Tuesday, February 21, 2017
The Scope and Effect of the “Small Partnership Exception”
Every partnership (defined as a joint venture or any other unincorporated organization) that conducts a business is required to file a return for each tax year that reports the items of gross income and allowable deductions. I.R.C. §§761(a), 6031(a). If a partnership return is not timely filed (including extensions) or is timely filed but is inadequate, a monthly penalty is triggered that equals $200 times the number of partners during any part of the tax year for each month (or fraction thereof) for which the failure continues. However, the penalty amount is capped at 12 months. Thus, for example, the monthly penalty for a 15-partner partnership would be $3,000 (15 x $200) capped at $36,000. Such an entity is also subject to rules enacted under the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. These rules established unified procedures for the IRS examination of partnerships, rather than a separate examination of each partner.
An exception from the penalty for failing to file a partnership return and the TEFRA audit procedures could apply for many small business partnerships and farming operations. However, it is important to understand the scope of the exception, and what is still required of such entities even if a partnership return is not filed. In many instances, such entities may find that simply filing a partnership return in any event is a more practical approach.
Just exactly what is the “small partnership exception”? That’s the focus of today post.
Exception for Failure to File Partnership Return
The penalty for failure to file is assessed against the partnership. While there is not a statutory exception to the penalty, it is not assessed if it can be shown that the failure to file was due to reasonable cause. I.R.C. §6689(a). The taxpayer bears the burden to show reasonable cause based on the facts and circumstances of each situation. On the reasonable cause issue, the IRS, in Rev. Proc. 84-35, 1984-1 C.B. 509, established an exception from the penalty for failing to file a partnership return for a “small partnership.” Under the Rev. Proc., an entity that satisfies the requirements to be a small partnership will be considered to meet the reasonable cause test and will not be subject to the penalty imposed by I.R.C. §6698 for the failure to file a complete or timely partnership return. However, the Rev. Proc. noted that each partner of the small partnership must fully report their shares of the income, deductions and credits of the partnership on their timely filed income tax returns.
So what is a small partnership? Under Rev. Proc. 84-35 (and I.R.C. §6231(a)(1)(B)), a “small partnership” must satisfy six requirements:
- The partnership must be a domestic partnership;
- The partnership must have 10 or fewer partners;
- All of the partners must be natural persons (other than a nonresident alien), an estate of a deceased partner, or C corporations;
- Each partner’s share of each partnership item must be the same as the partner’s share of every other item;
- All of the partners must have timely filed their income tax returns; and
- All of the partners must establish that they reported their share of the income, deductions and credits of the partnership on their timely filed income tax returns if the IRS requests.
Applying the Small Partnership Exception – Practitioner Problems
So how does the small partnership exception work in practice? Typically, the IRS will have asserted the I.R.C. §6698 penalty for the failure to file a partnership return. The penalty can be assessed before the partnership has an opportunity to assert reasonable cause or after the IRS has considered and rejected the taxpayer’s claim. When that happens, the partnership must request reconsideration of the penalty and establish that the small partnership exception applies so that reasonable cause exists to excuse the failure to file a partnership return.
Throughout this process, the burden is on the taxpayer. That’s a key point. In most instances, the partners will likely decide that it is simply easier to file a partnership return instead of potentially getting the partnership into a situation where the partnership (and the partners) have to satisfy an IRS request to establish that all of the partners have fully reported their shares of income, deductions and credits on their own timely filed returns. As a result, the best approach for practitioners to follow is to simply file a partnership return so as to avoid the possibility that IRS would assert the $200/partner/month penalty and issue an assessment notice. IRS has the ability to identify the non-filed partnership return from the TIN matching process. One thing that is for sure is that clients do not appreciate getting an IRS assessment notice.
The Actual Relief of the Small Partnership Exception
Typically, the small partnership exception is limited in usefulness to those situations where the partners are unaware of the partnership return filing requirement or are unaware that they have a partnership for tax purposes, and the IRS asserts the penalty for failing to file a partnership return. In those situations, the partnership can use the exception to show reasonable cause for the failure to file a partnership return. But, even if the exception is deemed to apply, the IRS can require that the individual partners prove that they have properly reported all tax items on their individual returns.
In addition, if the small partnership exception applies, it does not mean that the small partnership is not a partnership for tax purposes. It only means that the small partnership is not subject to the penalty for failure to file a partnership return and the TEFRA audit procedures.
Why does the “small partnership exception” only apply for TEFRA audit procedures and not the entire Internal Revenue Code? It’s because the statutory definition of “small partnership” contained in I.R.C. §6231(a)(1)(B) applies only in the context of “this subchapter.” “This subchapter” means Subchapter C of Chapter 63 of the I.R.C. Chapter 63 is entitled, “Assessment.” Thus, the exception for a small partnership only means that that IRS can determine the treatment of a partnership item at the partner level, rather than being required to determine the treatment at the partnership level. The subchapter does not contain any exception from a filing requirement. By contrast, the rules for the filing of a partnership return (a “partnership” is defined in I.R.C. §761, which is contained in Chapter 1) are found in Chapter 61, subchapter A – specifically I.R.C. §6031. Because a “partnership” is defined in I.R.C. §761 for purposes of filing a return rather than under I.R.C. §6231, and the requirement to file is contained in I.R.C. §6031, the small partnership exception has no application for purposes of filing a partnership return. Thus, Rev. Proc. 84-35 states that if specific criteria are satisfied, there is no penalty for failure to file a timely or complete partnership return. There is no blanket exception from filing a partnership return. A requirement to meet this exception includes the partner timely reporting the share of partnership income, deductions and credits on the partner’s tax return. Those amounts can’t be determined without the partnership computing them, using accounting methods determined by the partnership and perhaps the partnership making elections such as I.R.C. §179.
The small partnership exception does not apply outside of TEFRA. Any suggestion otherwise is simply a misreading of the Internal Revenue Code.
The small partnership exception usually arises as an after-the-fact attempt at establishing reasonable cause to avoid penalties for failure to file a partnership return. The exception was enacted in 1982 as part of TEFRA to implement unified audit examination and litigation provisions which centralize treatment of partnership taxation issues and ensure equal treatment of partners by uniformly adjusting the tax liability of partners in a partnership. It is far from a way to escape partnership tax complexity, and not a blanket exemption from the other requirements that apply to all partnerships. The failure to file a partnership return could have significant consequences to the small partnership. Ignoring Subchapter K also could have profound consequences, the least of which is dealing with penalty notices.
Under the Balanced Budget Act of 2015 (BBA) (Pub. L. No. 114-74, §1101(a), 129 Stat. 584 (2015)), new partnership audit rules are instituted effective for tax returns filed for tax years beginning on or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any partnership return filed after the date of enactment (November 2, 2015). The BBA contains a revised definition of a “small partnership” by including within the definition those partnerships that are required to furnish 100 or fewer K-1s for the year. If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner. If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers. Thus, the partnership will be audited separately from each partner and the TEFRA rules will not apply, and the reasonable cause defense to an IRS assertion of penalties for failure to file a partnership return can be raised.