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Mellow Partners v. Commissioner of Internal Revenue Service

United States Court of Appeals, District of Columbia Circuit

May 22, 2018

Mellow Partners, A Partnership, Appellant
Commissioner of Internal Revenue Service, Appellee

          Argued February 5, 2018

          On Appeal from the Decision of the United States Tax Court

          Amish M. Shah argued the cause for appellant. With him on the briefs was Thomas A. Cullinan.

          Richard Farber, Attorney, U.S. Department of Justice, argued the cause for appellee. With him on the brief were Thomas J. Clark and Richard Caldarone, Attorneys. Ellen Page DelSole, Attorney, entered an appearance.

          Before: Wilkins, Circuit Judge, and Edwards and Silberman, Senior Circuit Judges.


          Edwards, Senior Circuit Judge:

         Mellow Partners ("Mellow"), a general partnership formed by and between two single-member LLCs, appeals the Tax Court's decisions holding that it had jurisdiction over partnership-related determinations concerning Mellow's partnership return for the 1999 tax year and imposing penalties for the underpayment of taxes. The Internal Revenue Service ("IRS") determined that Mellow was "formed and availed of solely for purposes of tax avoidance" and "constitute[d] an economic sham." Final Partnership Administrative Adjustment Letter, Tax Year Ended: December 31, 1999, reprinted in Joint Appendix ("J.A.") 64. On the basis of this determination, IRS commenced partnership-level proceedings under the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), 26 U.S.C. §§ 6221-6234 (2012), to adjust the partnership items in Mellow's 1999 partnership return. On March 24, 2005, IRS issued to Mellow a Notice of Final Partnership Administrative Adjustment ("FPAA") setting forth adjustments to the partnership items, disallowing losses from unlawful transactions, and assessing penalties.

         Mellow filed a petition with the Tax Court challenging the FPAA. It then moved to dismiss the case for lack of jurisdiction, arguing that the FPAA was invalid because Mellow was a "small partnership" exempt from TEFRA's audit and litigation proceedings under 26 U.S.C. § 6231(a)(1)(B). The Tax Court denied the motion. The court held that, as set forth in Treasury Regulation § 301.6231(a)(1)-1(a)(2) and other authorities, a partnership does not qualify for the small-partnership exception if any of its partners is a "pass-thru partner" within the meaning of 26 U.S.C. § 6231(a)(9), and that disregarded single-member LLCs are such pass-thru partners. The Tax Court subsequently entered a decision upholding most of IRS's adjustments to Mellow's partnership return and imposing penalties.

         On appeal, Mellow asserts that the Tax Court erred in rejecting its contention that it qualified for the small-partnership exception to TEFRA. It contends that, pursuant to certain tax-classification regulations, the single-member LLCs' individual owners rather than the LLCs themselves were Mellow's partners for TEFRA purposes and, therefore, Mellow constituted a "small partnership" within the plain meaning of § 6231(a)(1)(B). Mellow also asserts that the Tax Court erred in imposing penalties because IRS failed to obtain the requisite written approval for such penalties, as required by 26 U.S.C. § 6751(b)(1) (2012).

         We affirm the Tax Court's holding that Mellow was subject to the TEFRA partnership proceedings. The record makes clear that Mellow's partners were the single-member LLCs, not their individual owners. Moreover, we defer to IRS's reasonable interpretation of its own regulation that a partnership with pass-thru partners is ineligible for the small-partnership exception and that single-member LLCs constitute pass-thru partners. We further hold that we lack jurisdiction over Mellow's challenge to the penalties because Mellow failed to raise its claim below and waived its claim by consenting to a decision applying penalties.

         I. Background

         A. Statutory and Regulatory Background

         The Internal Revenue Code ("Code") "recognizes a variety of business entities-including corporations, companies, associations, partnerships, sole proprietorships, and groups- and, based on the classifications, treats the entities in various ways for income tax purposes." McNamee v. Dep't of Treasury, 488 F.3d 100, 103 (2d Cir. 2007). Pursuant to its authority to "prescribe all needful rules and regulations for the enforcement of [Title 26, the Internal Revenue Code], " 26 U.S.C. § 7805(a) (2012), the Treasury Department has promulgated regulations governing, inter alia, business entities with only one owner, see Treas. Reg. §§ 301.7701-1 to -3. These regulations, which are often referred to as "check-the-box" regulations, permit "an eligible entity with a single owner [to] elect to be classified as an association or to be disregarded as an entity separate from its owner" for federal tax purposes. Id. § 301.7701-3(a); see also Pierre v. Comm'r, 133 T.C. 24, 24 (2009), supplemented, 99 T.C.M. (CCH) 1436 (2010). If the entity is "disregarded as an entity separate from its owner, " its activities "are treated in the same manner as a sole proprietorship, branch, or division of the owner." Treas. Reg. § 301.7701-2(a).

         In contrast, "[a] business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership." Id. Partnerships do not pay federal income taxes. 26 U.S.C. § 701 (2012). "A partnership's taxable income and losses instead pass through to the partners, who report their shares of partnership income or losses on their individual federal income tax returns." Petaluma FX Partners, LLC v. Comm'r, 792 F.3d 72, 75 (D.C. Cir. 2015) (citing § 701). Partnerships are nevertheless required to submit annual informational returns to IRS reporting income, gains, losses, and deductions. See 26 U.S.C. § 6031(a) (2012); Treas. Reg. § 301.6231(a)(3)-1(a)(1)(i).

         Congress established a framework for reviewing partnership tax matters in TEFRA. In 2015, Congress amended the TEFRA provisions. See Bipartisan Budget Act of 2015, Pub. L. No. 114-74, § 1101, 129 Stat. 584, 625-38 (2015). However, because the amendments apply to partnership returns filed for partnership taxable years beginning after December 31, 2017, id. at 638, we proceed with our analysis using the statutory provisions in force at the time of the events under consideration in this appeal.

         Under the applicable TEFRA framework, "if the IRS disagrees with a partnership's information return, it can bring a partnership-level proceeding in which it may adjust 'partnership items, ' defined as items 'more appropriately determined at the partnership level, '" by issuing a FPAA to the partnership's partners. Petaluma FX Partners, 792 F.3d at 75 (quoting §§ 6221 and 6231(a)(3)). The partners can challenge the FPAA by filing a petition for readjustment with the United States Tax Court, a federal district court, or the Court of Federal Claims. 26 U.S.C. § 6226(a) (2012). The reviewing court will have jurisdiction over the case so long as IRS has provided a valid FPAA and the taxpayer has "proper[ly] fil[ed] a petition for readjustment of partnership items for the year or years to which the FPAA pertains." Wise Guys Holdings, LLC v. Comm'r, 140 T.C. 193, 196 (2013). In particular, the court will have jurisdiction to "determine all partnership items of the partnership for the partnership taxable year to which the [FPAA] relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item." 26 U.S.C. § 6226(f) (2012).

         As a general rule, the TEFRA procedures apply to all business entities that are required to file a partnership return. Bedrosian v. Comm'r, 143 T.C. 83, 104 (2014) (citing 26 U.S.C. § 6231(a)(1)(A)). However, there is a limited exception for "small partnerships, " which are defined as having "10 or fewer partners each of whom is an individual . . ., a C corporation, or an estate of a deceased partner." 26 U.S.C. § 6231(a)(1)(B) (2012). In 1987, the Treasury Department promulgated temporary regulations setting forth rules governing the small-partnership exception. See Miscellaneous Provisions Relating to the Tax Treatment of Partnership Items, 52 Fed. Reg. 6, 779, 6, 789 (Mar. 5, 1987). As relevant here, one of the temporary regulations provided that, "[t]he [small-partnership] exception provided in section 6231(a)(1)(B) does not apply to a partnership for a taxable year if any partner in the partnership during that taxable year is a pass-thru partner." Id. In 2001, the Treasury Department issued a final regulation, which stated, inter alia, that the small-partnership exception "does not apply to a partnership for a taxable year if any partner in the partnership during that taxable year is a pass-thru partner as defined in section 6231(a)(9)." Unified Partnership Audit Procedures, 66 Fed. Reg. 50, 541, 50, 556 (Oct. 4, 2001) (codified at Treas. Reg. § 301.6231(a)(1)-1(a)(2)); see id. at 50, 544 (stating that the final regulations apply to partnership proceedings concerning partnership taxable years beginning on or after October 4, 2001). The Code, in turn, defines "partner" as "a partner in the partnership" and "any other person whose income tax liability . . . is determined in whole or in part by taking" partnership items "directly or indirectly" into account, 26 U.S.C. § 6231(a)(2) (2012), and "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, " id. § 6231(a)(9) (2012).

         Although the 2001 Treasury Department regulations at issue here apply prospectively, the parties do not dispute that the temporary regulations were in effect when Mellow filed its 1999 partnership return and that the temporary regulations applied to Mellow's return. The parties also agree that the material terms in the temporary and final regulations are the same. The only difference is that the 2001 regulation added the language, "as defined in section 6231(a)(9)." However, the parties agree that under both the temporary and final regulations, a pass-thru partner is as defined in § 6231(a)(9). Therefore, like the parties, we base our analysis on the language set forth in the final regulation, Treasury Regulation § 301.6231(a)(1)-1(a)(2).

         B. Factual and Procedural Background

         Mellow Partners was formed on November 12, 1999 and dissolved in December 1999. Mellow's partnership agreement states that the purpose of the partnership was to invest partnership assets in "securities, businesses, real estate interests and other investment opportunities, " including "stocks, bonds, options, foreign currencies, foreign exchange and over the counter derivatives, and other financial instruments." J.A. 68. The partnership agreement also states that the partnership was formed "by and between" MB 68th Street Investments LLC ("68th Street") and WNM Hunters Crest Investments LLC ("Hunters Crest") (collectively, "the single-member LLCs" or "the LLCs"). Id. Mr. Myer Berlow, the sole member of 68th Street, and Mr. William Melton, the sole member of Hunters Crest, signed the partnership agreement on behalf of their respective LLCs. The single-member LLCs did not elect to be treated as associations under the check-the-box ...

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