Does the Penalty Relief for a “Small Partnership” Still Apply?

Overview

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 $210 times the number of partners during any part of the tax year for each month (or fraction thereof) for which the failure continues.  This is for returns that are to be filed in 2021.  However, the penalty amount is capped at 12 months.  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 could apply for many small business partnerships and farming operations.  But this relief is tied to a provision that is no longer in the Code as of January 1, 2018.  So, does the relief still apply when the law it was tied to is gone?  The IRS answered this question last week.

The “small partnership” exception from the penalty for late filing the partnership return – it’s the topic of today’s 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.      

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.

Repeal by the Bipartisan Budget Act of 2015

The statutory definition of a “small partnership” contained in I.R.C. §6231(a)(1)(B) effective for tax years beginning on or after January 1, 2018.  The Bipartisan Budget Act of 2015 (BBA) repealed the TEFRA audit rules entirely and replaced it with a new system for auditing partnerships. 

So, that repeal wipes out the penalty relief that was tied to it, right?  Not so fast says the IRS.  In Program Manager Technical Advice 2020-01 (Nov. 19, 2019), the IRS noted that the Congress enacted the late-filing partnership return penalty of I.R.C. §6698 in 1978 (pre-TEFRA), and that it “apply automatically to a small partnership that meets certain criteria.”  The Conference Report accompanying the provision indicated an exception for a “small partnership” “so long as each partner fully reports his share of the income, deductions and credits of the partnership.”  H.R. Rep. No. 95-1800, at 221 (1978).  In Rev. Proc. 81-11, 1981-1 C.B. 651, the IRS provided a set of criteria under which partnerships with 10 or fewer partners would not be subject to the penalty of I.R.C. §6698.  It was later superseded by Rev. Proc. 84-35 after the TEFRA rules came out in 1982.

However, the IRS noted in Program Manager Technical Advice 2020-01 (Nov. 19, 2019), that the definition of a “small partnership” was not changed.  TEFRA made no change to I.R.C. §6698.  Thus, the IRS concluded, the BBA had no impact on the “application of the exception to the partnership failure to file penalty.  Rather, the BBA simply restored pre-TEFRA law which already contained the penalty relief for a small partnership.  Here’s how the IRS put it:  “…it is irrelevant that there does not exist any current section 6231(a)(1)(B) that is generally effective and applicable to partnerships seeking relief under Revenue Procedure 84-35.  Moreover, the legislative history of section 6698, which is the basis for the relief provided in Revenue Procedure, is still relevant, and the scope of the section 6698 penalty for failure to file a partnership return has not been affected by the repeal of the TEFRA provisions.  Thus, Revenue Procedure 84-35 is not obsolete and continues to apply.”  The IRS concluded by stating that it may develop procedures consistent with Rev. Proc. 84-35 to ensure that any partnership claiming relief is, in fact, entitled to the relief. 

Under the BBA, a “small partnership” can elect out of the new rules.  A “small partnership” is one that is required to furnish 100 or fewer Schedules K-1 for the year.  In addition, the partnership must have partners that are individuals, corporations or estates.  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.   There are more specifics on the election in the regulations, but a drawback of the election might be that a small partnership electing out of the BBA audit provisions could be at a higher audit risk. IRS has seemingly indicated that this could be the case.

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 $210/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. 

Conclusion

The best position is to simply not be late in filing partnership returns.  But, if it happens, the penalty relief of Rev. Proc. 84-35 still applies if the requirements are satisfied.