Late Election Relief Granted Where Partnership Tax Adviser Failed to Follow Through on Providing Guidance to LLC Members on Making Qualified Real Property COD Election

Sometimes events occur during an engagement that can cause an advisor to lose focus and fail to take into account issues the adviser knows about.  That appears to have been the case in a series of private letter rulings, each of which basically duplicates what is found in PLR 201509020.

In this case we have an LLC taxed as a partnership that lost the tenant in its major asset, a commercial building, leaving the building vacant.  Eventually the debt was restructured, creating a cancellation of debt at the LLC level.

The LLC discussed the issue with its tax adviser and it was determined the individual members should make an election under §108(c)(3)(C) to reduce the basis of property in the LLC in exchange for a decrease in the amount of COD income the partners would have to recognize.  In order to accomplish this the individual members would need to explicitly include an election under §108(c)(3)(C) with their returns by completing Form 982.  The adviser assured the LLC that the adviser would prepare all necessary disclosures to the members and prepare the necessary forms.

Generally if an individual or entity other than a C corporation incurs cancellation of debt related to debt restricting on debt that was used to acquire real property used in a trade or business, the taxpayer can elect to reduce the basis of the affected property rather than pick up the current income.

However, before the end of the tax year one of the members died, necessitating the preparation of a valuation of the real estate to properly compute the §743(b) adjustment as the partnership had made an election under §754 to adjust basis in applicable circumstances.  This appraisal was not yet complete as the other members apparently began to get concerned about having K-1 numbers to use for their own return.

In order to deal with this issue, the adviser prepared draft K-1s for the various members to use in preparing their returns.  However, the letter rulings note:

One of the consequences of the return’s preparation in draft form was that the review was focused primarily on the amounts reported on the K-1s. Relatively little time was spent on disclosures, including information relevant to the debt restructuring. As a consequence, the fact that partners needed to explicitly make the § 108(c)(3)(C) election on their tax returns by completing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, was overlooked when Tax Advisor 1 prepared the Year 1 tax returns for Taxpayer and the other partners. However, Tax Advisor 1 prepared the LLC’s Year 1 tax return with the exclusion of income as if the § 108(c)(3)(C) election had been made. In doing so, LLC applied the limitations outlined in § 108(c)(2) – ultimately limiting the income exclusion to the aggregate adjusted basis of depreciable real property held immediately prior to the discharge. The amount excluded was applied to reduce the basis of the depreciable real property to zero. The excess was included in LLC’s taxable income. Subsequently, LLC’s Year 1 tax return was completed and filed.

So while the actual amounts reported on the individual member’s returns were the amounts that should have been reported if the election had been made, the fact that no election had been made was a problem—without such an election each member’s share of the COD income would have been reportable in the year in question.

The problem was not uncovered until the following year when the LLC changed tax advisers.  The new adviser, while reviewing the prior year’s return, discovered the oversight and informed the members of the problem.  To solve this problem, each member had to apply for a private letter ruling asking for IRS permission to make a late election pursuant to Reg. §301.9100-3(a).

Reg. §301.9100-3 provides procedures under which a taxpayer can ask for IRS relief from late elections where:

  • The election due date is set by regulation and not by statute;
  • The taxpayer acted reasonably and in good faith; and
  • A grant of relief will not prejudice the interests of the government

The first requirement was satisfied in this case—the due date for the election under IRC §108(c)(3)(C) is set by Reg. §1.108-5(b) which requires the election to be made on a Form 982 made on a timely filed return (including) extensions of the partner for the year of the discharge.

For purposes of meeting the second requirement (taxpayer acted reasonably and in good faith), the ruling describes the rules applicable to a claim of reliance on a professional as follows:

Under § 301.9100-3(b) a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer reasonably relied on a qualified tax professional and the tax professional failed to make, or advise the taxpayer to make, the election. However, a taxpayer is not considered to have reasonably relied on a qualified tax professional if the taxpayer knew or should have known that the professional was not competent to render advice on the regulatory election or was not aware of all relevant facts. In addition, § 301.9100-3(b)(3) provides that a taxpayer is deemed not to have acted reasonably and in good faith if the taxpayer –

(i)           Seeks to alter a return position for which an accuracy-related penalty has been or could be imposed under § 6662 at the time the taxpayer requests relief and the new position requires or permits a regulatory election for which relief is requested;

(ii)         Was informed in all respects of the required election and related consequences, but chose not to make the election; or

(iii)        Uses hindsight in requesting relief

In this case the IRS found the taxpayer had reasonably relied on the professional, no accuracy related penalty under §6662 had been or could have been imposed as of the time relief is chosen, the taxpayer had not chosen not to make the election and the taxpayer was not using hindsight to request relief.

To meet the third criteria, Reg. §301.9100-3(c) provides the following:

  • A granting of the election generally must not result in a lower tax liability, in the aggregate for all affected taxpayers, than if the relief is not granted and
  • Generally, the statute of limitations on assessments for the years in question must remain open as of the time the relief is granted.

At first glance it might appear the first bullet is fatal to a request—after all, presumably the request is being made because the taxpayer is going to pay more tax if relief is not granted than if it was.

However the IRS most often, as in this case, will tend to look at whether the taxpayer either filed the returns consistent with the treatment that would have been allowed had the election been made or that the taxpayer clearly would have made the election had the adviser informed the taxpayer of the advantages of doing so at the time the return was filed (that is, essentially duplicating the “hindsight” test).

In this case the IRS found that both criteria were met, and so the IRS granted the relief to the taxpayer.

So while all ended well, that result was only obtained after paying for a number of private letter rulings—in this case, one for each affected member of the LLC.