Small partnerships still must file Form 1065

Plain-English summary

Chief Counsel advised that Revenue Procedure 84-35 does not automatically exempt small partnerships from filing Form 1065. Sections 6031 and 6698 contain no exception to the filing requirement, although a partnership may avoid the failure-to-file penalty by establishing reasonable cause. The revenue procedure supplies reasonable-cause criteria for qualifying domestic partnerships with ten or fewer eligible partners, proportionate allocations, and partners who timely reported their shares of partnership items. Partnerships with corporate or trust partners, tiered structures, disproportionate interests, or late-filing partners generally do not receive that relief. Examiners should follow the Internal Revenue Manual procedures and validate partner filing statements when practical.

Ruling snapshot

• Question: Does Revenue Procedure 84-35 automatically excuse qualifying small partnerships from filing Form 1065?
• Outcome: advice given
• Key authorities: IRC §§ 6031, 6698; Rev. Proc. 84-35; IRM 20.1.2.3.3.1

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201733013
           Release Date: 8/18/2017
           CC:PA:01
           POSTU-119552-17

 UILC:     6031.04-02, 6698.00-00

  date:    July 12, 2017

     to:   Julie A. Schwoebel
           Senior Attorney
           TEGEDC:GL:CHI
           (TEGE Division Counsel)

  from:    Blaise Dusenberry
           Senior Technician Reviewer
           Branch 1
           CC:PA:1
           (Procedure & Administration)


subject:   Rev. Proc. 81-11 and Rev. Proc. 84-35

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

                                                     ISSUE

           Whether Rev. Proc. 84-35, 1984-1 C.B. 509, superseding Rev. Proc. 81-11, 1981-1
           C.B. 651, provides an automatic exemption to partnerships from the requirement of
           filing a Form 1065, U.S. Return of Partnership Income.

                                          SUMMARY CONCLUSION

           No. Neither I.R.C. § 6031 nor I.R.C. § 6698 contain an automatic exception to the
           general filing requirement set forth in I.R.C. § 6031(a). Although the I.R.C. § 6698
           penalty may be avoided if it is shown that the failure to file a complete or timely return
           was due to reasonable cause, such relief may be granted under Rev. Proc. 84-35 if the
           partnership meets its requirements and examiners follow the procedures set forth in
           IRM 20.1.2.3.3.1.
POSTU-119552-17                                      2

                                            BACKGROUND

You have asked if Rev. Proc. 84-35 provides an automatic exemption to partnerships
from the requirement of filing a Form 1065. Those revenue procedures provide that a
domestic partnership with 10 or fewer partners that falls within the exceptions in I.R.C.
§ 6231(a)(1)(B) is deemed to have met the reasonable cause test, and, therefore, would
not be liable for the I.R.C. § 6698 penalty. You contend that although the partnership is
not relieved of the filing requirement, there is almost automatic reasonable cause relief
for the failure to file a partnership return.

                                        LAW AND ANALYSIS

Partnership Return Filing Requirement
Section 6031 of the Code requires every partnership (as defined in section 761(a)) to
file a return for each taxable year.1 The return must include all items of gross income
and deductions allowable under subtitle A. In addition, the return must provide the
names of all the partners and their distributive share of partnership income.

The Section 6698 Failure to File Penalty
Partnerships that fail to timely file a complete partnership return as required by section
6031(a) are subject to a penalty under section 6698, unless the failure to comply with
the section 6031(a) is due to reasonable cause.2 The section 6698 penalty is imposed
for each month, or fraction thereof, during which the failure to comply with section
6031(a) continues, but not to exceed five months.3 The penalty is computed at a rate of
$195 multiplied by the total number of partners in the partnership during any part of the
tax year for which the return was due.4 The amount of the penalty is adjusted for
inflation for partnership returns required to be filed after the 2014 calendar year.5 The
penalty is assessed directly against the partnership.6 It may be imposed in addition to
the criminal penalties under section 7203.7 Deficiency procedures do not apply.8


1
    I.R.C. § 6031(a).
2
    See generally I.R.C. § 6698.
3
    I.R.C. § 6698(a).
4
    I.R.C. § 6698(b).
5
    I.R.C. § 6698(e).
6
  I.R.C. § 6698(c). Although the penalty is assessed against the partnership, partners are individually
liable for the penalty to the extent of their liability for the partnership debts generally.
7
    I.R.C. § 6698(a).
8
    I.R.C. § 6698(d).
POSTU-119552-17                                    3

Generally, when a partnership fails to file a partnership return as required by section
6031(a), the partnership is subject to the section 6698 penalty.9 The penalty can be
assessed either automatically or manually when the partnership fails to timely file a
complete Form 1065 or when a substitute for return is prepared by the Internal Revenue
Service (Service) and reasonable cause is not established.10 The penalty may be
assessed before the partnership has an opportunity to assert reasonable cause or after
the Service has considered and rejected the taxpayer's claim. In either case, the
Service will generally reconsider the penalty either upon the taxpayer's request or when
the delinquent return is filed or selected for examination.11

Reasonable Cause Relief
Neither section 6031 nor section 6698 contains an exception to the general filing
requirement set forth in section 6031(a). As noted above, however, the section 6698
penalty may be avoided if it is shown that the failure to file a complete or timely return
was due to reasonable cause.12 In relevant part, the legislative history of section 6698
provides as follows:

          The penalty will not be imposed if the partnership can show that failure
          to file a complete or timely return is due to reasonable cause. The
          Committee understands that small partnerships (those with 10 or fewer
          partners) often do not file partnership returns, but rather each partner
          files a detailed statement of his share of partnership income and
          deductions with his own return. Although these partnerships may
          technically be required to file partnership returns, the Committee
          believes that full reporting of the partnership income and deductions by
          each partner is adequate and that it is reasonable not to file a
          partnership return in this instance.13

Revenue Procedure 84-35
With the Congressional intent in mind, the Service published guidance in the form of a
revenue procedure containing criteria under which partnerships with 10 or fewer
partners will not be subject to the penalty under section 6698. See Rev. Proc. 84-35,


9
    IRM 20.1.2.3.1(1) (7-18-2016).
10
     IRM 20.1.2.3.1(4) and (5) (7-18-2016).
11
   See generally Penalty Relief, IRM 20.1.2.3.3 (02-02-2013). See also IRM 20.1.1.3, Criteria for Relief
From Penalties, for a discussion of penalty relief, and IRM Exhibit 20.1.1-2, Penalty Reason Code Chart,
for the appropriate PRC. See IRM 20.1.2.3.4, Procedures for Assessment and Abatement, for additional
instructions.
12
     I.R.C. § 6698(a).
13
     See H. REP. NO. 95-1445, at 249 (1978).
POSTU-119552-17                                    4

1984-1 C.B. 509, superseding Rev. Proc. 81-11, 1981-1 C.B. 651. In relevant part, the
revenue procedure provides:

           A domestic partnership composed of 10 or fewer partners and coming
           within the exception outlined in section 6321(a)(1)(B) of the Code will
           be considered to have met the reasonable cause test and will not be
           subject to the penalty imposed by section 6698 for the failure to file a
           complete or timely partnership return, provided that the partnership, or
           any of the partners, establishes, if so required by the Internal Revenue
           Service, that all partners have fully reported their shares of the income,
           deductions, and credits of the partnership on their timely filed income
           tax returns.

Rev. Proc. 84-35 § 3.01.

Rev. Proc. 84-35 Does Not Provide Automatic Relief In Every Case
Although Rev. Proc. 84-35 does provide some relief for failure to file a partnership
return, we disagree that the guidance provides for almost automatic reasonable cause
relief for the failure to file a partnership return. Generally, the Service does not know
whether the partnership meets the reasonable cause criteria or qualifies for relief under
Rev. Proc. 84-35 unless and until the partnership files a partnership return or some
other document with the Service. The individual partners' income tax returns, even if
timely filed and complete, are not linked together during their initial processing. Thus,
the Service generally does not know how many partners are in the partnership or
whether all of the partners timely filed their income tax returns unless and until the
partnership (or one of its partners) is selected for an audit.

Moreover, partnerships having a trust or corporation as a partner, tier partnerships, and
partnerships where each partner's interest in the capital and profits are not owned in the
same proportion, or where all items or income, deductions, and credits are not allocated
in proportion to the pro rata interest, do not come within the exception of section
6231(a)(1)(B) and, as such, are not covered by Rev. Proc. 84-35.14 In addition, the
revenue procedure provides that “[a]lthough a partnership of 10 or fewer partners may
not be automatically excepted from the penalty imposed by section 6698 … under
section 3.01 [of the revenue procedure], the partnership may show other reasonable
cause for failure to file a complete or timely partnership return.”15 In that case, the


14
   Id., § 3.02. At the time Revenue Procedure 84-35 was promulgated, section 6321(a)(1)(B) provided
that the term “partnership,” as used in Subchapter C of Chapter 63, shall not include any domestic
partnership having 10 or fewer partners each of whom is a natural person (other than a nonresident alien)
or an estate, and each partner's share of each partnership item is the same as his share of every other
item.
15
     Id., § 3.03.
POSTU-119552-17                                    5

determination of reasonable cause must generally be made on a case-by-case basis,
taking all of the relevant fact and circumstances into consideration.16

Criteria For Relief under Rev. Proc. 84-35
While Revenue Procedure 84-35 does not exempt every small partnership from the
application of section 6698, it set forth criteria under which the Service will agree that a
small partnership meets the reasonable cause test of section 6698.17 Under these
criteria, although the Service may presume that all partners have fully reported their
shares of the income, deductions, and credits of the partnership on their timely filed
income tax returns, the Service may alternatively require the partners or the partnership
to establish that the partners have in fact fully complied with their filing requirement.18

Accordingly, the Service has set forth procedures for applying Rev. Proc. 84-35. See
IRM 20.1.2.3.3.1 (07-18-2016). That section of the IRM provides that the I.R.C. § 6698
penalty may be avoided if it is shown that the failure to file a complete or timely return
was due to reasonable cause, by meeting the following requirements:

       1. The partnership must consist of 10 or fewer partners. For the purpose of
          this requirement, a husband and wife (or their estate) filing a joint return is
          considered one partner.

       2. Each partner is either an individual (excluding nonresident aliens), or the estate
          of a deceased partner.

       3. Each partner’s items of income, deductions, and credits are allocated in the
          same proportion as all other items of income, deductions, and credits.

       4. The partnership has not elected to be subject to the consolidated audit
          procedures under I.R.C. §§ 6221 through I.R.C. § 6233.

       5. Each partner reported his or her share of partnership income on his or her timely
          filed income tax return. (emphasis added).19


16
     See Reasonable Cause, IRM 20.1.1.3.2(1) (11-25-2011)
17
     Rev. Proc. 84-35 § 3.01.
18
     Id.
19
  IRM 20.1.2.3.3.1(2). See Battle Flatt, LLC v. United States, 116 AFTR2d 2015-6193, 2015 WL
5554907 (D. S.D. 2015) (Rev. Proc. 84-35 enforced as the Service's interpretation that partners in a
“small” partnership timely file their personal income tax returns is reasonable and is consistent with
the legislative history in 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).
POSTU-119552-17                                           6

In addition, IRM 20.1.2.3.3.1(3) instructs examiners that when a partner requests
abatement of the failure to file penalty because the partnership has ten partners or
fewer, abate the penalty if the partner (or representative) confirms verbally or in writing
that—

      1. All partners are qualifying partners,

      2. All partners filed timely returns and included their share of partnership
         income on that return, and

      3. The partnership is not subject to the consolidated (unified) audit procedures
         under I.R.C. §§ 6221 through I.R.C. 6234.20

Moreover, the IRM instructs examiners that to the greatest extent practical, they should
validate the taxpayer’s statements by using CFOL to research each partner’s account
for timely filing, and should not abate the penalty if the examiner finds that any partner
filed late, or if any partner failed any other requirement.21

Meeting the 84-35 Requirements Encourage Voluntary Compliance
Finally, penalties exist to encourage voluntary compliance and support the standards of
behavior expected under the Internal Revenue Code by demonstrating the fairness of
the tax system to compliant taxpayers and increase the cost of noncompliance.22 In
considering the application of penalties to a particular case, the Service should be
consistent in the application of penalties in similar cases, apply unbiased analysis of the
facts in each case, and properly apply the law to the facts of the case.23 In addition, the
taxpayers against whom the penalty is imposed must be given an opportunity to have
their interests heard and considered.24 Requiring taxpayers to meet the requirements of
Rev. Proc. 84-35 and IRM 20.1.2.3.3.1 encourages voluntary compliance by reminding
taxpayers of the requirement to timely file partnership returns and their own individual
returns and that their individual income tax returns include their share of partnership
income.25

                                               CONCLUSION



20
     IRM 20.1.2.3.3.1(3).
21
     IRM 20.1.2.3.3.1(4).
22
     See generally Penalty Policy Statement 20-1 (06-29-2004), IRM 1.2.20.1.1(3).
23
     IRM 1.2.20.1.1(8).
24
     IRM 1.2.20.1.1(9).
25
     See Battle Flatt, LLC v. United States at note 19.
POSTU-119552-17                              7

Accordingly, we conclude that Rev. Proc. 84-35 does not provide an automatic
exemption to partnerships from the requirement of filing a Form 1065. Neither I.R.C.
§ 6031 nor I.R.C. § 6698 contain an exception to the general filing requirement set forth
in I.R.C. § 6031(a). Although the I.R.C. § 6698 penalty may be avoided if it is shown
that the failure to file a complete or timely return was due to reasonable cause, such
relief may be granted under Rev. Proc. 84-35 if the partnership meets its requirements
and examiners follow the procedures set forth in IRM 20.1.2.3.3.1.

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