Court rejects ‘in-substance’ small-partnership argument

The Tax Court dismissed a married couple’s claim for an increased flowthrough loss deduction from a partnership on their joint income tax return. The court said it lacked jurisdiction to consider the item because the partnership was not a small partnership under the TEFRA rules and thus all partnership matters for the year in question were closed.

Facts: On their 2007 joint federal income tax return, Charles Brumbaugh and C.E. Holifield claimed a business interest deduction of $317,098 on Form 1040, U.S. Individual Income Tax Return, Schedule C, Profit or Loss From Business (Sole Proprietorship). After the IRS disallowed $163,915 of the deduction because it was not adequately substantiated, the taxpayers claimed that $172,653 of the interest should have been reported on the 2007 partnership return of Panorama LLC, which was owned 59.99% by Brumbaugh, 39.99% by another individual, and 0.02% by Lynx Realty and Management LLC, a federal tax partnership. The taxpayers petitioned the Tax Court to reduce the deficiency assessed by the IRS because Panorama’s failure to deduct the interest understated their flowthrough loss by $103,575 (59.99% of $172,653).

Issues: TEFRA created unified partnership audit and litigation procedures in Secs. 6221 through 6234. Under those provisions, if the IRS does not begin partnership audit proceedings within the prescribed time for a given tax year and does not issue a notice of final partnership administrative adjustment, and if the taxpayers do not request an administrative adjustment to any partnership items, the tax treatment of all partnership items for that year is final. Exempt from the TEFRA rules are electing small partnerships under Sec. 6231(a)(1)(B)(i) (i.e., those with 10 or fewer partners). All partners must be an individual (other than a nonresident alien, and a husband and wife are considered one partner), a C corporation, or an estate of a deceased partner. If any partner is a passthrough partner, the partnership is not a small partnership. A passthrough partner is a partnership, S corporation, trust, estate, nominee, or similar person through which other persons hold an interest in the partnership. The IRS and courts have ruled that the definition encompasses LLCs that are disregarded for federal tax purposes.

The IRS argued that the taxpayers’ claim must be dismissed because Panorama was not a small partnership, while the taxpayers argued it was a small partnership exempt from TEFRA.

Holding: The court dismissed the taxpayers’ claim for a larger passthrough loss from the partnership, holding that Panorama was not a small partnership under the TEFRA rules because Lynx Realty and Management LLC was a passthrough partner. The taxpayers argued that Panorama satisfied the small partnership exception “in substance” because Lynx owned only 0.02% of the partnership. According to the court, the small extent of Lynx’s interest was irrelevant because there is no de minimis exception in the Code or regulations to provide relief, and the court cannot create one.

• Brumbaugh, T.C. Memo. 2015-65

—By Charles J. Reichert, CPA, ­instructor of accounting, University of Minnesota—Duluth.