Partner Level Adjustments without a Partnership TEFRA audit

In Muruelo v. Commissioner, 132 T.C. No. 18, here, the Court held that partnership affected items which are more properly determined at the partner level could be the subject of a notice of deficiency to the partner even without a TEFRA audit proceeding at the partnership level. The affected items that could be determined at the partnership level were (1) a partner's at risk with respect to the partnership, (2) the 704(d) limitation on partnership loss allocations to the partner's basis in his or her partnership interest, and (3) the accuracy related penalty. (Note that some courts hold that the good faith defense to the accuracy related penalty may be asserted at the partnership level in some cases, but that does not gainsay its application normally at the partner level).

The general progress of partnership tax contests starts with the partnership level audit and is thereafter followed with the partner level adjustments and further proceedings, if any, as to matters more properly determined at the partnership level. This case reminds practitioners that step 1 -- the partnership audit -- does not have to occur first.

The case is a cryptic as to why the IRS started with the partner level notice of deficiency. The tiered partnership whose activity was at issue had invested in a tax shelter that was a subject of a grand jury proceeding. Hence, I speculate, the IRS may not have wanted to move civilly via a partnership TEFRA proceeding. Alternatively, the IRS may have just recently learned of this particular shelter investment. It is clear that that partnership's and the partner's normal statutes of limitations absent fraud were about to expire when the IRS issued the notice of deficiency to the taxpayer-partner. The expiration of the partner's statute of limitation is irrelevant provided the IRS timely starts the partnership TEFRA proceeding, but the IRS had not done that here. Hence, it looks like the IRS was not certain that it would be able to prove fraud at the partnership level so as to extend the partnership level statute of limitations (thus automatically extending the partner level period for flow-through adjustments) and, rather than putting the bottom-line tax at the partner level at risk, it issued a notice of deficiency to the partner to use overlapping tools to deny the loss directly at the partner level.