Partnership Interest Held in a Single Member LLC Precludes Qualification as a Small Partnership Under TEFRA Provisions

In Revenue Ruling 2004-88 the IRS held that if a single partner of a partnership is a disregarded entity (such as a single member LLC or a grantor trust), that partnership cannot qualify for an exemption from the TEFRA consolidated partnership audit rules under the provisions of IRC §6231(a)(1)(B)(i).  In the case of Seaview Trading, LLC, et al v. Commissioner, (CA9 2017), Case No. 15-71330 the Ninth Circuit Court of Appeals agreed with the IRS’s view expressed in that Revenue Ruling.

Robert Kotick and his father Charles Kotick formed Seaview Trading, LLC, which was taxed as a partnership.  Each of the Koticks held their interest in Seaview through a single member LLC that was treated as a disregarded entity. 

Under the TEFRA consolidated partnership examination provisions, a partnership exam generally takes place at the partnership level for items of income, deduction, and credits as well as for any other partnership items.  The statute of limitations for the IRS to assess tax against the partners is the later of the expiration of the statute on the individual partner’s return or the expiration of the statute for the partnership under the TEFRA audit provisions.

Although generally partnerships are subject to the consolidated partnership audit rules, IRC Section 6231(a)(1)(B)(i) provides for an exemption for certain small partnerships.  These small partnerships are not subject to the TEFRA provisions unless the partnership affirmatively elects into the TEFRA regime by filing Form 8893 with its tax return for the year in question.

A partnership is exempt from the TEFRA consolidated audit provisions under the small partnership exception if:

  • The partnership has 10 or fewer partners and
  • Each of those partners is:
    • An individual (other than a nonresident alien)
    • A C corporation or
    • An estate of a deceased partner

If the partnership is exempt, the exam takes place at the individual partner level and the only statute of limitation for the IRS to assess tax is the standard statute on the partner’s return.  There is no partnership level statute in that case.

In this case Robert Kotick’s 2001 income tax return was examined by the IRS.  The IRS noticed that Robert had claimed a loss flowing to him from Seaview in 2001.  While the IRS made various adjustments to Robert’s return, they did not modify the flow through loss from Seaview.  Rather the IRS opened an examination of Seaview in 2005 and finally issued a final partnership administrative adjustment (FPAA) under the TEFRA rules in 2010.  In the meantime, the statute of limitations on Robert’s individual return had otherwise expired in 2005.

Robert contended that the IRS was too late in assessing tax, since Seaview qualified under the small partnership provisions noted above.  As the partnership had only 2 partners it clearly met the first requirement of having less than 10 partners. 

But the IRS contended that because both partners held their interests in single member LLCs, the second requirement was not met as the partnership had a member that was not an individual, a C corporation, or the estate of a deceased partner.  Robert countered that the single member LLC was, under the regulations for IRC Section 7701, disregarded and thus the “owner” should be viewed as an individual.

Under Reg. §301.6231(a)(1)-1(a)(2) a partnership does not qualify for the small partnership exception if any partner is a pass-thru partner as defined at IRC §6231(a)(9).  That provision 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.”  The IRS contended that an SMLLC is just such a pass-thru partner.

The Ninth Circuit references Revenue Ruling 2004-88, cited above, noting:

The IRS directly addressed the question of whether a disregarded entity may constitute a pass-thru partner in Revenue Ruling 2004-88, 2004-2 C.B. 165.1 We have previously applied Skidmore deference to revenue rulings. See Omohundro v. United States, 300 F.3d 1065, 1068 (9th Cir. 2002) (per curiam). Under Skidmore v. Swift & Co., 323 U.S. 134 (1944), and the Supreme Court’s decision in United States v. Mead Corp., 533 U.S. 218 (2001), an agency’s ruling “is eligible to claim respect according to its persuasiveness.” 533 U.S. at 221 (citing generally Skidmore, 323 U.S. 134). We consider multiple factors when exercising Skidmore review of agency action, including “the thoroughness and validity of the agency’s reasoning, the consistency of the agency’s interpretation, the formality of the agency’s action, and all those factors that give it the power to persuade, if lacking the power to control.” Tualatin Valley Builders Supply, Inc. v. United States, 522 F.3d 937, 942 (9th Cir. 2008); see also Tablada v. Thomas, 533 F.3d 800, 806–08 (9th Cir. 2008) (finding Skidmore deference warranted in light of the “rational validity” and consistent application of an agency’s position, despite the existence of reasonable alternative interpretations).

The Ninth Circuit then looks at the details of the ruling to see if it should be granted deference under the above standard.  While noting the ruling does not “contain extensive discussion of its analysis” it still found the logic persuasive. 

Ruling 2004-88 starts by emphasizing that the definition of a “pass-thru” partner contained in § 6231(a)(9) includes “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.” Rev. Rul. 2004-88 (quoting § 6231(a)(9)). In other words, the definition expressly contemplates its application beyond the specific enumerated forms. Single-member LLCs are indisputably entities “through whom other persons hold an interest in [a] partnership.” The question, therefore, is whether a single-member LLC constitutes a “similar person” in respect to the enumerated entities. 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.” Id. In support of this holding, Ruling 2004-88 cites White v. Commissioner, 62 T.C.M. (CCH) 1181 (1991), in which the custodian for minor children was not a pass-thru partner because it did not hold legal title to the children’s partnership interests. Ruling 2004-88 contrasts that result with the outcome in Primco Management Co. v. Commissioner, 74 T.C.M. (CCH) 177 (1997), in which a grantor trust holding legal title to an interest in an S corporation constituted a pass-thru shareholder. Ruling 2004-88 then goes on to state that,

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.

Rev. Rul. 2004-88 (emphasis added).

The panel rejected the argument that such a view was contrary to Reg. §301.7701-1(a)(1).  But the panel found that the issue was not whether the IRS had to follow a state law structure in its federal tax law treatment.  Rather, the ruling held:

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.

The panel also found that Robert did have standing to challenge the IRS by filing a petition on Seaview’s behalf, since the actual partner was not Robert but the SMLLC.  As the ruling noted:

Seaview does not dispute the tax court’s factual findings that AGK held the largest interest in Seaview, that AGK filed its own petition for relief, or that Kotick filed his petition within the 90-day period during which only the tax matters partner may file such a petition. Seaview additionally presents no argument as to why the tax court erred in its analysis, beyond Seaview’s general assertion that as a disregarded entity, AGK could not be tax matters partner. As we discuss supra, an entity’s disregarded status does not preclude its treatment as a separate, pass-thru partner for the purposes of applying TEFRA’s procedures.