Agreeing with the Ninth Circuit, DC Circuit Upholds IRS Position that SMLLC Partner Renders a Partnership Subject to TEFRA Procedures

In a TEFRA case that may have continuing implications under the new Centralized Partnership Audit Regime (CPAR) taking effect for partnership tax years beginning in 2018, the DC Circuit, following suit with a similar opinion last year from the Ninth Circuit, found that having a disregarded entity as a partner meant a partnership could not avoid being examined under the TEFRA partnership examination provisions.

The case, Mellow Partners v. Commissioner, Case No. 16-1454, CA DC appealed the Tax Court’s holding that the TEFRA audit provisions applied to a partnership where each partner held his interest in a single member LLC.

The facts of how the interests were held are outlined as follows in the opinion:

The partnership agreement also states that the partnership was formed “by and between” MB 68th Street Investments LLC (“68th Street”) and WNM Hunters Crest Investments LLC (“Hunters Crest”) (collectively, “the single-member LLCs” or “the LLCs”). Id. Mr. Myer Berlow, the sole member of 68th Street, and Mr. William Melton, the sole member of Hunters Crest, signed the partnership agreement on behalf of their respective LLCs. The single-member LLCs did not elect to be treated as associations under the check-the-box tax-classification regulations and therefore were treated as disregarded entities separate from their owners. Accordingly, the LLCs did not file federal income tax returns for the 1999 tax year.

The Court of Appeals describes the basic rules for partnerships that are covered by TEFRA and those that qualify as exempt in the paragraph below:

As a general rule, the TEFRA procedures apply to all business entities that are required to file a partnership return. Bedrosian v. Comm'r, 143 T.C. 83, 104 (2014) (citing 26 U.S.C. § 6231(a)(1)(A)). However, there is a limited exception for “small partnerships,” which are defined as having “10 or fewer partners each of whom is an individual . . ., a C corporation, or an estate of a deceased partner.” 26 U.S.C. § 6231(a)(1)(B) (2012). In 1987, the Treasury Department promulgated temporary regulations setting forth rules governing the small-partnership exception. See Miscellaneous Provisions Relating to the Tax Treatment of Partnership Items, 52 Fed. Reg. 6,779, 6,789 (Mar. 5, 1987). As relevant here, one of the temporary regulations provided that, “[t]he [small-partnership] exception provided in section 6231(a)(1)(B) does not apply to a partnership for a taxable year if any partner in the partnership during that taxable year is a pass-thru partner.” Id. In 2001, the Treasury Department issued a final regulation, which stated, inter alia, that the small-partnership exception “does not apply to a partnership for a taxable year if any partner in the partnership during that taxable year is a pass-thru partner as defined in section 6231(a)(9).” Unified Partnership Audit Procedures, 66 Fed. Reg. 50,541, 50,556 (Oct. 4, 2001) (codified at Treas. Reg. § 301.6231(a)(1)–1(a)(2)); see id. at 50,544 (stating that the final regulations apply to partnership proceedings concerning partnership taxable years beginning on or after October 4, 2001). The Code, in turn, defines “partner” as “a partner in the partnership” and “any other person whose income tax liability . . . is determined in whole or in part by taking” partnership items “directly or indirectly” into account, 26 U.S.C. § 6231(a)(2) (2012), and “pass-thru partner” as “a partnership, estate, trust, S corporation, nominee, or other similar person through whom other persons hold an interest in the partnership,” id. § 6231(a)(9) (2012).

But the issue remained open regarding whether a single member LLC or a grantor trust would be treated as a pass-thru partner under these rules.  Many hoped that since, in such cases, a person other than the entity is treated “as if” they were the owner for tax purposes, that regulatory (for an SMLLC) or statutory (for a grantor trust) fiction would apply for these purposes as well.

However, the IRS disagreed with that view, holding that these are pass-thru entities and, thus, remove any partnership with such partners from the category of partnerships that qualify for the small partnership exception to TEFRA applicability.  As Circuit Court opinion explains:

IRS presented a thorough explanation of its reasoning on this point in Revenue Ruling 2004–88, 2004–2 C.B. 165 (Aug. 9, 2004). The Revenue Ruling makes it clear that a partnership cannot qualify as a small partnership under § 6231(a)(1)(B) if it has pass-thru partners, and it concludes that a single-member LLC constitutes a pass-thru partner. In reaching this conclusion, the Revenue Ruling highlights that “'pass-thru partner' is defined in section 6231(a)(9) as 'a partnership, estate, trust, S corporation, nominee or other similar person through whom other persons hold an interest in the partnership.'” Id. (quoting § 6231(a)(9)). The Revenue Ruling then explains that “[i]f legal title to a partnership interest is held in the name of a person other than the ultimate owner, the holder of legal title is considered a pass-thru partner within the meaning of section 6231(a)(9).” Id.

The Revenue Ruling goes on to apply these principles to a hypothetical set of facts:

[A]lthough LLC is a disregarded entity for federal tax purposes, LLC is a partner of [Partnership (“P”)] under the law of the state in which P is organized. Similarly, although [individual “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.

Id. (emphasis added).

After reviewing a number of ways of viewing the validity of the IRS’s interpretation, including the Ninth Circuit 2017 ruling in Seaview Trading, LLC v. Commissioner, 858 F.3d 1281 that upheld the IRS position, the panel concludes that the IRS position is justified.  The agency had consistently taken this position regarding the interpretation of the provision, it was in line with the statutory language and not clearly unreasonable.

As the opinion concludes:

In sum, Mellow has “provide[d] no compelling reason to contravene the consistent stance of the IRS and the tax courts, which have uniformly treated disregarded single-member LLCs as pass-thru partners.” Seaview Trading, 858 F.3d at 1287. We therefore defer to the agency's reasonable construction of the term “pass-thru partner” and reject Mellow's claim that the Tax Court lacked jurisdiction.

Readers likely are aware that TEFRA audits are on their way to extinction, with the new CPAR regime taking effect for tax years beginning in 2018.  But the same issue regarding the status of disregarded entities rears its head under the new regime as well.

Under CPAR, certain entities can, at the time they file their partnership income tax return, file an election to “opt-out” of the CPAR regime under IRC § 6221(b).  Under Reg §301.6221(b)-1(b)(3) under the new CPAR rules the existence of any of the following partners will bar the partnership from making an “opt-out” election:

  • A partnership
  • A trust
  • A foreign entity that would not be taxed as a C corporation if it were a domestic entity
  • A disregarded entity described in § 301.7701-2(c)(2)(i)
  • An estate of an individual other than a deceased partner
  • Any person who holds an interest in the partnership on behalf of another person (Reg. § 301.6221(b)-1(b)(3)(ii))

Given that two Circuits found that such an interpretation was proper under the TEFRA rules even when contained in a Revenue Ruling rather than a regulation, it seems unlikely taxpayers will be able to successfully challenge the IRS treatment for CPAR of such entities.