Partnership elected BBA procedures; TEFRA FPAA invalid

An LLC treated as a partnership made a valid early election into the BBA partnership audit procedures, so a Notice of Final Partnership Administrative Adjustment (FPAA) issued by the IRS under the TEFRA partnership procedures was invalid.

TEFRA and BBA partnership audit and adjustment procedures

Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248, which established unified audit and litigation procedures (TEFRA procedures) through which the IRS could make adjustments at the partnership level.  Under the TEFRA procedures, while adjustments were determined at the partnership level, the assessment and collection of tax attributable to partnership items occurred at the partner level.

The Bipartisan Budget Act of 2015 (BBA), P.L. 114-74, replaced the TEFRA procedures with the BBA procedures, which established a new framework for auditing, adjusting, assessing, and collecting tax from partnerships.  The BBA procedures streamlined the audit process for partnerships by allowing audits, adjustments, and payments to all occur at the partnership level.  Although enacted in 2015, the BBA procedures included a delayed effective date, generally applying to partnership returns for tax years beginning after Dec. 31, 2017.

Thus, under the default rules in the BBA, any partnership return with a tax year beginning before Jan. 1, 2018, remained subject to the TEFRA procedures. However, the BBA included a provision allowing partnerships to elect into the BBA procedures for partnership tax years beginning after Nov. 2, 2015, and before Jan. 1, 2018.

Under this provision, partnerships were given the right to elect, in the form and manner prescribed by the IRS, into the BBA procedures for years beginning after the BBA’s enactment and before 2018.  The IRS issued Regs. Sec.  301.9100-22, containing the rules for making an early election into the BBA procedures.  The regulation specified that the election was valid only if it met the requirements of the regulation, and an otherwise valid election would be invalid if it frustrated the purposes of the BBA.

Among other substantive requirements for making the election, the regulation states that in the election the partnership must make a representation that “[t]he partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay a potential imputed underpayment with respect to the partnership taxable year that may be determined under subchapter C of chapter 63 of the Internal Revenue Code as amended by the BBA” (Regs.  Sec. 301. 9100-22(b)(2)(ii)(E)(4)).

Background of the case

SN Worthington Holdings LLC is a limited liability company (LLC) classified as a partnership for federal income tax purposes.  In 2017, it filed Form 1065, U. S. Return of Partnership Income, for 2016. In October 2018, the IRS sent the LLC a letter notifying it that the Service was auditing its 2016 partnership return and that it could elect into the BBA partnership audit procedures.  The letter stated that it must make the election within 30 days of the date of the letter.

SN Worthington timely submitted Form 7036, Election Under Section 1101(g)(4) of the Bipartisan Budget Act of 2015, signed under penalties of perjury. In Form 7036, the LLC made the representation, as required by Regs.  Sec. 301. 9100-22(b)(2)(ii)(E)(4).

Soon after receiving the election, the IRS questioned that representation and sent SN Worthington a letter stating:

As part of the election, you represented the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential imputed underpayment that may be determined during the partnership examination.  After reviewing the tax return it appears that you do not meet the requirements.

The letter further stated that if SN Worthington disagreed with the IRS’s determination, it could submit supporting documents within 30 days. SN Worthington did not respond to the letter, so the IRS sent a second letter notifying the LLC that it had determined that the election was invalid because the LLC had not provided proof of sufficient available assets to pay the potential imputed tax liability and also because the election was not signed by the tax matters partner or an individual authorized to sign the partnership return for the tax year under examination.  SN Worthington also did not respond to the second letter but subsequently communicated with the IRS and signed documents that referred to the TEFRA procedures.

Nonetheless, in June 2020, SN Worthington informed the IRS that it believed that the examination was being conducted under the wrong procedures.  It sent a fax to the IRS requesting to be a part of the Small Business/Self-Employed Fast Track Settlement program but also addressed its position that the IRS should not have been examining the return under TEFRA procedures because the LLC had elected into the BBA procedures. The letter discussed the LLC’s reasons why it disagreed with both of the reasons the IRS gave for determining the election into the BBA procedures was invalid, stating that “there is no requirement that a taxpayer provide proof of sufficient assets to pay an imputed tax liability and the Election was signed by the individual who, in fact, signed the Taxpayer’s partnership return for the taxable year under examination.”

The IRS denied the fast-track settlement request without addressing SN Worthington’s claim that the return was being examined under the wrong procedures.

In August 2020, the IRS issued an FPAA to SN Worthington, determining adjustments to its 2016 return.  The LLC timely filed a petition challenging the IRS’s determinations in Tax Court.  In its petition, SN Worthington LLC argued that its election into the BBA procedures was valid because the election complied with the plain text of Regs. Sec.  301.9100-22. It also argued that because the IRS did not have the authority to request additional information from SN Worthington that was not stated in or required by the regulation, the LLC’s failure to provide additional information asked for by the IRS did not make the election invalid.  Alternatively, SN Worthington contended that even if the IRS had the authority to request additional information, the LLC had already provided information proving it had enough assets to pay an imputed underpayment.  Thus, the IRS’s denial of SN Worthington’s election was unreasonable, arbitrary, and capricious.

The IRS argued it had the authority to ask for the additional information and that allowing an election into the BBA procedures if a partnership does not establish that it had, and would continue to have, sufficient assets to pay a potential imputed underpayment would frustrate the purpose of the BBA procedures.

On Aug. 4, 2023, the LLC filed a motion to dismiss and declare the FPAA invalid, arguing that the Tax Court lacked jurisdiction to hear the case because the FPAA was invalid. The IRS objected to the motion.

The Tax Court’s decision

The Tax Court held that SN Worthington had satisfied the requirement to make a representation that it had, and anticipated continuing to have, enough assets to pay a potential imputed underpayment for the year in issue, so its election into the BBA procedures was valid. Thus, the FPAA issued to the LLC was invalid, and the court lacked jurisdiction to hear the case.

The Tax Court explained that, under its own precedent, taxpayers make valid elections when they comply with the plain text of the election requirements. The manner for making an election can be set forth in various ways, including by statute or by IRS regulation, but once the manner for making an election is established, the IRS may not add ad hoc requirements.  Moreover, when the IRS is determining whether a taxpayer has made a valid election, it may not require the taxpayer to meet more stringent requirements than authorized in the provision that authorizes the election.

On the other hand, the Tax Court stated, it had previously found taxpayers’ elections invalid when they failed to comply with the essential requirements of making the election.  For example, in Fratantonio, T.C. Memo.  1988-158, it held that an election to be taxed as an S corporation was invalid when the taxpayer failed to fully and correctly complete the required form to make the election.

The Tax Court found that SN Worthington had satisfied the requirement that it represent that it had sufficient assets to satisfy an imputed underpayment by submitting a signed Form 7036, which included the text: “This partnership … [h]as sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential imputed underpayment that may be determined during the partnership examination,” noting that the form and the wording of the representation were designed by the IRS.

The IRS argued that to make a valid election into the BBA procedures, the partnership must establish (and not merely represent) that it has sufficient assets to satisfy an imputed underpayment.  It contended that this was necessary to meet the requirement under Regs.  Sec.  301.9100-22(a) that an election into the BBA procedures is not valid if it frustrates the purposes of the BBA.  The court found that the regulation does not define or describe the purposes of the BBA or what would frustrate those purposes, but the preamble to the regulation possibly provided some insight, stating: “An election is also not valid if it frustrates the purposes of section 1101 of the BBA, which include the collection of any imputed underpayment that may be due by the partnership” (T.D. 9780).

However, the court reasoned that the BBA procedures themselves refuted the IRS’s contention that it would frustrate the purposes of the BBA for a partnership to elect early into the BBA procedures when it does not have sufficient assets to pay an imputed underpayment that may become due. According to the court, the BBA procedures contemplate this situation because, under them, if a partnership does not promptly pay an imputed underpayment, the IRS can assess and collect from the partners of the partnership their proportionate shares of the imputed underpayment (Sec. 6232(f )(1)(B)).

The Tax Court also found that under Supreme Court precedent, when there is doubt as to the meaning of a regulation, a court interprets the regulation against the drafter (Merriam, 263 U.S. 179, 187–88 (1923)).

It further found that, under its own precedent, it was obliged to presume the drafter of a regulation “said what it means and means what it said” in the regulation (Sklar, Greenstein & Scheer, P. C., 113 T.C. 135, 143 (1999)), and in interpreting a transitional provision with limited applicability, as in this case, it should construe the provision liberally (Younger, T.C. Memo. 1992-387).

The Tax Court stated that the IRS could have required in Regs.  Sec. 301. 9100-22 that partnerships must establish that they have enough assets to pay an imputed underpayment.  Instead, the regulation requires the partnership to make a representation that it has enough assets to pay an imputed underpayment.  As SN Worthington had met this requirement, and the IRS was not allowed to create “additional hurdles” to making the election, the LLC had made a valid election into the BBA procedures, and, consequently, the FPAA issued to it under the TEFRA procedures was invalid.

Reflections

The IRS argued in the alternative that, due to SN Worthington’s actions in its dealings with the IRS, it should be equitably estopped from arguing that the BBA procedures applied. In particular, the IRS argued that equitable estoppel applies in SN Worthington’s case because the IRS “was not in possession of all relevant facts as to whether an election under Treas.  Reg.  § 301.9100-22 would frustrate the purposes of section 1101 of the BBA, including the collection of an imputed underpayment from the partnership, and relied to [its] detriment on the misleading silence and representations made by [SN Worthington].” For equitable estoppel to apply, five elements must be satisfied:

1. There must be false representation or wrongful misleading silence by the party against whom the estoppel is claimed;
2. The error must originate in a statement of material fact, not in opinion or a statement of law;
3. The party claiming the benefits of estoppel must not know the facts;
4. The party claiming the benefits of the estoppel must have actually, and reasonably, relied on the acts or statement of the party against whom the estoppel is claimed; and
5. As a consequence of that reliance, the party claiming the benefits of the estoppel must be adversely affected by the acts or statements of the party against whom the estoppel is claimed (Steiner, T.C. Memo. 1995-122).

The Tax Court, however, rejected the IRS’s argument.  After applying the factors to SN Worthington’s situation, it found the second and third factors were not present and held that the requirements for equitable estoppel were not met.

SN Worthington Holdings, LLC, 162 T. C. No.  10 (2024)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.