In June, the U.S. Court of Appeals for the Ninth Circuit held that a single-member LLC (disregarded entity) holding an interest in an LLC (treated as a partnership) was a "pass-thru" partner for purposes of the "small partnership" exception to the extended statute of limitations of partners under the partnership-level consolidated tax audit rule (known as the "Tax Equity and Fiscal Responsibility Act of 1982" (TEFRA)). This rule is in effect for taxable years beginning before 2018.
The case, called Seaview Trading, LLC v. Commissioner, Docket No. 15-71330 (9th Cir. June 7, 2017), aff'g, Tax Court, No. 1744-11, involved a typical fact pattern: The IRS did not finish the audit of an LLC (treated as a partnership) before the statute of limitations on one of the LLC's members (partners) expired. Ordinarily, in such case, the partner would not be subject to tax as a result of any adjustment flowing from the partnership audit. However, unless an exception applies, TEFRA extends the statute of limitations of the partners with respect to their partnership items (such as their allocable shares of the partnership's income, gain, loss, deduction and credits) until the close of the partnership's statute of limitations.
The taxpayer claimed exactly that, i.e., it qualified for the so-called "small partnership" exception to TEFRA because it had less than 10 members (partners) and, wholly heavens, was not bound by the outcome of the LLC audit. The IRS shook its head and pointed to the "pass-thru" partner rule. This "pass-thru" partner rule provides that the small partnership exception does not apply to a partnership if any of its partners is a "pass-thru" partner, such as a partnership, estate, trust, S corporation, nominee or another similar person through whom other persons hold an interest in the partnership.
Since TEFRA was passed in 1982, well before the concept of a "disregarded entity" was adopted through tax regulations in 1997, there has been a certain level of ambiguity regarding whether a disregarded entity, such as a single-member LLC, counted as a pass-thru partner despite IRS published stance to the affirmative. This Ninth Circuit case wipes away any doubt that previously may have existed on this question.
This holding raises two interesting gummy-bears for the fund community: First, many LLCs forming part of a typical fund or joint venture ownership chain, in particular with respect to investment managers and general partners, are populated by members organized as single-member LLCs. A prudent investor may want to weigh the cost and benefit of using such single-member LLCs from the tax risk management point of view under TEFRA.
Second, and, perhaps, more important, this "pass thru" partner concept survives as part of a newer version of the "small partnership" exception in the new tax audit regime becoming effective in 2018 (this time, by expressly including disregarded entities). The new exception is elective (rather than definitional) and gives a partnership the choice to opt out of the new tax audit regime (falling back to a rule similar to the current TEFRA rule) if the partnership is not required to issue more than 100 Schedule K-1's and complies with election procedures. Given the increased number of partners a partnership may have under the new regime, maybe organizers of funds will consider whether a new tax entity form restriction (alongside the existing securities, AML and tax restrictions) would be an attractive tool to manage fund profile and risk distribution among the investors.
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