The Joint Committee on Taxation published its Blue Book (General Explanation of Legislation Enacted in 2015) for tax laws passed in 2015, and it gives some insight into the limited extent of statutorily mandated “acceptable” partners that Congress decided should enable a partnership to elect out of the new partnership audit regime when it comes into full effect for tax years beginning on or after January 1, 2018.
The regime, passed as part of the Bipartisan Budget Act of 2015 in November of 2015, removes the current TEFRA audit regime and replaces it with a new, even more centralized partnership audit program. In new IRC §6221(b) provides for an election out that reads, in part:
(1) In general. -- This subchapter shall not apply with respect to any partnership for any taxable year if –
(A) the partnership elects the application of this subsection for such taxable year,
(B) for such taxable year the partnership is required to furnish 100 or fewer statements under section 6031(b) with respect to its partners,
(C) each of the partners of such partnership is an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner...
The “allowed partner list” at IRC §6221(b)(1)(C) above can be expanded by the IRS in regulations [IRC §6221(b)(2)(C).
The JCT Blue Book, in its examples, suggests that the “allowed list” as enacted by Congress may be much more restrictive than some believed. As was noted in a Tax Analysts article in Tax Notes Today published on March 17, 2016 (JCT's Surprising Interpretation of the Partnership Audit Opt-Out, 2016 TNT 52-1, Tax Notes Today, March 17, 2016) the examples suggest that many types of “disregarded entities” were not intended by Congress to be disregarded for this purpose unless the IRS decides, by regulation, to allow them to be disregarded.
For instance, a single member LLC (SMLLC), 100% owned by a C corporation, is discussed in the first example the Committee offers when discussing the provision allowing the IRS to expand the allowed group:
For example, assume that a partner of a partnership is a disregarded entity such as a State-law limited liability company (“LLC”) with only one member, a domestic corporation. Such guidance may provide that the partnership can make the election if the partnership includes (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of each of the disregarded entity and the corporation that is its sole member, and each of them is taken into account as if each were a statement recipient in determining whether the 100-or-fewer-statements criterion is met.
Thus, the example indicates that, absent IRS action, that SMLLC would block the partnership’s option to elect out of the new regimes. As well, even if the IRS allowed the entity, it would count as 2 partners toward the 100 K-1 limit (the example clearly requires counting both the SMLLC and the corporation separately in determining if the 100 K-1 limit has been met).
The report goes on to provide a similar problem for grantor trusts in a separate example:
As another example, such guidance may provide that a partnership with a trust as a partner can make the election if the partnership includes (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of the trustee, each person who is or is deemed to be an owner of the trust, and any other person that the Secretary determines to be necessary and appropriate, and each one of such persons is taken into account as if each were a statement recipient in determining whether the 100-or-fewer-statements criterion is met. Similar guidance may be provided with respect to a partnership with a partner that is a grantor trust, a former grantor trust that continues in existence for the two-year period following the death of the deemed owner, or a trust receiving property from a decedent’s estate for a two-year period.
Thus, a revocable living trust that qualifies as a 100% grantor trust would also appear to fail to be an “allowable” partner unless the IRS regulations specifically allow such trusts to be counted.
The Tax Notes article points out that while many observers had concluded that such disregarded entities should not cause problems for making the election since the law or regulations generally provide that either the interest shall be treated as owned by the party holding a 100% interest in the ignored entity, the IRS had previously indicated that a single member LLC disregarded entity was a partner that blocked the application of the small partnership exception to the TEFRA partnership rules the new law replaces.
In Revenue Ruling 2004-88 the IRS held that despite the general rule under Reg. §301.7701-3(a) that such an entity is disregarded as an entity separate from its owner for federal tax purposes, the regulation does not apply for this test:
Under the facts of this ruling, although LLC is a disregarded entity for federal tax purposes, LLC is a partner of P under the law of the state in which P is organized. Similarly, although A, LLC's owner, is a partner of P for purposes of the TEFRA partnership provisions under section 6231(a)(2)(B) because A's income tax liability is determined by taking into account indirectly the partnership items of P, A is not a partner of P under state law. Because A holds an interest in P through LLC, A is an indirect partner and LLC, the disregarded entity, is a pass-thru partner under the TEFRA partnership provisions. Consequently, the small partnership exception does not apply to P because P has a partner that is a pass-thru partner.
The IRS is in the process of developing regulations in this area, including what, if any, expansion of the “opt-out” group should be allowed. Advisers may discover that, unless the IRS grants the relief discussed in the examples, that a lot more partnerships will automatically fall under the new regime than they might have expected. Thus advisers need to keep a close eye on the regulations the IRS eventually issues in this area.