IRS Guidance on Reasonable Cause Exception to Penalties for Failure to File Partnership Return Upheld

September 29, 2015

Battle Flat, LLC v. United States, No. 5:13-5070-JLV, 2015 U.S. Dist. LEXIS 125678 (D. S.D. Sept. 21, 2015).


Overview

In 1984, the IRS created a reasonable cause exception that a “small partnership” can utilize to avoid the penalties imposed for failure to timely file a partnership return.[1]  The exception has gained importance in recent years due to the increase in the penalties that are triggered by the failure to timely file a partnership return.  Many farm and ranch partnerships might qualify for the reasonable cause exception.  But, as a recent federal court case from South Dakota points out, the exception only applies if each partner of the small partnership fully reports their respective share of income, deductions and credits of the partnership on their timely filed income tax returns.  Timeliness is the key.  In addition, there is no blanket filing exemption for small partnerships. 

Penalty For Failing to File a Partnership Return

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.[2]  If a partnership return is not timely filed (including extensions) or is timely filed but is inadequate,[3] a monthly penalty is triggered that equals $195 times the number of partners during any part of the tax year for each month (or fraction thereof) for which the failure continues.[4]  However, the penalty amount is capped at 12 months.  Thus, for example, the penalty for a 10-partner partnership would be $1,950 (10 x $195) capped at $23,400.  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.[5]  

The Reasonable Cause Exception

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.[6]  The taxpayer bears the burden to show reasonable cause based on the facts and circumstances of each situation.[7]  On the reasonable cause issue, the IRS, in Rev. Proc. 84-35[8] established an exception from the filing requirement 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, a “small partnership” must satisfy six requirements.[9]

  • The partnership must be a domestic partnership;
  • The partnership must have 10 or fewer partners;[10]
  • All of the partners must be natural persons (other than a nonresident alien) or an estate of a deceased partner;[11]
  • 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 have 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.      

South Dakota Case

In Battle Flat, LLC v. United States,[12] the plaintiff was an LLC taxed as a partnership.  The IRS asserted the late filing penalties against the partnership.  The plaintiff was comprised on six partners and filed its Form 1065 for 2007 and 2008 six months late.  That triggered penalties of over $7,000 for each year.  Unfortunately for the partnership, none of the partners timely filed a Form 1040 for 2007 and three of them didn’t timely file their Form 1040s for 2008.  Consequently, when the plaintiff tried to use the reasonable cause exception to the penalties set forth in Rev. Proc. 84-35, the IRS denied relief because all of the partners had not timely filed their individual returns.  The plaintiff sued, challenging the requirement contained in Rev. Proc. 84-35 that the reasonable cause exception to the penalties could be imposed only if all of the partners report their shares of the income deductions and credits of the partnership on their respective timely filed returns.

The resolution of the issue turned on the amount of deference to be given Rev. Proc. 84-35.  The court first noted that the plaintiff was a partnership as defined in I.R.C. §6031 (thus, there is no blanket exemption for a small partnership from the requirement to file a return) and that the penalty provisions for failure to timely file a partnership return don’t apply if the failure was due to reasonable cause.[13]  While “reasonable cause” is not statutorily defined, the taxpayer bears the burden to show that the failure to timely file was on account of reasonable cause.  It was Rev. Proc. 84-35 that fleshed out the requirements to show reasonable cause.  One of those requirements, as noted above, is that each partner timely file their individual return reporting their respective shares of partnership income and deductions.  The plaintiff claimed that Rev. Proc. 84-35 was not entitled to deference, and the court agreed that it was not entitled to substantial deference, but that the level of deference to be given a Rev. Proc. varied with the circumstances.  Based on a Supreme Court decision setting forth factors for considering the level of deference to be given IRS procedural rules, the court said the factors weighed in favor of enforcing Rev. Prov. 84-35.  The court noted that the Rev. Proc. was issued over 30 years ago and that the timeliness requirement has always been present with respect to all partners filing their individual returns.   The court also noted that the IRS position was reasonable, highly practical and consistent with the legislative history of I.R.C. §6698.  The court stated that, “it strains credulity to characterize a personal income tax return filed years after the reporting deadline as an adequate, full reporting of each partner’s share of the partnership’s income and deductions.”  On the other hand, the court stated that the plaintiff’s position that the reasonable cause exception could be satisfied simply by the partners filing their personal income tax returns at some point in the future was unreasonable.  The court also noted that the Rev. Proc. was created to aid taxpayers, not benefit the IRS. 

Conclusion

The reasonable cause exception to the failure to file penalties for small partnerships is important.  It’s also important to pay attention to what’s required to be able to use the reasonable cause exception.  In addition, small partnerships are not excused from filing a partnership return.  There is no blanket filing exemption.  A small partnership is a partnership.  In any event, it’s just simpler to file the partnership return on a timely basis.           

 

[1] Rev. Proc. 84-35, 1984-1 C.B. 509.

[2] I.R.C. §§761(a), 6031(a).

[3] Meaning that the return does not contain the information required by I.R.C. §6031.

[4] I.R.C. §6698(b).

[5] The TEFRA procedures are contained in I.R.C. §§6221-6234 and apply to partnership tax years beginning after September 3, 1982.

[6] I.R.C. §6689(a).

[7] See, e.g., IRS Significant Service Advice 200135029 (Aug. 31, 2001).

[8] 1984-1 C.B. 509.

[9] A partnership that satisfies the following requirements is deemed to be a “small partnership” and is not subject to the TEFRA audit procedures unless an election is made to have the TEFRA requirements apply.

[10] A husband and wife and their estate are treated as a single partner.

[11] At the time Rev. Proc. 84-35 was issued, I.R.C. §6231(a)(1)(B) defined a “small partnership” for these purposes.  The statutory definition has been amended effective for tax years ending after August 5, 1997, to state that a small partnership must be made up entirely of “individuals.”  Rev. Proc. 84-35 should be read in accordance with that statutory amendment.

[12] No. 5:13-5070-JLV, 2015 U.S. Dist. LEXIS 125678 (D. S.D. Sept. 21, 2015).

[13] I.R.C. §6698(a).

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