IRS’ Office of Chief Counsel recently weighed in on an important question for small partnerships: Are they automatically exempted from the requirement of filing a Form 1065, U.S. Return of Partnership Income, because of Rev. Proc. 84-35, 1984-1 C.B. 509?
Simply put, the answer was, “No.”
The conclusion of the CCA 201733013 was not a surprise, especially in light of the 2015 case of Battle Flat, LLC v. United States[i], and Internal Revenue Manual procedures detailing the requirements for applying Rev. Proc. 84-35.[ii] Yet, the advice very clearly sets forth the IRS position on this matter, which is very important to many agricultural partnerships. It also raises the question of how this provision will be applied in 2018, after new partnership audit rules are implemented.
The taxpayer seeking the advice acknowledged that “a small partnership is not relieved of the filing requirement,” but sought confirmation for the contention that they have “almost automatic reasonable cause relief for the failure to file a partnership return.” With this assertion, the CCA did not concur.
The CCA began with the proposition that IRC § 6031(a) requires partnerships to file partnership returns and that when they don’t, they are generally subject to an IRC § 6698 penalty. In 2017, these penalties are $200 per month per partner (for a period up to 12 months).[iii] While there is no statutory exception to the § 6031(a) filing requirement for any partnership (regardless of size), the CCA explains that the § 6698 penalty may be avoided if it is shown that the failure to file a complete or timely return was due to “reasonable cause.”[iv]
The legislative history for § 6698 suggests that lawmakers intended this “reasonable cause” exception to protect small partnerships that did not file a partnership return:
The Committee understands that small partnerships (those with 10 or fewer partners) often do not file partnership returns, but rather each partner files a detailed statement of his share of partnership income and deductions with his own return. Although these partnerships may technically be required to file partnership returns, the Committee believes that full reporting of the partnership income and deductions by each partner is adequate and that it is reasonable not to file a partnership return in this instance.[v]
In 1984, IRS issued Rev. Proc. 84-35 to provide guidance on when partnerships with 10 or fewer partners would not be subject to the § 6698 penalty under this reasonable cause provision. Specifically, the Rev. Proc. states:
A domestic partnership composed of 10 or fewer partners and coming within the exception outlined in section 6231(a)(1)(B) of the Code will be considered to have met the reasonable cause test and will not be subject to the penalty imposed by section 6698 for the failure to file a complete or timely partnership return, provided that the partnership, or any of the partners, establishes, if so required by the Internal Revenue Service, that all partners have fully reported their shares of the income, deductions, and credits of the partnership on their timely filed income tax returns.[vi]
IRC § 6231(a)(1)(B) provides that for purposes of subchapter C of chapter 63 (which sets forth TEFRA audit procedures), the term “partnership” shall not include "any partnership having 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.” At the time Rev. Proc. 84-35 was drafted, this definition also required that “each partner’s share of each partnership item is the same as his share of every other item.” Section 6031 (the provision requiring partnerships to file a return) is found in subchapter A of chapter 61 and § 6698 (the provision imposing the penalty for not filing) is found in subchapter B of chapter 68.
The CCA reviewed Rev. Proc. 84-35 and reasoned that “partnerships 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 or income, deductions, and credits are not allocated in proportion to the pro rata interest, do not come within the exception of section 6231(a)(1)(B) and, as such, are not covered by Rev. Proc. 84-35.” These partnerships can, however, attempt to prove “reasonable cause” based upon some other factors, taking all of the relevant facts and circumstances into consideration.
The CCA then reviewed the criteria that must be established in order for Rev. Proc. 84-35 penalty relief to apply and concluded that it is the same criteria that has been documented in IRM 20.1.2.3.3.1(2):
1. The partnership must consist of 10 or fewer partners. For the purpose of 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 (subchapter C).
5. Each partner reported his or her share of partnership income on his or her timely filed income tax return.
The CCA concludes by stating that Rev. Proc. 84-35 “does not provide an automatic exemption to partnerships from the requirement of filing a Form 1065.” Rather, the “penalty may be avoided if it is shown that the failure to file a complete or timely return was due to reasonable cause.” This may be established under Rev. Proc. 84-35, the CCA continues, if the partnership meets the requirements and the examiners follow the procedures set forth in IRM 20.1.2.3.3.1.
Until next year, this CCA means business as usual for small partnerships. If the partnership failed to file a timely Form 1065, if each partner reported his or her share of partnership income on his or her timely filed return, and if other Rev. Proc. 84-35 requirements are met, the IRS should grant the partnership penalty relief under the “reasonable cause” exception to the filing penalty. Most tax professionals advise all partnership clients to file a Form 1065, as required by the statute, and to not rely on penalty relief. However, Rev. Proc. 84-35 is a great help to small partnerships in the event they have not filed a timely return. Two hundred dollars per month per partner is a huge penalty. For example, a family farm partnership with three siblings and parents would be looking at an $800 per month penalty that could be assessed for 12 months (up to $9,600).
The future of penalty relief for these partnerships is much less certain. The Bipartisan Budget Act of 2015 (BBA) replaced TEFRA with new unified partnership audit procedures beginning in 2018. This means that subchapter C of chapter 63 has been replaced. With it, the TEFRA audit exception for partnerships with 10 or fewer partners[vii] has been eliminated. Under § 6221(b)(1)(D)(1) of the BBA, partnerships with 100 or fewer partners must affirmatively opt out of the new audit regime each year by filing a timely partnership return if they don't want new rules to apply.[viii] If these partnerships do not opt out of the centralized partner audit regime, all audits and adjustments for items of income, gain, loss, deduction, or credit, in addition to each partner's distributive share, will be determined at the partnership level, rather than the individual level. Likewise, tax attributed to these items will be assessed and collected at the partnership, rather than the individual, level. Finally, any tax assessed during an audit would be assessed and collected for the year in which the adjustment is made, not the year for which the partnership was under audit. This means that current partners may pay an assessment for an audited year during which they were not partners.
This new audit regime and the requirement that small partnerships must affirmatively opt out or face its new rules, further increases the importance of small partnerships timely filing their Form 1065s. But, what will happen under the new law if they don’t file? The answer is unclear.
The new law does not change the statutory exception to the failure to file penalty for “reasonable cause.” In other words, if a small partnership can establish “reasonable cause” for its failure to file a timely return, the penalty exemption provided by § 6698(a)(2) will still apply. But the question remains: How will IRS apply its guidance in Rev. Proc. 84-35 in light of the new partnership audit rules? Can partnerships with 10 or fewer partners still rely on the requirements of this guidance to meet the “reasonable cause” exception? Although § 6231 does not statutorily apply to the penalty provisions found in § 6698, Rev. Proc. 84-35 linked the two by saying that the “reasonable cause” exception of § 6698(a)(2) would apply to partnerships meeting the “10 or fewer partners” definition found in § 6231. This was apparently an easy way to reference the small partnership exception described in the legislative history of § 6698. And the IRM, referenced in the CCA, specifically includes the following requirement for the penalty relief of Rev. Proc. 84-35 to apply: The partnership has not elected to be subject to the consolidated audit procedures under subchapter C. This is because the current statute says that if the partnership has elected to be subject to the centralized audit procedures, the small partnership exclusion of § 6231(a)(1)(B)(i) does “not apply.”[ix]
With § 6231 gone, will all partnerships be required to establish “reasonable cause” grounds for penalty relief outside the parameters of Rev. Proc. 84-35 or will IRS continue to allow partnerships with “10 or fewer partners” to rely on that guidance, in keeping with the legislative history of § 6698? The answer to that question remains to be seen.
Penalty relief or abatement can be a great help when the unexpected happens. However, it's usually best not to rely on that option when ordering business affairs. All small partnerships should file timely Form 1065s. Tax year 2017 forms will be due March 15, 2018. This filing is especially important in light of the new partnership audit rules and the affirmative requirement that small partnerships opt out if they do not want those rules to apply.
[i] 2015 U.S. Dist. LEXIS 125678, 116 A.F.T.R.2d (RIA) 6193 (D. S.D. 2015).
[ii] IRM 20.1.2.3.3.1 (07-18-2016).
