership return but the sales gain would apparently only be reported on the partner’s separate form 1040. 

Even though the very same transaction with the same parties is involved on both sides of the transaction, the final regulations push strongly in the direction noted immediately above, although it would have been very useful if alternative facts under examples 1 and 2 had tested the results if the other person had been a partner instead. 

In both examples 1 and 2, the other person is clearly not identified as a partner in the partnership at issue. If that were otherwise the case, section 6222 would generally require the partner to follow the partnership’s treatment of the item. The most pertinent example of the case where the other person is in fact a partner, for purposes of this commentary, is a disguised sale by the partner to the partnership under section 707(a)(2)(B) and reg. §1.707-3. (It should be noted as an aside that the only significant set of BBA audit regulations that are still in proposed form are those relating to attribute adjustments under sections 704, 705, 706, 6225, and 6226, REG-118067-17, Feb. 2, 2018). 

The regulations are also unclear, and this relates to the main point at issue in this commentary, as to whether the computation of the imputed underpayment (IU) includes the sales gain that the partner will incur if it is determined in a partnership proceeding that a sale and purchase occurred under section 707(a)(2)(B) and its underlying regulations. 

As a technical matter, in computing an IU, there is first a determination of whether there is a “partnership adjustment” which is any adjustment to a partnership-related item. (Reg. §§301.6241-1(a)(6)(i), 301.6225-1(a)(1), 301.6225-1(b)). Thus, unless the item is a “partnership-related item”, it will not enter into the computation of an IU. 

Similarly, if an election is made under section 6226 to push out a partnership adjustment that is part of an IU, there first needs to be a determination of whether the item is a partnership-related item. 

For these reasons, it is critical to understand whether, in the case of partner-partnership transactions, the item attributable to the partner side of the transaction is a partnership-related item and a partnership adjustment. Given the fact that the proposed regulations specifically listed disguised sales and related items as partnership-related items (prop. reg. §301.6241-6(b)(5)) and the final regulations do not include that language but contain instead the “reportable on the partnership return” or “reportable on the other person’s return” standard, the apparent answer is that the partner sale gain on a disguised sale with a partnership will not be part of the computation of an IU.  

The preamble to T.D. 9844 is confusing and circular in how it describes what is a partnership-related item in these types of cases, particularly when there is a transaction between a partner and the partnership. It states, in pertinent part:

“[The proposed regulations] provided as an example of an “item of income, gain, loss, deduction, or credit” any items related to transactions between a partnership and any person including disguised sales, guaranteed payments, section 704(c) allocations, and transactions to which section 707 applies….One comment suggested that this provision inappropriately included partner items such as a disguised fee under section 707(a)(2)(A) and the gain or loss a partner may realize from a disguised sale under section 707(a)(2)(B). … Similarly, another comment expressed concern about situations where a partner was not acting in the partner’s capacity as a partner, but rather as a counterparty to a transaction with the partnership. …. These comments are addressed by the final regulations …regarding the definition of partnership-related item. …[T]he final regulations clarify that items or amounts relating to transactions of the partnership are items or amounts with respect to the partnership only if those items or amounts are shown, or required to be shown, on the partnership return or are required to be maintained in the partnership’s books and records. The final regulations further clarify that items or amounts shown, or required to be shown, on a return of a person other than the partnership (or in that person’s books and records) that result after application of the Code to a partnership-related item and that take into account the facts and circumstances specific to that person are not partnership-related items and, therefore, are not determined at the partnership level under the centralized partnership audit regime. ….”

There are a number of issues with how this particular provision (partnership-related item) is defined and the explanation given for it in the final regulation preamble as it relates to transactions between a partner and a partnership where the partner is acting in a partner capacity and, thus, the transaction is not governed by section 707(a)(1) (partner acting in non-partner capacity). In that latter case, the final regulation is worded properly because unless either res judicata or collateral estoppel apply to the other non-partner person, the determination at the partnership level has nothing to do with how the other person reports the transaction, which can be inconsistent with how the partnership treats it because that other person is not a partner.  An assessment of tax at the partnership level will have absolutely no effect on the assessment of tax of that other person in that case.

A transaction between a partner and the partnership invokes, first, section 6222 which generally requires the partner to report the transaction consistently with how the partnership reports it. Thus, if the partnership treats a contribution of built-in gain property to it as a purchase because it is determined to be a disguised sale under reg.§1.707-3, then the partner must also treat the transaction as a purchase by the partnership absent timely notice of inconsistent treatment by the partner. 

This would seem to mean that since the same factors are taken into account in determining whether there is a sale and a purchase under reg. §1.707-3(b)(1) and 1.707-3(b)(2), it would be difficult for a partner who files an inconsistent treatment statement under section 6222(c) to sustain a position that there is no sale by him even though the partnership either reports or is required to report that a purchase occurred as part of a partnership level proceeding. 

If the issue of whether the partner sold property to a partnership is determined first before the partnership level proceeding, section 6222(d) states that if the partnership was not a party to the partner proceeding then the partner determination is not binding on the partnership. Although such a determination is not technically binding on the partnership, it is difficult to see how a later separate partnership level proceeding based on the same facts with the same parties could lead to a different result but that is not discussed or explained in any set of BBA audit regulations. 

However, the reverse is not true. Thus, section 6222 does not prohibit a proceeding at the partnership level from binding the partner in a partner level proceeding relating to the same transaction with the same facts. It would seem that any partnership level proceeding as to whether there was a sale would bind the partner as well under common law rules given that the same prime legal issue (whether there was a sale) and the same facts as well as the same parties are involved. Section 6223(b) says as much by stating that “A partnership and all partners of such partnership shall be bound (1) by actions taken …by the partnership, and (2) by any final decision in a proceeding …with respect to the partnership.” See, also, reg. §301.6223-2(a). 

Now, for the “due process of law” question left unaddressed in the regulations. Assume, as it appears is most likely the case as discussed above, that the gain portion of the disguised sale is not a partnership-related item but only the purchase side of the transaction is a partnership related item. (If the sales gain was part of the computation of the IU, the liability for tax under section 6225 would then be shared by all adjustment year partners and would not be limited to the selling partner only. If, on the other hand, the push-out election is made under section 6226 in that case, then the partners with whom the partnership-related adjustment “is associated” will be required to include the amount in income. That push-out may allocate all of the sales gain to the seller although the regulations do not address that issue either). 

Left unresolved by the regulations, and here I think lies the due process question in a nutshell, is whether the selling partner may still contest in a separate proceeding whether he owes tax on the now determined (by the partnership) disguised sale to the partnership. It seems that the legal issue involved (sale versus contribution) will be resolved by how the partnership treats the transaction or is required to treat the transaction in a partnership level proceeding. And section 6222(b) seems to allow for immediate assessment as a mathematical error the inconsistent treatment by the partner as a non-sale if the partnership treats the transaction as a purchase and the partner does not file a notice of inconsistent treatment. And even if the partner does file a notice of inconsistent treatment, it is not clear whether the doctrines of collateral estoppel or res judicata or other common law doctrine will apply to prevent the selling partner from relitigating the question in a separate court proceeding.

But this is not all there is to the question. Only the partnership representative can represent the partnership in a proceeding with the IRS regardless of the limitations on the representative’s power in the partnership agreement. This seems to mean that the selling partner, if he is not the partnership representative, can be forced solely to pay tax on a transaction, the sale, without the partner’s participation in the IRS proceeding with the partnership. If the partnership proceeding occurs first, can inconsistent treatment by the partner result in an immediate math error assessment? If a notice of inconsistent treatment is given, is the prior partnership proceeding legally binding so that no challenge to the merits can occur anyway in the separate partnership proceeding? And, is this a violation of due process by the government taking property from the partner without any rights by the partner to contest or challenge the partnership proceeding?

The answer to this question is not clear. On the one hand, the partner has agreed to enter into the partnership and will be charged with the knowledge that the partnership representative is the sole party representing the partnership with the IRS. Thus, it may be argued, the partner has given his consent to the consequences of not being able to participate in his own audit in this kind of case. On the other hand, are the terms of the statute and regulations sufficient to override fundamental notions of no taking of property by either the federal government or the states “without due process of law” as set forth by the Fifth and Fourteenth amendments to the U.S. Constitution? 

It should be noted that the regulations could most likely have eliminated this issue by stating that the seller partner side of the transaction is also a partnership-related item along with the partnership purchase side of the transaction. In that case, the tax liability would be shared by all adjustment year partners under section 6225 and there would be no meaningful due process question. (Otherwise, the entire BBA audit regime would be unconstitutional). But the regulations seem to say just the opposite, as this commentary has explained. 

I know that both sides of this argument have been taken by a number of practitioners. I have previously taken the position that there is a clear violation of due process in this case and the BBA statutory regime is invalid to that extent. I still think so. What do others think?  

BBA Partnership Tax Provisions and Bankruptcy– A Recipe for Disaster, Part 1

We welcome back guest blogger, A. Lavar Taylor.  Lavar’s practice is based in Southern California though you can find him pursuing cases around the country.  He spent the early days of his career in the General Litigation Division of Chief Counsel’s office where he learned the intricacies of the intersection of tax and bankruptcy.  We enjoy his insights today on a new issue that could vex bankruptcy and tax attorneys in the coming years.  Keith

Some of us practitioners are old enough to have endured the transition to the TEFRA Partnership audit provisions from the unwieldy pre-TEFRA rules that required the IRS to audit the tax returns of all partners in a tax partnership in order to assess deficiencies resulting from adjustments to Forms 1065 filed by those partnerships.  That transition required a considerable learning curve. Even 30+ years after the enactment of the TEFRA Partnership audit provisions, we have still been “learning through litigation” about the proper interpretation of some of the more poorly drafted TEFRA Partnership audit provisions.  See, e.g., Petaluma FX Partners, LLC v. Comm’r, 792 F.3d 72 (D. C. Cir. 2015).

The intersection between the TEFRA Partnership audit provisions and the bankruptcy/insolvency world has also proven to be quite interesting, as illustrated by the Ninth Circuit’s opinion in Cent. Valley Ag Enters. v. United States, 531 F.3d 750 (9th Cir. 2008). In that case, the taxpayer/debtor was allowed to challenge a claim filed by the IRS based on a TEFRA Partnership audit even though the IRS had issued an FPAA and the deadline for filing a Tax Court petition with respect to the FPAA had expired without any petition having been filed.  Outside of bankruptcy, no judicial challenges to the audit assessment made against that partner as the result of the TEFRA Partnership audit would have been permissible as of the date on which the Chapter 11 bankruptcy case was filed. But once inside Chapter 11, per the Ninth Circuit, the taxpayer/debtor/partner was entitled to challenge the merits of the audit assessment under section 505(a)(2) of the Bankruptcy Code.  The filing of the Chapter 11 by the partner allowed the debtor/taxpayer/partner to escape the otherwise preclusive effect of the failure of any party in interest to file a Tax Court petition in response to the FPAA.

Now, thanks to Congress, we are faced with learning an entirely new set of partnership audit provisions: the BBA Partnership audit provisions. Learning how these new provisions will operate in the real world is likely to be no less painful than it was to learn how the TEFRA Partnership audit provisions operate in the real world.

This learning process will be even more painful where a bankruptcy is involved. How much more painful? That remains to be seen, but masochists and sadists will likely rejoice.

read more...

This post discusses one of the many problems that are going to arise when the BBA Partnership audit provisions collide with the Bankruptcy Code, namely, how to classify, for purposes of the Bankruptcy Code, claims for audit assessments of income taxes arising under the BBA Partnership Audit proceedings. I plan to follow up this post with additional posts which will further discuss the problems that are going to arise as the result of the intersection of these two statutory schemes. A discussion of these issues appears timely in light of the current economic climate.

Classifying income tax claims under the Bankruptcy Code is important. How income tax claims get classified under the Bankruptcy Code determines matters such as: a) the order in which such claims get paid in Chapter 7 relative to other types of claims, b) whether such claims must be paid in full in a Chapter 11 case or in a Chapter 13 case, c) the terms on which such claims can or must be paid in a Chapter 11 case or in a Chapter 13 case, and d) the extent to which such claims can be discharged in bankruptcy.

Without getting too technical, there is a big distinction under the Bankruptcy Code between income tax claims that are for tax periods that end prior to the date of the filing of the bankruptcy petition (“pre-petition tax claims”) and income tax claims for tax periods that end after the date of the filing of the bankruptcy petition (“post-petition tax claims”).  Pre-petition income tax claims, if not secured by the proper filing of a tax lien notice, are either “general unsecured” claims or “priority” claims. See, e.g., Bankruptcy Code 507(a)(8)(A), which determines what pre-petition income tax claims are treated as “priority” tax claims.

Post-petition income tax claims are sometimes (but not always) entitled to be paid as an administrative expense in the bankruptcy case.  In other cases, post-petition income tax claims are not treated as administrative expense and cannot be paid out of proceeds held by a Chapter 7 Trustee and cannot be paid at all under a Chapter 11 plan.

In any bankruptcy case, unsecured pre-petition tax claims, whether treated as “priority” tax claims or as “general unsecured” claims, do not get paid until all administrative expense claims have been paid in full. Also, “priority” tax claims get preferred treatment over general unsecured claims in all types of bankruptcy cases.  

Thus, determining whether an income tax claim is a pre-petition claim or is instead a post-petition claim is important. Also, if an income tax claim is a pre-petition claim, determining whether that claim is a “priority” tax claim or is instead a “general unsecured” tax claim is important. Similarly, if an income tax claim is a post-petition claim, determining whether or not that post-petition income tax claim is an administrative expense claim is important.  See, e.g., Towers for Pacific-Atlantic Trading Co. v. United States (In re Pacific-Atlantic Trading Co.), 64 F.3d 1292 (9th Cir. 1995), which dealt with all of these issues in the context of an IRS claim for taxes for the tax year during which a corporate debtor/taxpayer went into chapter 11 bankruptcy.

Those of you who have some familiarity with the BBA Partnership audit provisions should already have an idea of where this discussion is headed.  Under the BBA Partnership provisions, an audit of a partnership return for the year 2019 which ends in the year 2023 and which generates a deficiency can result in any of the following:  1) deficiency assessments against the 2019 partners for the 2019 tax year, 2) a deficiency assessment against the partnership for the tax year 2023, or 3) deficiency assessments against the 2023 partners for the tax year 2023. 

Suppose, then, that the tax partnership files for chapter 11 at the end of 2022 and that this Chapter 11 case remained pending as of the end of 2023 without a chapter 11 plan being confirmed.   If an IRS audit of the partnership’s 2019 tax return comes to an end in 2023 and the taxes are assessed against the partnership for the year 2023 in 2024, how should that claim be classified under the Bankruptcy Code?  The claim is for the 2023 tax year, a post-petition year.  That suggests that the claim is a post-petition claim. But the claim is clearly based on pre-petition activity. Thus, there is an argument that the claim against the partnership should be treated as a pre-petition claim, even though the claim is for a post-petition tax year.

If the claim is to be treated a pre-petition claim, is the claim entitled to priority treatment under section 507(a)(8) even though that section only applies to claims for tax years that ended before the date on which the bankruptcy was filed? If the claim is to be treated as a post-petition claim, is the claim an administrative expense claim allowed under section 507(a)(2) of the Bankruptcy Code? Resolution of these issues will be important not only to the IRS, which will want to be paid what it is owed, but also to the 2023 partners of the partnership, who can be held personally liable for the partnership’s 2023 income tax deficiency assessment if it is not paid by the partnership.

Sorting out these classification issues in this very simple fact pattern, based on the law as it presently stands, will take years of litigation. There will undoubtedly be variations of this fact pattern, and there will be bankruptcy cases involving the partners in a partnership subject to the BBA Partnership audit provisions in which claim classification issues arise.  Such claim classification issues are but a small fraction of the issues that will arise in bankruptcy cases involving individuals and entities subject to the BBA Partnership audit provisions.

Conclusion of Part I

It will be far more efficient to solve these problems through legislative and administrative action, rather than through litigation. The first step in this process, however, is to identify the problems that need to be solved. I hope to identify additional problems in future posts, and I invite the PT Community to help identify the problems that are out there. (For those of you interested in reading a short article which identifies some of the due diligence that bankruptcy professionals must perform as the result of the enactment of the BBA Partnership audit provisions, I invite you to review the following article which appeared in Business Law News, published by the California Lawyer’s Association, which can be found here.

The Newest Time Machine

Yesterday in Part 1Monte A. Jackel, discussed issues relating to the extension of deadlines due to COVID-19. In today’s post Monte considers whether in light of retroactive law changes in CARES the IRS can force a partner to amend a return when the original tax return filed was correct. Les

Revenue Procedure 2020-23 (originally discussed on PT by Marilyn Ames) sets forth the terms and conditions for a partnership subject to the BBA audit regime to file an amended tax return for the 2018 and 2019 tax years. The revenue procedure provides welcome relief for cases where the retroactive law changes allowing 5-year loss carrybacks and the technical correction for QIP (qualified improvement property) would not otherwise have been available because section 6031(b) generally disallows amended returns by such partnerships; AARs are the preferred route. 

The revenue procedure, however, assumes that all partners would favor such retroactive relief. However, that may not always be the case. This brings to the forefront the issue of whether one or more partners of such a partnership that wants to file an amended form 1065 must also ensure that all of its partners file amended form 1040s. That is not directly addressed in the revenue procedure. There is only a reference to section 6222 and the amended form 1065 substituting for the original form 1065. This strongly suggests that the IRS believes that the partners have a legal duty to file amended form 1040s. 

read more...

Revenue Procedure 2020-25 sets forth the options for taxpayers, including partnerships, to obtain relief due to the retroactive law change making QIP eligible for bonus depreciation under section 168(k). This revenue procedure essentially provides for amended forms 1040 or 1065 or automatic changes via a form 3115 to obtain relief due to the retroactive QIP change in the law. The revenue procedure assumes, without citing any supporting law, that when the law relating to a timing of income statute, such as section 168(k), is retroactively changed by Congress, that the taxpayer is now using an impermissible method of accounting. There does not appear to be any law that expressly supports that treatment although it may be the correct policy result. 

Further, there does not appear to be any law that expressly supports mandating the filing of an amended tax return where the original return  was true and correct at the time it was filed. Both reg. §§1.451-1(a) and 1.461-1(a)(3) state that to correctly treat an item of income or deduction in a different tax year than originally reported, the taxpayer “should”, if within the period of limitations, file an amended return. The word “shall” is not in the regulations; only “should”. (See, also, reg.§1.453-11(d) (an amended return for an earlier year “may” not “must” be filed.)

Further, under sections 6662 and 6694, the taxpayer tests a position of substantial authority either at the end of the tax year or when the tax return is filed, and the return preparer tests the level of authority when the tax return is filed. And, at those times, the method of accounting for QIP over a long useful life was the only permissible method to use. The retroactive law change does not change that. And neither Circular 230 or the ABA model rules of professional conduct change that result either.

If the taxpayer does not want to amend either a form 1040 or a form 1065 and the government cannot force the taxpayer to amend its tax return, what is the government remedy? There has been no change in method initiated by the taxpayer and the taxpayer properly adopted the original method and never changed that method. How is the government to force the taxpayer from the retroactively determined impermissible method to the now permissible method? And AARs are voluntary. It is not uncommon for revenue procedures to mandate accounting method changes where there is a prospective change in the law. And, at times, accounting method changes have been mandated (such as the Rule of 78s issue in the 1980s) where the method change applies to a tax year but a return for the prior year may or not have been already filed before the mandate to change (the issue is not discussed). However, I am not aware and could not find any authority that deals with a statutory retroactive law change and applying that change to a prior year where a true and correct tax return containing the prior treatment has already been filed. 

If the taxpayer  cannot be forced off the 39-year method, what does the taxpayer report for future years? Zero or 1/39? If the property is sold after year one but before year 39, section 1245 will only recapture the depreciation actually taken. It would seem that the duty of consistency would mandate continuing to depreciate over a 39-year period although the same tax adviser for year one may not be able to continue to advise the taxpayer because that person would arguably be perpetuating an error. 

The solution may be to mandate the filing of an amended return because the government can only collect from the partnership an imputed underpayment spread over the remaining years in the 39-year period because presumably there is no underpayment in year one by imposing bonus depreciation in that earlier year. But forcing an amended return will create a huge quagmire.

AndA, as noted earlier, what if one or more partners do not want to amend their 1040s but the partnership does amend its form 1065 under Rev. Proc. 2020-23? This revenue procedure does reference the duty to file consistent returns under section 6222, but is this to be read as mandating the filing of an amended tax return? It seems so but doing that would be an issue of first impression to me under existing law. A true time machine.

Tax Court Adopts Final Rules For BBA Partnership Audit Regime

Today we welcome Greg Armstrong and Rochelle Hodes to the community of Procedurally Taxing guest posters. Greg is a Director with KPMG, LLP Washington National Tax in the Practice, Procedure, & Administration group in Washington D.C. and former Senior Technician Reviewer with the IRS Office of Chief Counsel. Rochelle is a Principal in Washington National Tax at Crowe LLP and was previously Associate Tax Legislative Counsel with Treasury.  Both Greg and Rochelle in their immediate prior positions with IRS and Treasury respectively spent considerable time working on the new partnership audit regime enacted to replace TEFRA as part of the Bipartisan Budget Act of 2015 (BBA) and as revised in subsequent technical legislative corrections. Rochelle is a Contributing Author on the BBA chapter that will be published this fall for Saltzman and Book IRS Practice & Procedure, and Greg has contributed over the years in updating and revising the treatise.

In this post, Greg and Rochelle discuss the Tax Court’s amendments to its Rules of Practice as relating to the BBA regime. Les

On July 15, 2019 the United States Tax Court announced that it had adopted final amendments to its Rules of Practice and Procedure to address actions under the new partnership audit regime enacted by BBA. The final amendments, which were first introduced as proposed and interim amendments on December 19, 2018, add a new Title XXIV.A (Partnership Actions under BBA Section 1101) and also make conforming and miscellaneous amendments.  New Title XXIV.A is effective as of December 19, 2018 and generally applies to partnership actions commenced with respect to notices of final partnership adjustment (FPAs) for partnership taxable years beginning after December 31, 2017.  The new rules also apply to actions commenced with respect to FPAs for partnership taxable years for which an election under §301.9100-22 is in effect.    

The following post offers a high level summary of the highlights of the Court’s new rules with respect to the BBA regime.  Because this post is focused on the new Tax Court rules, only a summary of the BBA provisions relevant to understanding the Court’s rules are discussed.  For a more robust discussion of the BBA provisions, see the latest update to Saltzman and Book, IRS Practice and Procedure, which includes a new chapter 8A entitled “Examination of Partnership Tax Returns under the Bipartisan Budget Act of 2015”.

read more...

The Tax Court’s rules reflect the prominent and powerful role of the partnership representative (PR) under the BBA.  The PR is the individual or entity that has the sole authority to act on behalf of the partnership for purposes of the BBA and replaces the Tax Matters Partner (TMP) concept that existed under TEFRA.  Pursuant to section 6223(a) and the regulations thereunder, a partnership subject to BBA must designate a PR for each taxable year.  If the IRS determines that there is no PR designation in effect for the taxable year, the IRS may select the PR.  If the partnership designates an entity as the PR, the regulations require that the partnership also appoint a designated individual to act on behalf of the entity PR.

Rule 255.2 provides that a BBA partnership action is commenced like any other action in the Tax Court – by filing a petition.  The caption of the petition, and any other paper filed in a BBA partnership action, must state the name of the partnership as well as the name of the PR.  Rule 255.1(d).  This is consistent with TEFRA Rule 240(d), Form and Style of Papers, which requires the caption to state the name of the partnership and the partner filing the petition, and whether the partner is the TMP.  Since under BBA only a PR can bring a partnership action in Tax Court, and because no partner (unless they are the PR) can file a petition, it makes sense that the PR is named in the caption in addition to the partnership.  The body of the petition must also identify the PR’s place of legal residence or principal place of business if the PR is not an individual.  Rule 255.2(b).  Interestingly, Rule 255.2(b) does not require the petition to provide the name or address of the designated individual.  The rule does require the petition to indicate whether the PR was designated by the partnership or selected by the IRS.

Identification and Removal of a Partnership Representative by the Court

New Rule 255.1(b)(3) defines the PR for purposes of BBA partnership actions to mean the partner (or other person) designated by the partnership or selected by the IRS pursuant to section 6223(a), “or designated by the Court pursuant to Rule 255.6.”  Rule 255.6 sets out circumstances in which the Court may act to identify or remove a PR in a partnership action under BBA.  The first such circumstance is if at the time of commencement of the action the PR is not identified in the petition.  Rule 255.6(a).  The second such circumstance is if after the commencement of the case the Court “may for cause remove a partnership representative for purposes of the partnership action.”  Rule 255.6(b).  The Court’s rule requires that before removal there must be notice and an opportunity for a hearing.  Neither Rule 255.6(b) nor the explanation to the rule delineate what causes would warrant removal.

Rule 255.6(a) provides that where there is no PR identified in the petition at the beginning of the case, the Court “will take such action as may be necessary to establish the identity” of the PR.  Rule 255.6(a) is vague as to what action might be necessary to establish the identity of the PR.  If no PR is identified, one possible outcome may be that the case is dismissed on the ground that a proper party did not file the petition.

Rule 255.6(b) provides that “if a partnership representative’s status is terminated for any reason, including removal by the Court, the partnership shall then designate a successor partnership representative in accordance with the requirements of section 6223 within such period as the Court may direct.”  Rule 255.6(b) does not address what happens if the partnership is unable or unwilling to designate a successor PR.  It is also interesting that Rule 255.6(b), while referencing the requirements of section 6223, only cites the authority of the partnership to designate a PR, and does not cite the Commissioner’s authority to select a PR.  The ability of the Commissioner to select a PR for the partnership raises intriguing issues that also arose in the early days of TEFRA.  See, e.g., Computer Programs Lambda v. Comm’r, 90 TC 1124, 1127-28 (1988).

Per the explanation to Rule 255.6, the authority to identify or remove a PR “flows from the Court’s inherent supervisory authority over cases docketed in the Court.” The explanation to Rule 255.6 also states, however, that the rule “does not take a position on whether the Court may appoint a partnership representative.”  In the context of a TEFRA partnership action, Rule 250 permits the Court to appoint a TMP in certain circumstances.  Notably, Rule 250(a) provides that if there is no TMP at the outset of the TEFRA action, the Court “will effect the appointment of a tax matters partner.”  Similarly, Rule 250(b) provides that where the TMP has been removed by the Court or the TMP’s status has otherwise terminated, the Court “may appoint another partner as the tax matters partner” if the partnership has not designated one in the time frame prescribed by the court.  Consistent with the explanation to Rule 255.6, and unlike Rule 250, Rule 255.6 does not contain language permitting the Court to appoint a partnership representative.   However, the explanation to Rule 255.6 appears to leave the door open for the Court to appoint a PR if the facts warrant such action, though it is unclear what those facts might be.

Jurisdiction Over the Imputed Underpayment and Modifications

Rule 255.2(b) also reflects the fact that the partnership as a result of an action under BBA may be liable for tax, i.e., an imputed underpayment determined under section 6225.  An imputed underpayment is initially computed by the IRS during the administrative proceeding, but may be modified if timely requested by the partnership and approved by the IRS.  The modified imputed underpayment and any modifications approved or denied by the IRS will be reflected in the FPA mailed to the partnership. 

Rule 255.2(b)(5) requires that the petition reflect the amount of the imputed underpayment determined by the Commissioner and “if different from the Commissioner’s determination, the approximate amount of the imputed underpayment in controversy, including any proposed modification of the imputed underpayment that was not approved by the Commissioner.”  Further, Rule 255.2(b)(6) requires the petition to clearly and concisely state each error that the Commissioner allegedly committed in the FPA “and each and every proposed modification of the imputed underpayment to which the Commissioner did not consent.”  Rule 255.2(b)(7) provides the petition should also include “[c]lear and concise lettered statements of the facts on which the petitioner bases the assignments of error and the proposed modifications.”

The petition requirements set forth in Rule 255.2(b) make clear that the Tax Court will have jurisdiction to redetermine an imputed underpayment reflected in the FPA, including any “proposed modifications” to the imputed underpayment that were not approved by the Commissioner.  Prior to the Tax Technical Corrections Act of 2018, Public Law 115-141 (TTCA), the issue of jurisdiction over imputed underpayments and modifications was unsettled.  By amending the definition of partnership-related item to specifically include an imputed underpayment while also amending section 6234(c) to provide the court with jurisdiction “to determine all partnership-related items” for the taxable year to which the FPA relates, the TTCA amendments make clear that the court has jurisdiction to determine an imputed underpayment.  Therefore, the Code provides the court with jurisdiction to determine an imputed underpayment, including any modifications to that imputed underpayment that were denied by the Commissioner.  This is reflected in Rule 255.2(b).   

Binding Effect of Tax Court’s Decision

Rule 255.7 provides that any decision that the Tax Court enters in a partnership action under BBA is binding on the partnership and all of its partners.  The term “partner” is not defined under New Title XXIV.A.  However, under Rule 240 “partner” is defined for purposes of a TEFRA action to mean “a person who was a partner as defined in Code section 6231(a)(2)” at any time during the taxable year before the Court.  Section 6231(a)(2), prior to amendment by the BBA, defined partner for TEFRA purposes to mean a partner in the partnership and “any other person whose income tax liability under subtitle A is determined in whole or in part by taking into account directly or indirectly partnership items of the partnership.” 

Unlike TEFRA, the BBA does not define the term “partner”.  However, the BBA does define a partnership-related item broadly to include items or amounts “relevant in determining the tax liability of any person” under chapter 1 (emphasis added).  See section 6241(2)(B)(i).  In addition, the Joint Committee on Taxation explanation accompanying TTCA explicitly states that the scope of BBA is not narrower than TEFRA, “but rather, [is] intended to have a scope sufficient to address those items described as partnership items, affected items, and computational items in the TEFRA context…, as well as any other items meeting the statutory definition of a partnership-related item.” See Technical Explanation of the Revenue Provisions of the House Amendment to the Senate Amendment to H.R. 1625 (Rules Committee Print 115-66), p.37, JCX-6-19 (March 22, 2018). 

Consistent with the broad scope of partnership-related item under BBA, when describing the binding nature of final decisions in proceedings under the BBA, Treas. Reg. §301.6223-2(a) provides that such decisions are binding on the partnership, its partners, and “any other person whose tax liability is determined in whole or in part by taking into account directly or indirectly adjustments determined under the [BBA]”.   Whether the Tax Court follows this regulation in extending the binding effect of its own decisions in BBA partnership actions remains to be seen.

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.

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.