Court holds SMLLC is a TEFRA pass-through partner
Appeals court defers to revenue ruling when applying TEFRA audit rules
TAX ALERT |
Relying on the authority of an IRS revenue ruling and unofficial IRS guidance,1 the U.S. Court of Appeals for the Ninth Circuit took the pro-government position2 that a single-member limited liability company (SMLLC), which is disregarded for federal income tax purposes, is a pass-through partner for purposes of applying the partnership audit procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).3 The deference to these IRS administrative pronouncements was justified, the court explained, by the concept of ‘Skidmore4 deference.’
The case, Seaview Trading, LLC, et al v. Commissioner, involved a partnership which held an interest in a common trust fund. The partners were two single-member limited liability companies (SMLLCs) owned by two individuals. One of the key issues was whether the ‘small partnership’ exception from the TEFRA partnership audit rules applied, since there were only two individuals as ultimate partners, if the SMLLCs were disregarded. The IRS position was that small partnership treatment was unavailable, because the SMLLCs were viewed as if they were partnerships investing in another partnership, referred to as pass-through partners.
Among other issues discussed in the opinion, the Court of Appeals for the Ninth Circuit, reviewing the Tax Court, addressed the issue of which entities are considered pass-through partners.
The court reviewed the TEFRA partnership audit rules and the small-partnership exception. The small-partnership exception provides that in a partnership-level proceeding, a partnership for purposes of TEFRA will not be considered a partnership if they have 10 or fewer partners and the partners must be either individuals, C corporations or estates of a deceased partner. However, under the regulations pertaining to section 6231, 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-through partner as defined in section 6231(a)(9).5 The cross reference defines pass-through partners as a partnership, estate, trust, S corporation, nominee or other similar person through whom other persons hold.6
The Ninth Circuit reasoned that a SMLLC fits within the definition of a pass-through partner based on an IRS revenue ruling, which itself is supported by other informal IRS guidance.7 The decision stated that such reliance is appropriate under Skidmore deference, a judicial doctrine developed by a Supreme Court case and its progeny holding that courts can rely on administrative agency action if the guidance meets certain requirements. Finding that Rev. Rul. 2004-88 merits deference because it ‘carries persuasive, if not decisive, force’ the Ninth Circuit followed the reasoning in the ruling, which stated that the definition of a pass-through partner was intended to look beyond the actual list of possible partner forms. Principally, the ruling and likewise the Ninth Circuit placed great emphasis on the catch-all category reasoning that SMLLCs easily meet the definition as they are entities ‘through whom other persons hold an interest in.8 The Ninth Circuit deferred to the ruling’s supporting cases looking at other situations where legal title to a partnership interests is held in the name of someone who is not the ultimate owner. In addition, the Ninth Circuit relied on a Chief Counsel Advice memorandum that argued that the entity classification regulations9 serve a different purpose from the pass-through partner exception.10
One takeaway for tax practitioners is that an entity that is disregarded under the entity classification rules of section 7701 might not be disregarded for other purposes, such as the pass-through partner rules of the TEFRA provisions. In addition, this case illustrates the ongoing uncertainty regarding the deference to be given to unofficial IRS guidance or even to official revenue rulings. Although they are not expressly binding on taxpayers, such authorities should be consulted when any tax advice is given or considered.
2 While the Ninth Circuit does address the substantive issue under Skidmore deference and notes that the issue is ‘inextricably intertwined with’ another issue related to standing, the court ultimately ruled based on the standing issue. Thus, the issues discussed in this Alert may relate to judicial ‘dicta’ rather than a holding as such.