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.

TEFRA Partnership Rules -- IRS Protective Position at Partner Level

In Bausch & Lomb Inc. v. Commissioner, T.C. Memo 2009-112, decided yesterday, at the IRS's request, the Tax Court held that the notice of deficiency issued by the Tax Court was invalid which meant that the Tax Court had no jurisdiction since a notice of deficiency is a jurisdictional prerequest in cases where the taxpayer petitions for redetermination. What's the deal? Why would the IRS urge the invalidity of its own notice of deficiency?

The reason is that the TEFRA partnership provisions, enacted in 1982, leave many issues undecided and the courts have been working through them ever since. In the meantime, as to at least some of these undecided issues, parties must take protective positions -- going through some formal steps even when they believe the steps should not apply given the purpose of the TEFRA patnership provisions. Although the Court's background discussion is somewhat cryptic as to the precise reasons for the protective position, that appears to be what happened in Bausch & Lomb and is certianly what happened in other cases where the unnecessary steps are less visible.

Extrapolating from the decision,. the following is probably the type of fact background for the IRS issuing a notice of deficiency. As readers will recall, the TEFRA provisions mandate unified audit and litigation for partnership items and affected items and then creates a special statute of limitations independent of the partners' statutes of limitations so that the unified result can be imposed on the parters. In lay terms, this requires the IRS to conduct a single partnership level audit and litigation of partnership items affecting a partnership and then, in a relatively summary assessment action, impose the results on the partners without concern for the individual partners' statutes of limitations.

The system is commendable in its purpose and most of the times serves that purpose of having a single proceeding rather than multiple and potentially inconsistent partner level proceedings as to the same items or items arising from the partnership. One of the rubs was likely presented in Bausch & Lomb. What should the IRS do when the IRS's position is that the partnership is a sham? One way of viewing a sham is that the partnership is to be disregarded altogether so that the TEFRA partnership proceedings simply never apply. This would mean that, if the IRS wants to actually collect related tax from the partners for items on their returns related to the sham partnership, the IRS must move against the partners via the notice of deficiency procedure rather than through the TEFRA rules. On the other hand, if the partnership even though a sham, is subject to the TEFRA partnership rules (administratively a good position given the purpose of the TEFRA partnership rules, even if not necessarily commanded by the explicit text of the statutory provisions) the IRS must proceed under the TEFRA provisions to issue a FPAA and then, failing litigation that would change the result, impose the results on the partners via a direct assessment. Notwithstanding logic that suggests that the latter -- proceeding under TEFRA -- is the right result, the statute does not literally foreclose a taxpayer argument that proceeding under TEFRA is the wrong result. The IRS in such cases might protectively proceed under both potential avenues -- i.e., (1) issue a notice of deficiency directly to the taxpayer even while the partnership level audit is going on and (ii) proceed under TEFRA to issue the FPAA and, upon final resolution fo the FPAA, impose the results on the partners as allowed the the TEFRA provisions.

That type of protective position appears to be what happened in Baush & Lomb. The IRS thinks the second avenue -- use of the TEFRA provisions -- is correct and thus that its protective notice of deficiency is not correct. The taxpayer for some reason wanted to litigate via the notice of deficiency rather than via the TEFRA procedures. The Tax Court accepted the IRS's position. That is the right result although we cannot provide a statutory analysis that necessarily commands that result. Let's just say that it is the only one that makes sense. Maybe Justice Scalia would decry it because the statute does not expressly command it, but he would be the only one that would have such qualms.

Hat tip to the Tax Professor List Serv.

TEFRA Tax Matters Partner Consents to Extend the Statute of Limitations

In United States v. Martinez, ___ F.3d ___ (5th Cir. 2009), decided 4/3/09, the Fifth Circuit held that actions taken by the tax matters partner in a TEFRA partnership were not ineffective to toll the statute of limitations because of an alleged disabling conflict between the tax matters partner and the other partners. The specific actions involved executing consents to extend the statute of limitations and filing a Tax Court proceeding. Under the TEFRA scheme, both of these actions result in the extension of the statute of limitations at the partnership level and thus extension of the statute of limitations for the TEFRA partnership adjustments at the individual partner level.

The Fifth Circuit distinguished an earlier Second Circuit case which had found a disqualifying conflict between the tax matters partner and the partners that made it unreasonable and inappropriate for the IRS to rely upon consents given by the tax matters partner. The Fifth Circuit concluded that (i), unlike the facts in Transpac Drilling, the IRS had not sought consents from the partners and been denied the consents, (ii) the IRS did not have a pending criminal investigation against the tax matters partner, (iii) the tax matters partner’s request for a quid pro quo via relief from the preparer penalties was not disabling because the IRS had already determined not to seek the penalty, and (iv), although the IRS believed the tax matters partner was dishonest, that alone did not create a per se conflict between his interests and the limited partners’ interests sufficient to put the IRS' reliance unreasonable under the circumstances.