The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) procedures were intended to make it easier for the IRS to audit partnership tax returns. TEFRA failed to deliver. The rules are nuanced and hard to apply. The new partnership audit procedures are intended to remedy this.
With the new partnership IRS audit procedures coming online next year, one cannot help but pause to consider the TEFRA disputes that are still taking place today, thirty-five years after the TEFRA procedures were enacted, and wonder if the new audit procedures will generate the same types of disputes for the next thirty-five years.
The recent Seaview Trading LLC v. Commissioner, No. 15-71330 (9th Cir. 2017), case is a prime example. The court addressed the fundamental question as to whether the TEFRA procedures even apply to partners who hold their partnership interest through a single-member limited liability company (“LLC”). Thirty-five years and this very fundamental question is still being litigated.
Facts & Procedural History
Here are the facts in the case: The taxpayer is a limited liability company (“LLC”) owned by a father and his son. It was taxed as a partnership for federal income tax purposes. The father and son owned the taxpayer through their separate wholly-owned LLCs. The two wholly-owned LLCs were disregarded for Federal income tax purposes.
The taxpayer’s investment produced a taxable loss in 2001. The IRS audited the father’s personal tax return and did not adjust the loss that flowed through to the father’s return. The assessment date for the father’s return expired in 2005. After it expired, the IRS initiated an audit of the taxpayer. Five years later, in 2010, the IRS issued a final partnership administrative adjustment (“FPAA”) notice disallowing the taxpayer’s loss.
The dispute concerned whether the IRS had the ability to adjust the tax loss reported on the partner’s personal tax returns after the assessment date had expired. This turns on whether the TEFRA procedures applied. If the TEFRA procedures apply, the IRS is able to conduct the audit at the partnership level and issue an FPAA to the partnership to adjust the partner’s personal tax returns. If the TEFRA procedures do not apply, the IRS can still conduct the audit at the partnership level, but it has to directly adjust the partner’s personal tax returns.
The TEFRA Procedures
The TEFRA procedures apply to partnerships with more than 10 partners. The rules specifically say that the TEFRA procedures do not apply to partnerships that have 10 or fewer partners that are individuals or C corporations. This exception for 10 or fewer partners does not apply if any partner is a pass-thru partner. A pass-thru partner means “any “partnership, estate, trust, S corporation, nominee, or other similar person through whom other persons hold an interest in the partnership.”
This gets to the dispute in Seaview Trading LLC. The LLCs that owned the taxpayer were single member LLCs that, according to the check-the-box regulations, are to be disregarded for Federal income tax purposes. The taxpayer argued that these two LLCs, which had to be disregarded, could not be pass-thru partners within the meaning of the TEFRA procedure rules. The trial and appeals courts did not agree.
The courts concluded that single member LLCs that are disregarded for Federal income tax purposes are not disregarded in determining whether the TEFRA procedure rules apply. This is consistent with the IRS’s prior administrative guidance.
The New Parntership Audit Rules
The new partnership audit rules will apply starting next year. Under these rules, for partnerships that do not opt out of the rules, the IRS will issue a final partnership determination. It will be similar to the FPAA.
It should be noted that, unlike the TEFRA rules, the new partnership audit rules address the very issue in the Seaview Trading case. They (the regulations) generally say that a disregarded entity that owns the partnership will prevent the partnership from being able to opt out of the new partnership audit rules.