Memorandum Disagrees With Observation That Certain Small Partnerships Effectively Have No Tax Return Filing Requirement

In Chief Counsel Advice 201733013 the IRS concluded there is not an exemption from filing a tax return for small partnerships under any of the below authorities:

  • IRC §6031;
  • IRC §6693; or
  • Revenue Procedure 84-35.

IRC §6031(a) imposes the requirement that each partnership must file an annual partnership return. IRC §6698 imposes a per month penalty when the partnership fails to file a return—and for 2017 returns that penalty amount is set at $200 per month.[1]  This penalty can be waived if the failure to file is due to reasonable cause. [2]

Revenue Procedure 84-35 provides that a partnership that meets the requirements of IRC §6231(a)(1)(B) to be exempt from the TEFRA consolidated partnership rules will be considered to have shown reasonable cause for late filing if the partnership or any of the partners establishes, if requested by the IRS, that all partners fully reported their share of income, deductions and credits on a timely filed income tax return. [3]

This procedure was adopted in response to the following language found in the Conference Committee report related to Section 6698:

The penalty will not be imposed if the partnership can show reasonable cause for failure to file a complete or timely return. Smaller partnerships (those with 10 or fewer partners) will not be subject to the penalty under this reasonable cause test so long as each partner fully reports his share of the income, deductions, and credits of the partnership. . . .

In the memorandum, the national office was asked whether this doesn’t, effectively, give such partnerships an exemption from having to file a partnership income tax return.

The memorandum rejects the view that this is a grant of relief from filing. The memorandum points out:

Although Rev. Proc. 84-53 does provide some relief for failure to file a partnership return, we disagree that the guidance provides for almost automatic reasonable cause relief for the failure to file a partnership return. Generally, the Service does not know whether the partnership meets the reasonable cause criteria or qualifies for relief under Rev. Proc. 84-35 unless and until the partnership files a partnership return or some other document with the Service. The individual partners’ income tax returns, even if timely filed and complete, are not linked together during their initial processing. Thus, the Service generally does not know how many partners are in the partnership or whether all of the partners timely filed their income tax returns unless and until the partnership (or one of its partners) is selected for an audit.

The memorandum goes on to note that the Internal Revenue Manual outlines procedures for employees to follow before granting this relief. That discussion provides:

Accordingly, the Service has set forth procedures for applying Rev. Proc. 84-35. See IRM (07-18-2016). That section of the IRM provides that the I.R.C. § 6698 penalty may be avoided if it is shown that the failure to file a complete or timely return was due to reasonable cause, by meeting the following requirements:

1. The partnership must consist of 10 or fewer partners. To this requirement, a husband and wife (or their estate) filing a joint return is considered one partner.

2. Each partner is either an individual (excluding nonresident aliens), or the estate of a deceased partner.

3. Each partner's items of income, deductions, and credits are allocated in the same proportion as all other items of income, deductions, and credits.

4. The partnership has not elected to be subject to the consolidated audit procedures under I.R.C. §§ 6221 through I.R.C. § 6233.

5. Each partner reported his or her share of partnership income on his or her timely filed income tax return. (emphasis added).

In addition, IRM instructs examiners that when a partner requests abatement of the failure to file penalty because the partnership has ten partners or fewer, abate the penalty if the partner (or representative) confirms verbally or in writing that—

1. All partners are qualifying partners,

2. All partners filed timely returns and included their share of partnership income on that return, and

3. The partnership is not subject to the consolidated (unified) audit procedures under I.R.C. §§ 6221 through I.R.C. 6234.20

Moreover, the IRM instructs examiners that to the greatest extent practical, they should validate the taxpayer’s statements by using CFOL to research each partner’s account for timely filing, and should not abate the penalty if the examiner finds that any partner filed late, or if any partner failed any other requirement.

The memorandum concludes:

Requiring taxpayers to meet the requirements of Rev. Proc. 84-53 and IRM encourages voluntary compliance by reminding taxpayers of the requirement to timely file partnership returns and their own individual returns and that their individual income tax returns include their share of partnership income.

The memorandum carefully avoids analyzing what was the basic point of the inquiry—that a qualifying partnership will face no consequence if it fails to file, aside from correspondence with the IRS should the agency discover the existence of the entity. But from a tax administration policy standpoint the memorandum position makes sense—if an entity doesn’t file a partnership return the IRS may have no evidence at all the entity’s existence, and thus not be aware that the agency may want to check that the partnership complies.

This exception is narrower than many CPAs may believe. The Rev. Proc. notes that “[p]artnerships having a trust or corporation as a partner, tier partnerships, and partnerships where each partner's interest in the capital and profits are not owned in the same proportion, or where all items of income, deductions, and credits are not allocated in proportion to the prorata interests” do not qualify for this relief.

Revenue Ruling 2004-88 provides that partnerships with grantor trust partners, or partners that are single member LLCs, do not qualify as “small partnerships” under the TEFRA rules. Since meeting the requirements of that provision is a condition for Revenue Procedure 84-35 to apply, a partnership with such partners would not qualify for automatic relief even if it had less than 10 members.

Similarly, this old Revenue Procedure cannot be reliably cited to get an S corporation out of its late filing penalty. The procedure rather clearly notes that it was issued to comply with the Conference Committee report discussion related to small partnerships. No similar Congressional discussion of exempting similarly “small” S corporations from late filing penalties exists.

Another problem may loom on the horizon—the version of IRC §6231 referenced in this ruling to determine whether a partnership qualifies for relief is repealed and replaced for partnership tax years beginning on or after January 1, 2018 as the TEFRA consolidated audit rules go away.

While the IRS has not mentioned how or whether that will impact the small partnership relief ruling, the Service may decide that Congress’s intent in passing the revised partnership audit regime is no longer consistent with this grant of relief. Remember that under the new audit rules, a partnership is subject to the consolidated audit procedures unless it timely files a return and elects not to have the rules apply. Arguably, a partnership that fails to file a return beginning with 2018 tax years has forfeited the right to be treated as a small partnership. Certainly, advisers need to watch for any signs of whether or how this special small partnership filing relief might change beginning with 2018 tax years.

[1] IRC §§6698(a)(1), 6698(e), Rev. Proc. 2016-55

[2] IRC §6698(a)(1)

[3] Rev. Proc. 84-43, Section 3.01