Fred Witt PLC, Phoenix Federal Tax Attorney
   

Tax Alert — October 2014

Don’t Be Blindsided by the TEFRA IRS Tax Audit Rules

If your LLC is subject to the TEFRA partnership tax audit procedures, is your operating agreement TEFRA compliant?

Fred Witt

 

Fred Witt

 

Found in Subtitle F – Procedure and Administration, Chapter 63 – Assessment, Subchapter C – Tax Treatment of Partnership Items of the Internal Revenue Code, the TEFRA provisions provide special IRS audit and tax procedures for TEFRA partnerships. If a limited liability company files a Form 1065, U.S. Return of Partnership of Partnership Income, it will be regarded as a partnership and subject to the application of these rules. I.R.C. § 6231(a).

The TEFRA rules apply broadly. Generally, a partnership with eleven or more partners at any time during the tax year is a TEFRA partnership. On the other hand, a small partnership – with ten or fewer partners, each of whom is an individual (husband and wife partners count as one), a C corporation or an estate of a deceased partner – is excepted. I.R.C. § 6231(a)(1)(B). The narrow scope of the exception means many partnerships with smaller numbers of partners may get caught in the TEFRA net. Further, the small partnership (non-TEFRA) determination is one made for each taxable year.

To summarize, an LLC with ten or fewer members will be a TEFRA partnership (and will not qualify as a small partnership) if it has a member that is any one of the following:

  • Partnership

  • Limited Liability Company that files a Form 1065

  • Trust (whether complex or grantor)

  • S corporation

  • Nonresident alien individual

Given the breadth of the statute, it may be reasonable to assume your operating business LLC is likely a TEFRA partnership and then examine, for each tax year, whether the small partnership exception applies. Ignore these rules at your peril.

The consequences of being treated as a TEFRA partnership are numerous. For example, the position of “tax matters partner” exists only for TEFRA partnerships. According to the IRS, a non-TEFRA entity cannot have a tax matters partner.