The taxpayers in the case of Brumbaugh and Holifield v. Commissioner, TC Memo 2015-65 argued that an extremely small interest of a partnership held by an LLC (0.02%) should not cause the partnership to be subject to the TEFRA audit procedures, but rather qualify for the small partnership exception to those rules found in IRC §6231(a)(1)(B)(i).
The issue of TEFRA applicality involves whether the partners are bound by reporting at the partnership level of partnership items, as their status is determined at the partnership level under the TEFRA procedures. A partner who does not agree with the partnership treatment of an item must request an administrative adjustment under IRC §6227. Generally that request must be filed within three years of the partnership return filing but before the issuance of a notice of final partnership administrative adjustment to the partnership in a TEFRA exam.
The rules were enacted by Congress as an attempt to simplify the examination of partnerships, especially large partnerships that had 100s of partners. While the partner, and not the partnership, is the taxpayer, it was an administrative nightmare to deal with a potential determination for each partner rehashing the same issue. Thus the TEFRA rules provided rules where generally partnership items are decided at the partnership level, with the special “administrative adjustment” provisions put in place to allow for an individual partner challenge on a timely basis.
In this case the partners had not filed an administrative adjustment request under §6227 and the time for doing so had passed. In the matter before the court the IRS had disallowed interest deductions claimed on Schedule C by the individuals for lack of substantiation.
The taxpayers argued that they had erroneously claimed the interest deduction on Schedule C and that it should have been claimed on the partnership return, increasing the flowthrough losses they would have reported on Schedule E.
The interests of the partnership were held 59.99% by the taxpayer in this case, 39.99% by another individual and the final 0.02% were held by an LLC that was taxed as a partnership for federal tax purposes.
The IRS argued that the taxpayers could not challenge the amount of partnership losses, as that was a partnership item and, under the TEFRA procedures, the taxpayers would have had to have filed an administrative adjustment request in a timely manner, something they failed to do.
The taxpayers argued that the entity should qualify as a small partnership not subject to the TEFRA procedures. Under IRC §6231(a)(1)(B)(i) a “small partnership” is treated as not a partnership for TEFRA procedure purposes. The definition of a small partnership provided in that section reads as follows:
The term “partnership” shall not include any partnership having 10 or fewer partners each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner. For purposes of the preceding sentence, a husband and wife (and their estates) shall be treated as 1 partner.
The IRS pointed out that while there were less than 10 partners, one of them was an LLC taxed as a partnership—and therefore the exception did not apply in this case.
The taxpayers argued that because the LLC owned such an extremely small interest (0.02%) that they should be deemed to be “in substance” a small partnership.
The Tax Court sided with the IRS, noting that the plain language of the IRC itself provide for no “de minimis” exception to this rule. As the Court noted “[e]ither a partner is a passthrough entity or it is not; the Court
does not inquire into the entity's ownership percentage or its upstream partners.”
The taxpayer was a member in a partnership with a passthrough entity, a choice the taxpayer had made. As the Tax Court commented:
As the Supreme Court has observed, a taxpayer is free to organize his affairs as he chooses, but once having done so, he must accept the tax consequences of his choice, whether contemplated or not. Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974).
This case is instructive to many practitioners dealing with “small” partnerships that may not be TEFRA-style small partnerships due to having non-individual members. Although we don’t know all of the facts in this case, the taxpayers’ attempt to modify partnership income suggests that the problem resulted from the taxpayers having (at least in the taxpayer’s view) “mixed up” reporting between an entity they controlled and their own personal business.
Note that the Court never addressed this issue—so it’s very possible the problem was that the interest deduction simply ended up on Schedule C and that, had the partnership return been properly prepared, it would have ended up on Schedule E. But the technicality of the TEFRA rules was likely simply not noticed by the taxpayer during the examination process and thus no request for administrative adjustment was filed.
What can make this even worse is that, often, the other entity may also be one controlled by the taxpayer. Advisers need to remember that merely being “small” is not enough to escape the applicability of the TEFRA procedures—having an S corporation or partnership partner means the resulting partnership is subject to the TEFRA procedures even if those other entities are controlled by the individuals who otherwise are members of the partnership.
And, as this case makes clear, if the TEFRA rules apply the adviser must make sure that timely action is taken to preserve the taxpayer’s rights pursuant to the TEFRA rules.