Entity's Disregarded Status Doesn't Preclude It from Being a Pass-Thru Partner Subject to TEFRA

(Parker Tax Publishing June 2017)

The Ninth Circuit agreed with the Tax Court in holding that entities that are disregarded for federal tax purposes may nevertheless constitute pass-through partners subject to TEFRA. The Ninth Circuit also sustained the lower court's rejection of a partnership's contention that a partner's status as a single-member disregarded LLC precluded it from being the partnership's tax matters partner. Seaview Trading, LLC v. Comm'r, 2017 PTC 272 (9th Cir. 2017).

Background

In 2001, Robert Kotick and his father formed a Delaware limited liability company, Seaview Trading, LLC (Seaview). Seaview is treated as partnership for federal tax purposes. The Koticks each held their respective interests in Seaview through Delaware LLCs: AGK Investments LLC (AGK), owned wholly by Kotick, and KMC Investments LLC (KMC), owned wholly by Kotick's father. Both AGK and KMC are disregarded entities.

Seaview acquired an interest in a common trust fund, which in 2001 reported a loss that was allocated to its investors - including Seaview. Kotick reported the loss arising from Seaview's interest in the trust fund on his 2001 Form 1040. In 2004, the IRS audited Kotick's 2001 Form 1040, at which time it became aware of his claimed loss resulting from Seaview's investment. At the conclusion of the audit, the IRS disallowed certain transaction expenses relating to Seaview, and assessed additional taxes. It did not, however, disallow the loss that Kotick had reported on his individual tax return as a result of Seaview's trust investment. The statute of limitations for Kotick's 2001 Form 1040 expired in July 2005.

The IRS began an audit of Seaview in October 2005. Five years later, in October 2010, the IRS issued a final partnership administrative adjustment (FPAA) notice disallowing the loss from Seaview's trust investment and imposing penalties. Kotick filed a petition in Tax Court on behalf of Seaview challenging the IRS's notice in regard to Seaview's 2001 taxes. Kotick argued that the IRS's notice was invalid because Seaview was exempt from the otherwise-applicable partnership audit rules pursuant to the small-partnership exception set forth at Code Sec. 6231(a)(1)(B)(i). AGK filed a separate petition seeking the same relief.

The IRS sought to dismiss Kotick's petition for lack of jurisdiction, arguing that (1) Seaview did not fall within the Code Sec. 6231 small-partnership exception, and (2) Kotick lacked standing to file the petition on behalf of Seaview because he was not Seaview's tax matters partner (TMP). The Tax Court found that AGK was Seaview's TMP, and that Kotick, a party other than Seaview's TMP, filed a petition within 90 days of the date the FPAA was mailed. As the Tax Court explained, Seaview failed to designate a TMP for 2001. Therefore, under Code Sec. 6231(a)(7)(B), Seaview's TMP was the general partner having the largest profits interest. Since AGK held a 99.15 percent interest in Seaview, AGK was thus the TMP. The Tax Court rejected Seaview's contention that AGK's status as a single-member LLC precluded it from being Seaview's TMP, citing to a Tax Court decision in which a single-member LLC and pass-thru partner was deemed the TMP for a partnership. In March 2015, the Tax Court granted the IRS's motion to dismiss the petition and Kotick appealed.

Analysis

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) sets forth unified audit and litigation procedures applicable to partnerships. In a partnership-level proceeding, the Tax Court has jurisdiction to determine all of a partnership's partnership items for the tax year to which an FPAA relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item. Under an exception provided by Code Sec. 6231(a)(1)(B)(i), an entity will not be considered a "partnership" for the purposes of TEFRA's audit procedures if the entity has 10 or fewer partners each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner. Reg. Sec. 301.6231(a)(1)-1 provides that the exception provided in Code Sec. 6231(a)(1)(B) does not apply to a partnership for a tax year if any partner in the partnership during that tax year is a pass-thru partner as defined in Code Sec. 6231(a)(9).

Kotick and Seaview argued that under the check-the-box regulations in Reg. Sec. 301.7701-3, AGK and KMC were disregarded entities treated as sole proprietorships and, as such, they could not constitute pass-thru partners. Thus, Seaview and its owners were subject to the exception from the TEFRA audit procedures.

While agreeing with the taxpayers that AGK and KMC were disregarded entities, the Ninth Circuit concluded that their disregarded status for the purpose of federal taxes did not preclude their classification as pass-thru partners under Reg. Sec. 301.6231(a)(1)-1. To the contrary, the court said, single-member LLCs qualify as pass-thru partners, regardless of their elected classification under the check-the-box rules. Thus, Kotick and Seaview were not excepted from the TEFRA audit procedures.

The court noted that the IRS had directly addressed the question of whether a disregarded entity may constitute a pass-thru partner in Rev. Rul. 2004-88 and found that it could. According to the court, Rev. Rul. 2004-88 carries persuasive, if not decisive, force, and therefore warrants judicial deference. The court conceded that Rev. Rul. 2004-88 does not contain extensive discussion of its analysis; but the concise nature of its reasoning, the court said, does not undercut its basic logic.

The Ninth Circuit also agreed with the Tax Court's finding that Kotick was not Seaview's TMP and because he was not Seaview's TMP, he did not have standing to file the petition at issue.

For a discussion of the rules relating to TEFRA audit procedures, see Parker Tax ¶28,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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