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”.

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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.

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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.