TAX COURT HOLDS THAT NEW MILLENNIUM TRADING IS A SHAM

04 / 17 / 2017

The Tax Court has made clear in New Millennium Trading, LLC v. IRS, T.C. Memo 2017-9, that if a LLC formed as a hedge fund manager under state law (and entity and its members think will be taxed for Federal income tax purposes as a partnership by filing IRS Form 1065 and issuing K-1s) was created solely for tax avoidance purposes, the Tax Court will not recognize it as an entity for Federal tax purposes.  When the Tax Court find that any LLC or other such entity is not a "tax-recognized" entity under the Federal tax laws, the Court will find it is ineligible to be classified as a "partnership" under the so-called check-the-box regulations under Regs Section 301.7701-3(a).

At that point, the Tax Court will further declare that there can be no partnership losses generated by this entity, no partnership deductions, no contributions of capital or services to the entity, and thus, no distributions from that entity to its purported partners.  These are all "partnership items" properly decided in a partnership-level proceeding.

The consequences of a sham partnership are thus that the IRS will be able to make adjustments to all "partnership items" and bring them all to zero.  This is because the rules of Subchapter K no longer apply and the partnership's activities will be deemed to have been engaged in by one or more of its purported partners.  In other words, the Tax Court will treat a "disregarded partnership" as having no identity separate from its owners and will furthermore treat it as nothing more than an agent or nominee.  Yet, the TEFRA procedures are still applied, because a partnership tax return (Form 1065) was filed, giving the Tax Court jurisdiction over the matter because the Court has the right to determine any items that would have been "partnership items" had the asserted partnership been valid.   

Also, the Court held since the LLC was not a "tax-recognized entity," none of its members have any interest in it in which they could have any tax basis.

The Tax Court further determined that a 40% gross valuation misstatement penalty is applicable under IRC Section 6662, and that looking only at the "reasonable cause" arguments of the managing partner (not a limited partner)(i.e., those with authority to act on behalf of the entity), whose conduct is the only conduct relevant for determining the penalty, the petitioner had failed to show that he reasonably relied on the advice of a highly sophisticated CPA given that the CPA was promoting and facilitating the tax losses arising out of the spread transaction put forth. 



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