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Disregarded Entities Can’t Opt Out of New Partnership Audits

Posted on Jan. 8, 2018

The IRS has rejected requests to allow disregarded entities and revocable trusts to opt out of the new partnership audit regime but indicated it may revisit the issue.

The decision, announced in final regulations (T.D. 9829) issued December 29, means that tax professionals are likely to be offering different guidance to partnerships to either help them navigate the changes or offer options that could allow for the rules to be avoided altogether.

The regulatory package “is clear, but really is some coal in the Christmas stocking,” said Eric B. Sloan of Gibson, Dunn & Crutcher LLP. There are several instances in the final regulations where the rules are “unnecessarily restrictive,” he said.

In rejecting requests to expand the list of eligible entities that can elect out, the final regulations explain that the government “considered the burdens of the centralized partnership audit regime on taxpayers” but decided those burdens are outweighed by the “interests of efficient tax administration.”

“After gaining experience with the centralized partnership audit regime, the Treasury Department and the IRS will be in a better position to reconsider any expansion of partnerships eligible to elect out of the regime,” the guidance says. 

The new partnership audit regime, enacted by the Bipartisan Budget Act of 2015, permits partnerships with 100 or fewer eligible partners to elect out of the rules. Section 6221(b)(1)(C) defines eligible partners for election out purposes as individuals, C corporations, S corporations, any foreign entity that would be treated as a C corporation if it were a domestic corporation, and the estates of deceased partners.

Section 6221(b)(2)(C) grants authority to the government to expand the types of entities permitted to elect out, but the government didn’t use that authority when proposed regs (REG-136118-15) were released in June. Expanding the eligible partners list was a frequent request the IRS received in comments to the proposed regs.

Disregarded entities were on the list that practitioners and stakeholders frequently urged the government to include. A government official questioned how the rules would work for disregarded entities at a hearing in SeptemberOther officials indicated it was unlikely the list would be expanded because of the uncertainty presented by electing out.

“I can certainly appreciate the administration’s hostility to the election out, but most of the tax community had hoped that Treasury and the IRS would exercise the same judgment with respect to [disregarded entities (DREs)] and electing out that they exercised with respect to tiered partnerships and push-out elections,” Sloan said.

Monte A. Jackel of Akin Gump Strauss Hauer & Feld LLP noted that the IRS refuses to allow disregarded entities to be partners and elect out but requires them to get a Form K-1 as a partner and be counted as part of the 100-or-fewer requirement.

Jackel questioned the correctness of the government’s rationale in the preamble on its treatment of disregarded entities. The government states in the final regs that “the only operative definition of the term ‘partner’ in the code is located in section 7701(a)(2).” This ignores the fact that section 761(b) also defines “partner” and it applies to subtitle A, which also includes the centralized partnership audit rules, he said. 

Jackel said the instructions to Form 1065, Schedule K, provide that a partner that is a disregarded entity should use the name and identification number of the owner. Further, in Rev. Rul. 2004-77, 2004-2 C.B. 119, the IRS determined that a state law partnership between an owner and his disregarded entity is not a federal tax partnership, he said. “The IRS position on DREs seems wrong as a result,” he added.

S Corporations

Tax professionals found it notable that the government would use the election-out rules to determine whether a disregarded entity is a valid S corporation shareholder.

In reg. section 301.6221(b)-1(b)(3)(iv), which provides rules for eligible partners to elect out, the government in Example 2 states in part: “One of S [corporation]’s shareholders is a disregarded entity, and one is a qualified small business trust. S is an eligible partner under paragraph (b)(3)(i) of this section even though S’s shareholders would not be considered eligible partners if those shareholders held direct interests in Partnership.”

Sloan said there has been “some minor concern in the tax community about whether a disregarded entity could be a valid shareholder of an S corporation” because the IRS has provided only informal guidance on this issue until now. “Promulgating substantive guidance on tangentially related areas in examples is an odd way to administer the code,” he said. 

“I suspect that this was done because the IRS, like nearly all tax lawyers I know, believes that there is no meaningful debate about the ability of a DRE to be an S corporation shareholder,” Sloan said. 

Jackel said it was odd that the final regs provide that a disregarded entity can be an S corporation shareholder even though such entities aren’t mentioned in section 1361 as eligible S shareholders.

Revocable Trusts

Dean I. Friedman of Clark & Trevithick PLC said he was disappointed the IRS didn’t add revocable trusts to the list of entities eligible to elect out.

In California, taxpayers invested in a partnership typically do so through a revocable living trust for estate planning purposes, he said, adding that the partnership audit rules create “a lot of hoops to go through just to avoid probate of that partnership interest.”

“I expect partnerships will require that to invest you have to be an eligible partner, meaning that taxpayers would have to hold the interest individually,” Friedman said.

Not including revocable living trusts among the list of eligible partners will frustrate a taxpayer’s estate plan because it may force them to expose these interests to probate, he said. 

“Going forward, we’ll have to recommend to clients that invest in partnerships to do so without using a revocable living trust, which is contrary to our typical advice,” Friedman said. “They may have a very important reason they are going to exclude all trusts,” but “I can’t appreciate why the Service has the view that a revocable living trust can’t be eligible,” he said.

Spouses Are Partners

Practitioners questioned other elements of the rules, including language about how statements to spouses count toward a threshold set by the law.

Section 6221(b)(1)(B) measures the “100 or fewer partners” requirement on the number of statements under section 6031(b) the partnership must issue. Comments to the proposed regs suggested that statements to spouses or to passthrough or disregarded entities should not be counted for purposes of the threshold. The final regs reject these recommendations, noting that section 6031(b) requires the partnership to furnish a statement to each person that is a partner in the partnership.

Sloan said the decision not to treat spouses as one partner for purposes of counting the 100-or-fewer section 6031(b) information statement threshold is also unnecessarily restrictive. Sloan called the requirement a “trap for the unwary,” noting that the test is whether there are 100-or-fewer information statements, not 100-or-fewer partners.

According to Sloan, another requirement in the final regs that is “overly harsh” is that taxpayers must provide complete taxpayer identification numbers for non-U.S. partners. Section 6221(b)(1)(D) requires that the election out be made on a timely filed return for the tax year and include the name and TIN of each partner in the partnership. Section 6221(b)(2)(B) permits the government to require alternative identification for foreign partners.

Rather than require alternative identification for foreign partners, the proposed regs required that all partners of an eligible partnership have a U.S. TIN. The final regs maintain this requirement and note that it “treats all partners the same, regardless of whether they are foreign or domestic, and ensures that the partners of the partnership can be easily identified.”

Sloan said the “government should have been satisfied with the provision” of Forms W-8, “Certificate of Foreign Status.” The final rules indicate the government will continue to study the issue and “one can only hope that . . . will produce a more favorable answer in the future,” Sloan said. “I think the fact that the regulations specifically contemplate this possibility bodes well.”

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