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Partnership Consisting of Disregarded Entities Did Not Qualify for TEFRA Small Partnership Exception

(Parker Tax Publishing June 2018)

The D.C. Circuit held that a partnership consisting of two single-member LLCs classified as disregarded entities did not qualify for the exception under the Tax Equity and Fiscal Responsibility Act (TEFRA) for small partnerships because a small partnership cannot have a partner that is a passthrough entity. The D.C. Circuit rejected the taxpayers' arguments that the individuals, not the LLCs, were the actual partners of the partnership, finding that the partnership agreement clearly named the LLCs as the partners and that the definition of a pass-thru partner in the regulations was a reasonable interpretation of an ambiguous statute. Mellow Partners v. Comm'r, 2018 PTC 148 (D.C. Cir. 2018).


Mellow Partners was a partnership formed in November 1999 and dissolved less than a month later. Mellow's partnership agreement stated that it was formed to invest in securities and other assets. The agreement also stated that the partnership was formed by and between MB 68th Street Investments LLC (68th Street) and WNM Hunters Crest Investments LLC (Hunters Crest). Myer Berlow, the sole member of 68th Street, and William Melton, the sole member of Hunters Crest, signed the partnership agreement on behalf of their respective LLCs. The LLCs were treated as disregarded entities and did not file tax returns for 1999.

In 2000, Mellow filed a Form 1065 partnership return with Schedules K-1 attached identifying 68th Street and Hunters Crest as Mellow's partners. Mellow answered "No" to the question on the Form 1065 of whether it was subject to the consolidated audit procedures under the Tax Equity and Fiscal Responsibility Act (TEFRA). Notwithstanding that assertion, the IRS audited Mellow and issued a Final Partnership Administrative Adjustment (FPAA) setting forth adjustments to Mellow's partnership items. The FPAA concluded that Mellow was formed solely for tax avoidance purposes, lacked economic substance, and constituted an economic sham for tax purposes. According to the FPAA, Mellow's partners engaged in a series of offsetting transactions involving digital options that were designed to generate losses to offset the partners' tax liabilities. The partners' outside bases in their partnership interests were reduced to zero and accuracy related penalties under Code Sec. 6662 were applied.

Mellow petitioned the Tax Court to challenge the FPAA. It asserted that the FPAA improperly asserted adjustments that were not partnership items over which the court had jurisdiction. The Tax Court found that the IRS's adjustments in the FPAA were correct and rejected Mellow's jurisdiction argument. Mellow appealed to the D.C. Circuit.


TEFRA allows the IRS to bring a partnership level proceeding to adjust partnership items by issuing a FPAA to the partnership's partners. TEFRA procedures apply to all business entities that are required to file a partnership return. However, a limited exception applies for small partnerships, defined as having 10 or fewer partners, each of whom is an individual, C corporation, or an estate of a deceased partner. Reg. Sec. 301.6231(a)(1)-1(a)(2) provides that the small partnership exception does not apply if any partner is a "pass-thru partner" as defined in Code Sec. 6231(a)(9). That statute defines a pass-thru partner as a partnership, estate, trust, S corporation, nominee, "or other similar person through whom other persons hold an interest in the partnership."

Mellow argued that a disregarded entity is treated as a nullity for all tax purposes; therefore, if a disregarded single member LLC is a partner in a partnership, the LLC's owner, rather than the LLC, is the partner. On that basis, Mellow asserted that it was a partnership consisting not of two LLCs but two individual partners and, as such, qualified for the small partnership exception. Mellow reasoned that the list of entities in Code Sec. 6231(a)(9) does not include disregarded entities or single member LLCs, and contended that a "similar person" under the statute must be one who can have multiple owners, because the catchall phrase refers to "a similar person through whom other persons [plural] hold an interest."

Mellow also challenged the Code Sec. 6662 penalty, for the first time on appeal, by arguing that the IRS failed to comply with the written approval requirement in Code Sec. 6751(b)(1). Mellow argued that it would have been premature to raise the issue in the Tax Court because the Second Circuit's decision in Chai v. Comm'r, 2017 PTC 124 (2d Cir. 2017), holding that the signature requirement is part of the IRS's burden of production, created new law and was decided after the Tax Court's decision in this case. Mellow asked the D.C. Circuit to remand the case to the Tax Court to determine whether the IRS met its Code Sec. 6751(b)(1) obligations.

The D.C. Circuit held that Mellow did not qualify for the small partnership exception and declined to consider its challenge to the penalty. The court found ample evidence in the record to reject Mellow's argument that Berlow and Melton, and not the LLCs, were Mellow's partners. Mellow had stipulated in the Tax Court proceeding that its only partners were the LLCs. The partnership agreement stated that it was formed by and between the LLCs, and it identified Hunters Crest as its managing partner. The partnership agreement was signed by Berlow and Melton on behalf of their respective LLCs. Mellow issued Schedules K-1 to the LLCs, not to their individual owners.

The court found no authority for Mellow's assertion that an LLC's tax classification dictated whether the LLC or its sole owner was treated as a partner in a partnership comprised of two single member LLCs under TEFRA. In the court's view, the check-the-box regulations merely determine the tax consequences of that particular entity. They do not determine the tax consequences of a higher-level partnership composed of two or more disregarded entities, nor do they specify who holds a partnership interest for TEFRA purposes.

The D.C. Circuit also rejected Mellow's argument that the pass-thru partner provision should not be applied to narrow the contours of the small partnership exception. The court explained that although Code Sec. 6231(a)(9) does not expressly include disregarded single member LLCs as pass-thru partners, the IRS has consistently interpreted Code Sec 6231(a)(9) to include disregarded entities. The court cited Rev. Rul. 2004-88 which, in the court's view, clearly provides that a partnership is not a small partnership if it has pass-thru partners and concludes that a single member LLC constitutes a pass-thru partner. According to the court, the IRS's position in Rev. Rul. 2004-88 had been consistently maintained and was entitled to deference. The D.C Circuit agreed with the conclusion in Seaview Trading, LLC v. Comm'r, 2017 PTC 272 (9th Cir. 2017), where the Ninth Circuit found that the IRS's position in Rev. Rul. 2004-88 was consistent with the statute and eminently reasonable.

The D.C. Circuit found that the IRS's determination was further supported by the language of Code Sec. 6231(a)(9). The court agreed with Seaview's finding that the "other similar person" catchall phrase expressly contemplates its application beyond the specific enumerated entities. In the court's view, the IRS's focus on whether an entity holds legal title on behalf of another was consistent with the plain text of the statute, which specifically refers to the holding of a partnership interest on behalf of another. The D.C. Circuit was unpersuaded that a "similar person" had to be an entity that could have multiple owners; as the court explained, Mellow was ignoring the plain meaning of the plural term "persons" in the statute, which in the court's view necessarily includes the singular "person."

The D.C. Circuit rejected Mellow's Code Sec. 6751(b)(1) challenge to the penalty because Mellow failed to raise it in the Tax Court. The court reasoned that in other Tax Court cases decided after Chai, the issue of whether the IRS had met its Code Sec. 6751(b)(1) obligations was raised while that dispute remained pending. In the court's view, nothing precluded Mellow from raising a Code Sec. 6751(b)(1) challenge in the Tax Court; although Chai was decided after the Tax Court's decision in this case, the statute had been in existence since 1998. In the court's view, Mellow was free to bring the same challenge raised by the taxpayer in Chai. By failing to do so, Mellow failed to preserve the argument and the court declined to consider it.

For a discussion of TEFRA audit procedures, see Parker Tax ¶28,505. For a discussion of procedural requirements for computing penalties, see Parker Tax ¶262,195.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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