Taxpayer Barred from Raising TEFRA Adjustments in Collection Due Process Hearing

The case of Davison v. Commissioner, T.C. Memo 2019-26 raises the issue of contesting the merits of adjustments contained in a Final Partnership Administrative Adjustment (FPAA). The Tax Court determines that Mr. Davidson cannot raise the merits of those issues which resulted in computational adjustments to his return. He argued that he never had a chance to raise those issues. Essentially, the court says too bad. He also sought to raise the issue of the penalty imposed on him due to the amount of the adjustments. The court signals that he might have been able to raise that issue had he done so when he made his Collection Due Process (CDP) request but having failed to raise the separate penalty issue when he submitted his request he could not do so during the Tax Court proceeding.

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Mr. Davison was a partner in a partnership that had an interest in two other partnerships. The IRS audited the partnerships he did not directly own and made adjustments. Those adjustments flowed through to his individual return through the partnership interest he did own. Although the IRS sent the FPAA regarding the adjustments to the tax matters partners of the two partnerships, no one petitioned the Tax Court.

Years later as the IRS began to collect from him Mr. Davison requested a CDP hearing and sought in the hearing to raise the issue of his underlying liability. The Settlement Officer in Appeals told him that he could not do so and he ultimately petitioned the Tax Court. In Tax Court he tried to raise the issue of the liability arguing that he had not previously had the opportunity to litigate the merits of the tax assessed against him. As with most things involving TEFRA, things get tricky.

This is not the first case involving this issue which does not surprise me given that two decades have passed since Collection Due Process came into existence; however, I had not noticed this issue before. I thought that perhaps others may not have noticed the issue since it does not arise with great frequency in litigation. The prior decisional law drives the outcome in this case.

The Court states:

In Hudspath v. Commissioner, T.C. Memo. 2005-83, aff’d, 177 F. App’x 326 (4th Cir. 2006), we addressed whether a taxpayer may contest his underlying income tax liability in a CDP case to the extent that this liability was based on computational adjustments resulting from a TEFRA proceeding. The case involved only income tax assessments for the taxpayer’s 1996 and 1997 taxable years that were attributable to computational adjustments resulting from two FPAAs. Those FPAAs had been the subject of a TEFRA proceeding that this Court ultimately dismissed for lack of jurisdiction. We held that pursuant to section 6330(c)(2)(B), the taxpayer was precluded from challenging the existence or amount of his 1996 and 1997 underlying income tax liabilities because he had had the opportunity, in the TEFRA proceeding, to challenge the partnership items that were reflected on the two FPAAs.

The instant case is indistinguishable from Hudspath. Pursuant to section 226(a) and (b), within 90 days of the mailing of an FPAA a tax matters partner may file a petition with this Court or other referenced Federal court for readjustment of the partnership items; and if the tax matters partner fails to file such a petition, any notice partner may file a petition for readjustment within 60 days after the 90-day period has closed. Here, the parties stipulated that on October 4 and 20, 2010, the IRS issued the Cedar Valley FPAA and the TARD Properties FPAA, but no petition was ever filed pursuant to this statutory prescription challenging either FPAA. These defaulted FPAAs then became binding and conclusive upon petitioner, allowing the IRS to make the computational adjustments to income that petitioner desires to place in dispute. See sec. 6230(c)(4); Genesis Oil & Gas, Ltd. v. Commissioner, 93 T.C. 562, 565-566 (1989). It is undisputed that petitioner’s income tax liability for 2005 was attributable solely to the computational adjustments resulting from the defaulted Cedar Valley FPAA and the defaulted TARD Properties FPAA. Accordingly, petitioner’s “earlier opportunity to dispute his liability” for income tax for 2005 was the opportunity to commence a TEFRA proceeding challenging the FPAAs upon their issuance.

Mr. Davison’s problem with this analysis stems from his lack of knowledge of the earlier opportunity to go to Tax Court. He complains that he never received notice of the FPAA and had no voice in whether the partnerships would file a Tax Court petition. He contends that he only learned about the FPAAs after the time to petition the Tax Court had passed. The IRS did not put on any evidence to contest his statement on this point – not that it was obligated to do so. There was also no indication that the IRS knew he was an indirect partner of the entities to which it issued the FPAAs. The court explained why this did not matter with respect to the issue of whether Mr. Davison could raise the underlying merits in the CDP case:

Under section 6223(h)(2), the tax matters partner of Six-D [this is the partnership in which Mr. Davison owned an interest] was required to forward copies of the Cedar Valley FPAA and the TARD Properties FPAA to petitioner. Furthermore, in any event, “[t]he failure of a tax matters partner, a pass-thru partner, the representative of a notice group, or any other representative of a partner to provide any notice or perform any act * * * [such as an appeal to an FPAA] does not affect the applicability of any proceeding or adjustment * * * to such partner.” Sec. 6230(f); Kimball v. Commissioner, T.C. Memo. 2008-78, slip op. at 9. Because petitioner indirectly held interests in Cedar Valley and TARD Properties and section 6223(c)(3) is of no avail here, the IRS was not required to provide him individual notice of the FPAAs.

Therefore, we find that petitioner had a prior opportunity to challenge his liability for income tax attributable to the computational adjustments resulting from the defaulted TARD Properties FPAA (as well as the defaulted Cedar Valley FPAA) and is precluded from challenging this liability in this case.

So, Mr. Davison does not have the opportunity to raise the merits of the partnership adjustments in his CDP case. While harsh, this result is the same result outside of CDP and is a feature of the way TEFRA operates with respect to certain affected items. The case does not discuss what possibilities of success Mr. Davison might have had if the court had allowed him to contest the underlying liabilities. It seems that the tax matters partners would have raised the issue if a meritorious case existed. He was removed from those partnerships and would likely have had a difficult time marshalling the evidence to contest the liabilities even if he had been given the opportunity.

In addition to contesting the underlying liability, Mr. Davison sought to contest the accuracy related penalty imposed upon him for one of the years because of the amount of the liability. The court noted that the partnership should also contest the penalty; however, the TEFRA rules that prevent him from contesting the partnership adjustments would not keep him from contesting the application of the penalty in a refund action after he paid the penalty. Unfortunately, he runs into another barrier.

Mr. Davison raised the penalty issue for the first time in his Tax Court petition having failed to mention it in his CDP request. The court stated:

We find that he did not properly raise this issue below and therefore is precluded from challenging his liability for the penalty in this proceeding.

This result flows directly from the CDP regs and serves as a reminder of the need to anticipate all arguments in submitting the Form 12153 at the beginning of the CDP case. The IRS should receive the opportunity to consider all issues the taxpayer seeks to raise as it considers the case during the administrative phase. The court does not want to see an issue for the first time that the taxpayer has failed to previously mention.

AJAC and the APA, Designated Orders 4/8/2019 – 4/12/19

Did the Appeals’ Judicial Approach and Culture (AJAC) Project turn conversations with Appeals into adjudications governed by the Administrative Procedure Act (APA) and subject to judicial review by the Tax Court? A petitioner in a designated order during the week of April 8, 2019 (Docket No. 18021-13, EZ Lube v. CIR (order here)) thinks so and Tax Court finds itself addressing its relationship with the APA yet again.

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I spent time reviewing the history of the APA’s relationship with the IRS as well as the somewhat recent Tax Court cases that have addressed it (including Ax and Altera). The argument put forth by petitioner in this designated order appears to be novel – but ultimately the Tax Court’s response is similar to its holding in Ax, with perhaps even more insistence on the Tax Court’s jurisdictional limitations.  

Most recently, the Ninth Circuit withdrew its decision in the appeal of Altera, and we wait to see if it decides again to overturn the Tax Court’s decision which held that the IRS violated the APA when issuing regulations under section 482. For the most recent PT update on the case, see Stu Bassin’s post here.

The case in which this order was designated is also appealable to the Ninth Circuit. Is petitioner teeing up another APA argument before the Ninth Circuit depending on what happens in Altera? That’s a stretch – since petitioner is asking the Court to treat a phone call with Appeals as a adjudication – but it is possible that something more is going on than what is conveyed in the order.

First, let me provide some background: Petitioner is an LLC taxed as TEFRA partnership; it filed bankruptcy in 2008 but then reorganized. Part of the reorganization involved the conversion of debt that Goldman Sachs (or entities controlled by it) had in the old partnership into a controlling equity interest in the new partnership.  After the reorganization, the partnership filed tax returns taking the position that the partnership was terminated on the date of the reorganization because more than 50% of the partnership interests had been ousted through what was in substance a foreclosure of the old partners’ interests. Accordingly, the old partners treated the reorganization as a deemed sale of their property and reported $22 million in gain.

Then, in 2011, reorganized EZ Lube filed an Administrative Adjustment Request (AAR) taking a position contrary to the former partners’ previously filed returns. The position taken in the AAR was that the partnership was not technically terminated, and instead the exchange of debt for equity created $80 million in cancelled debt income.

The IRS agreed with the AAR and issued a final partnership administrative adjustment (FPAA) reflecting that the partners’ originally filed returns were wrong. But one of the former partners liked the old characterization so in response to the FPAA, he petitioned the Tax Court.

In due course the case was assigned to Appeals and this is where things start to get messy. The Appeals officer stated, over the phone, that she agreed with the former partner. In other words, that the FPAA should be conceded. The Appeals Officer’s manager concurred but explained that they would need to consult with Appeals National Office before the agreement could be conveyed in a TEFRA settlement.  Appeals National Office did not agree with the Appeals Officer’s position, so the case did not settle.

Petitioner argues that the phone conversation with the Appeals Officer was a determination and should end the case. The basis for petitioner’s argument is that the IRS’s Appeals Judicial Approach and Culture initiative transformed Appeals to a quasi-judicial part of the IRS which listens to each side and then issues a decision (like a court) instead of negotiating settlements to end litigation.

The IRS does not dispute that the phone call occurred, nor does it dispute the substance of what the Appeals Officer said, but it does dispute that the phone call was a determination. The IRS acknowledges that AJAC may have changed how Appeals processes cases, but maintains it did not set up a system of informal agency adjudication followed by judicial review as those terms are commonly used in administrative law.  

The Court tasks itself to answer the only question it sees fit for summary judgment, which is: what is the proper characterization of what the Appeals officer said?

The Court can decide, as it has in other cases, whether the parties actually reached a settlement by applying contract law and by making any subsidiary findings of fact. But petitioner argues that the call was not a settlement, it was a determination and the Court has jurisdiction to review such determinations.

This is where the Court insists on its jurisdictional limitations and goes on to review all the different code sections that grant it jurisdiction. It does not find anything in the Code that allows it to review determinations by Appeals in TEFRA, or deficiency, cases.

The petitioner agrees that nothing in the Code provides the Court with jurisdiction to review Appeals determinations in deficiency cases. Instead petitioner argues that the default rules of the APA give the Court jurisdiction, because the Appeals Officer was the presiding agency employee and she had the authority to make a recommended or initial decision as prescribed by 5 U.S.C. 554 and 557, and the Appeals Officer’s decision is subject to judicial review under 5 U.S.C. 702.

This is where the Tax Court revisits some of the arguments made in Ax – that the Internal Revenue Code assigns Tax Court jurisdiction. This arrangement is permissible under what the APA calls “special statutory review proceedings” under 5 U.S.C. 703. See Les’s post here and Stephanie Hoffer and Christopher J. Walker’s post here for more information.

If petitioner seeks review under default rules of the APA, the Court’s scope of review would be limited to the administrative record with an abuse of discretion standard. This creates two different standards for TEFRA cases, and the Court finds this impossible to reconcile.

The reality is that when a petitioner is unhappy with a decision made by Appeals in a docketed case, they can bring the case before the Court. It seems as though petitioner in this case is trying to treat a decision made by the Appeals Officer assigned to the case as something different than a decision made by Appeals National Office – but a decision has not been rendered until a decision document is issued and executed by both parties. The Court points out that phone calls can be a relevant fact in determining whether the parties have reached a settlement, but it doesn’t mean the Court has the jurisdiction to review phone calls. Petitioner says phone call itself is of jurisdictional importance, but if that’s the case, it is the District Court, not the Tax Court, that is the appropriate venue to review it.

Is this a situation where petitioner is unhappy because there was a glimmer of hope that the case would go his way which was ultimately destroyed by the National office? Or is something more going on here?  AJAC is called a project and caused changes to the IRM. It’s not a regulation or even guidance provided to taxpayers – rather it is a policy for IRS employees to follow and seems to be a permissible process and within the agency’s discretion to use. But it’s not even AJAC itself that petitioner seems to have a problem with, instead petitioner’s problem lies with the difference between the appeals officer’s position and the National Office’s position on the case.

The Court denies petitioner’s summary judgment motion and orders the parties to file a status report to identify any remaining issues and explain whether a trial will be necessary.

Other Orders Designated

There were no designated orders during the week of April 1, which is why there is no April post from Patrick. The Court seemingly got caught up during the following week and there were nine other orders designated during my week. In my opinion, they were less notable, but I’ve briefly summarized them here:

  • Docket No. 20237-16, Leon Max v. CIR (order here): the Court reviews the sufficiency of petitioner’s answers and objections on certain requests for admissions in a qualified research expenditure case.
  • Docket No. 24493-18, James H. Figueroa v. CIR (order here): the Court grants respondent’s motion to dismiss a pro se petitioner for failure to state a claim upon which relief can be granted.
  • Docket No. 5956-18, Rhonda Howard v. CIR (order here): the Court grants a motion to dismiss for failure to prosecute in a case with a nonresponsive petitioner.
  • Docket No. 12097-16, Trilogy, Inc & Subsidiaries v. CIR (order here): the Court grants petitioner’s motion in part to review the sufficiency of IRS’s responses to eight requests for admissions.
  • Docket No. 1092-18S, Pedro Manzueta v. CIR (order here): this is a bench opinion disallowing overstated schedule C deductions, dependency exemptions, the earned income credit, and the child tax credit.
  • Docket No. 13275-18S, Anthony S. Ventura & Suzanne M. Ventura v. CIR (order here): the Court grants a motion to dismiss for lack of jurisdiction due to a petition filed after 90 days.
  • Docket No. 14213-18L, Mohamed A. Hadid v. CIR (order here): a bench opinion finding no abuse of discretion and sustaining a levy in a case where the taxpayer proposed $30K/month installment agreement on condition that an NFTL not be filed, but the financial forms did not demonstrate that petitioner had the ability to pay that amount each month.
  • Docket No. 5323-18L, Percy Young v. CIR (order here): the Court grants respondent’s motion to dismiss in a CDP case where petitioner did not provide any information.
  • Docket No. 5323-18L, Ruben T. Varela v. CIR (order here): the Court denies petitioner’s motion for leave to file second amended petition.

Recent Tax Court Case Explores Tax Matter Partner SOL Extensions

TEFRA is still with us. Despite the coming launch of new partnership procedures in the Bipartisan Budget Act (BBA), TEFRA will remain relevant, as old cases work their way through the courts and also likely continuing to inform interpretations of many statutory holes in BBA. A recent Tax Court case, BCP Trading and Investments v Commissioner, explores whether alleged conflicts of interest taint what was an otherwise valid extension to the SOL on assessment.

I will skip the sordid details, but the case involves Son of Boss transactions implicating asset transfers to partnerships, with liabilities attaching to the assets in an effort to increase basis in the partnership and thus produce super sized partner tax losses. (Judge Holmes’ opinion describes the transactions for those who like that sort of thing).

The main procedural issue in the case involved claims that the consents to extend to the SOL on assessment that the tax matters partner (TMP) executed were invalid. The argument focused on how the TMP, Bolton, was under the influence of E&Y. E&Y was under criminal investigation for its role in structuring the transactions. That control, according to the argument, meant that the TMP had a conflict of interest, which invalidated the SOL extensions.

There is precedent for invalidating a TMP consent to extend the SOL. Transpac is a Second Circuit case which held that a TMP’s SOL extension did not have effect when IRS turned to a TMP who himself was under criminal investigation, when the partners individually would not extend the SOL.

The BCP Trading opinion (citations removed) describes Transpac further:

The TMP [in Transpac] s were, unsurprisingly, more receptive to the Commissioner’s request. They had “a powerful incentive to ingratiate themselves to the government,” and worked with the IRS in a criminal prosecution of the Transpac promoter because their immunity or suspended sentence depended on it. The TMPs signed the extensions right about the time they were especially trying to coax the government into granting them immunity or agreeing to lighter sentences.

The Second Circuit in Transpac held that the Commissioner couldn’t use these consents to bind the partners because he knew the TMPs had a strong incentive to cooperate with the government and had conflicting interests with the partners.

As BCP discusses, the issue is “very fact dependent.” The opinion distinguishes Transpac for two main reasons: 1) in BCP many of the individual partners did not turn IRS down in the face of individual requests to extend the SOL and 2) the TMP was not under criminal investigation when the IRS turned to him to sign the original extension.

BCP also argued that the E&Y role in the transactions should bring its actions into the lens as to whether the TMP had an impermissible conflict. One of the partnership employees, who started out working at the slippery sounding E&Y group with the acronym VIPER (which stood for Value Ideas Produce Extraordinary Results) went to BCP as a BCP employee to be a liaison with E&Y. BCP argued that the TMP was in effect controlled by the former E&Y/VIPER employee. The opinion gives that pretty short shrift, noting that the former E&Y employee left for messy reasons and that in any event the individual partners also signed consents to extend the SOL.

E&Y’s conduct, beyond its former employee’s role in the partnership, was not irrelevant to a related issue, however. BCP argued that the consents to extend were not valid because E&Y breached its fiduciary duty and exercised undue influence in getting the TMP to sign the consents. The opinion notes that while the consents to extend are not contracts (and should be treated as a waiver of a defense, rather than as a contract itself), contract principles are key to this inquiry. In light of those principles, the argument fell short, looking at contract principles to define undue influence:

Undue influence is unfair persuasion by a person who dominates a party or when, because of their relationship, a party justifiably assumes the person won’t do anything against his welfare.

It was here that the sophistication and extent of the partners’ other advisors worked against the undue influence argument. The opinion details the parade of high-profile advisors other than E&Y that were involved in looking over the shoulder of E&Y. In light of that, the opinion concludes that the evidence did not support a finding that E&Y manipulated the TMP to sign the consents to extend.

Conclusion

As we have discussed before it is difficult to argue against a signed consent to extend. The argument in BCP was a long shot, especially given the partners’ sophistication and the less than appealing atmosphere of a reviled tax shelter.

9th Circuit Opines on TEFRA Small Partnership Exception’s Application to Disregarded Entities and Punts on Issue of Deference Given to Revenue Rulings

Today Treasury re-released regulations under the new partnership audit regime, and that is a reminder that TEFRA is on its way out, putting pressure on me and my Saltzman/Book colleagues to finish our new chapter on partnership audits. Despite the new regime, courts, taxpayers and IRS still wrestle with TEFRA, which, given its complexity, will still produce developments for the blog and the treatise for the foreseeable future. Those developments include technical TEFRA issues, as here, but also broader issues of importance to tax procedure, including the degree of deference that courts should give to revenue rulings and when disregarded entities under the check the box regulations are not to be disregarded for all purposes.

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Last week the 9th Circuit in Seaview Trading v Commissioner considered one nook and cranny of TEFRA, the Section 6321 small partnership exception that applies when the partnership has “10 or fewer partners each of whom is an individual . . . , a C corporation, or an estate of a deceased partner.”

In Seaview, the father and son partners each held their interest in a partnership via single member LLCs that were organized under Delaware law. IRS audited the partnership and under TEFRA issued a final partnership administrative adjustment (FPAA) disallowing partnership losses relating to the 2001 year. The statute of limitations had long passed on the father and son’s individual 2001 tax returns if the TEFRA rules were not applicable. The son, on behalf of the partnership, filed a petition in Tax Court claiming that the FPAA was invalid because the partnership was exempt from TEFRA due to its qualifying for the small partnership exception. The Tax Court disagreed, and the Ninth Circuit, on appeal, affirmed the Tax Court. In so doing, it expounded on the relationship between State and Federal law and the deference given to revenue rulings.

In this brief post I will explain the issue and summarize the appellate court’s opinion.

As most readers know, the check the box regulations under Section 7701 disregard a solely owned LLC unless the owner elects otherwise. Regulations under Section 6321 provide that the small partnership TEFRA 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).” TEFRA, at Section 6321(a)(9), defines a pass-thru partner as any “partnership, estate, trust, S corporation, nominee, or other similar person through whom other persons hold an interest in the partnership.” Section 6321(a)(9) predates the LLC and like entity explosion of the late 20th century, and there are no Treasury regulations that define LLCs and the like as a pass-thru partner.

The partnership in Seaview argued that under the check the box regulations, the LLCs that held the partnership were treated as sole proprietorships of their respective individual owners, and that consequently they could not constitute pass-thru partners within the meaning of the TEFRA regulations.

Despite the absence of regulations that address the issue of how interests held through single member LLCS are treated under the small partnership exception, the IRS, in Revenue Ruling 2004-88, specifically considered that issue. The revenue ruling held that a partnership whose interest is held through a disregarded entity ineligible for the small partnership exemption because a disregarded entity is a pass-thru entity.

In reaching its conclusion that the small partnership exception did not apply, the 9th Circuit addressed how much deference it should give to the IRS’s revenue ruling. The opinion notes that there is some uncertainty on the degree of deference to informal agency positions like revenue rulings. The court explained that in Omohundro v. United States the 9th circuit has generally given Skidmore deference to them. On the other hand, it noted that under the 2002 Schuetz v. Banc One Mortgage Corp., the 9th Circuit had given greater Chevron deference to an informal HUD agency position, and that there is some tension between the circuit’s approach in Schuetz and its approach in Omohundro.

It avoided having to resolve the tension between Omohundro and Schuetz by finding that the Service position in the revenue ruling was correct even when applying the less deferential Skidmore standard. The Skidmore test essentially means that courts defer to the position if it finds it persuasive. As the opinion describes, factors that courts have considered in analyzing whether a position is persuasive include the position’s thoroughness, agency consistency in analyzing an issue and the formality associated with the guidance.

The taxpayers in Seaview essentially hung their hat on the revenue ruling’s rather brief discussion of the sole member LLC issue, but the court nonetheless found the ruling persuasive and also consistent with other cases and less formal IRS counsel opinions that likewise considered the application of the small partnership exception to disregarded entities.

For those few readers with an appetite for TEFRA complexity, I recommend the opinion, but in a nutshell the court agreed with the Service approach that looked first to how the statute’s language did not reflect a Congressional directive to limit the exception to only listed entities. As the opinion discussed, Section 6321(a)(9) defines a pass thru partner as a “partnership[s], estate[s], trust[s], S corporation[s], nominee[s] or [an]other similar person through whom other persons hold an interest in the partnership.” Noting that the statute itself contemplates its application beyond the “specific enumerated forms” the question turns on “whether a single- member LLC constitutes a “similar person” in respect to the enumerated entities.”

The opinion states that “Ruling 2004-88 holds that the requisite similarity exists when ‘legal title to a partnership interest is held in the name of a person other than the ultimate owner.’ ” That line drawing, in the 9th Circuit view, was persuasive, and the revenue ruling had in coming up with the approach cited to and briefly discussed cases that supported the IRS position, including one case where a custodian for minor children was not a pass thru partner because he did not have legal title and another case where a grantor trust was a pass thru partner because it did hold legal title.

One other point, the relationship between state and federal law, is worth highlighting. The taxpayers gamely argued that the IRS view impermissibly elevated state law considerations to determine a federal tax outcome. The court disagreed:

But the issue here is not whether the IRS may use state-law entity classifications to determine federal taxes. Rather, the question is whether an LLC’s federal classification for federal tax purposes negates the factual circumstance in which the owner of a partnership holds title through a separate entity. In other words, state law is relevant to Ruling 2004-88’s analysis only insofar as state law determines whether an entity bears the requisite similarity to the entities expressly enumerated in § 6231(a)(9)—that is, whether an entity holds legal title to a partnership interest such that title is not held by the interest’s owner.

Conclusion

The Bipartisan Budget Act (BBA) new rules for partnership audits begin for returns filed for partnership tax years beginning in 2018. As partners and advisors navigate the uncertain waters of a new BBA partnership audit regime, TEFRA and its complexity will be with us for some time.

The BBA regime has opt out procedures for partnerships that have 100 or fewer qualifying partners. Essentially the statute states that all partners must be individuals,  C corporations, or any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner. While silent on the treatment of disregarded entities, the BBA statute also states that Treasury and IRS by “regulation or other guidance” can prescribe rules similar to the rules that define the category of qualifying partners. 

Proposed Treasury regulations under the BBA were in limbo but earlier today Treasury re-released regulations that provide guidance for the new regime. The proposed BBA regulations specifically address disregarded entities. Despite comments in response to an earlier notice asking Treasury to allow disregarded entities to be treated as qualifying partners, the proposed regulations do not include disregarded entities as qualifying partners and the preamble specifically states that Treasury declined to do so because “the IRS will face additional administrative burden in examining those structures and partners under the deficiency rules.”

The upshot is that for under both TEFRA and likely BBA disregarded entities holding interests in a partnership mean that the general partnership audit rules will apply.

 

 

 

 

Tenth Circuit Holds Partner Can Raise Reasonable Cause Defense in Partner Proceeding

TEFRA holds a special place in my tax procedure loving heart. Working with a recently-married colleague of mine (who did the heavy lifting), we rewrote the content on TEFRA in Saltzman and Book a couple of years ago. Digging deeply into its nooks and crannies, we dutifully update it now, while at the same time preparing to write fresh content on the new regime ushered in by the Bipartisan Budget Act of 2015.

Lest I whine too much about Congress replacing TEFRA after putting all that time in, it will still have relevance for many years. There are still plenty of unresolved TEFRA issues that courts are struggling with, including one that the Tenth Circuit tackled this week in McNeill v US. That case involved the question as to which party, the partnership or the managing partner, could raise a reasonable cause/good faith penalty defense. The penalty arose from the disallowance of losses in a shelter that artificially shifted losses from non-US partners, who contributed low value high basis securities, to retiring executive McNeill, who contributed some cash but had many millions in gains he was looking to offset with the other parties’ unusable losses.

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One of the issues we struggled with/wrote about in Saltz/Book was the reasonable cause/good faith defense, and in particular who (the partnership or the partner) is the proper party to make that argument. There are a number of cases that essentially now stand for the proposition that the reasonable cause/good faith defense may be a partner- or partnership-level defense, depending on who is asserting it. So, while a partnership as a pass through entity is not a taxpayer in the sense that it has no separate income tax liability, it does, often through its managing partner, have the ability to raise at the partnership level a reasonable cause/good faith defense.

In  McNeill, in a federal district court in Wyoming, the government successfully argued that since the partnership in an administrative proceeding had consented to the penalties then McNeill, as the managing partner, was precluded from arguing in a partner level proceeding from raising a separate partner-level reasonable cause good faith defense. This was not based on judicial preclusion doctrines such as issue or claim preclusion; rather, the district court looked to TEFRA itself and in particular Section 6230(c)(4), and the interplay of the second sentence and third sentence in the statute.

The second sentence states that “the determination under the final partnership administrative adjustment or under the decision of the court (whichever is appropriate) concerning the applicability of any penalty . . . which relates to an adjustment to a partnership item shall also be conclusive.” The next sentence states that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.”

McNeill appealed, and at the Tenth Circuit the government argued that the issue was resolved by the second sentence, i.e., that penalty determinations “must be conclusive not just against the partnership itself but also against the managing partner in any later partner level refund action.” The circuit court found some appeal in that argument but not enough to carry the day:

It’s an argument that is sound as far as it goes but one that doesn’t go quite far enough. It fails to account for the statute’s very next and last sentence, which expressly says that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.” Here, then, Congress pretty clearly seemed to contemplate a regime in which any partner may assert any “partner level defenses” that may apply. And by statute the reasonable cause/good faith defense appears to be one available at the partner level: after all, it applies when (among other things) the “taxpayer” can show he acted in good faith and (again) under TEFRA it is usually the partner who is the taxpayer. Id. § 6664(c)(1).

(emphasis added)

Parting Thoughts

There is more in the opinion, including a spirited dissent that essentially adopts the district court’s reasoning, the majority’s discussion as to why the government’s efficiency argument might have been misguided, and a walk-through of precedents that while not on point support the Tenth Circuit’s conclusion. The opinion is also noteworthy though for it suggests that if there were a judicial proceeding on the merits of the penalty defense (as opposed to just an administrative determination) then the government could have argued that issue preclusion would prevent the managing partner from raising a separate defense.

I also note that in many instances the analysis as to reasonable cause/good faith as to the partnership and managing partner overlaps so much that the difference may not matter much on the merits. Lawyers and accountant letters attempting to justify the tax position likely do not differ that much in terms of recipient, especially as here there was very little space between the managing partner and the partnership itself. Yet the majority opinion suggests that were differing opinion letters, and McNeill will now be able to get the lower court to look at those. The result is not quite a clean victory, but it at least gets him in the door.

 

Summary Opinions — For the last time.

This could be our last Summary Opinions.  Moving forward, similar posts and content will be found in the grab bags.  This SumOp covers items from March that weren’t otherwise written about.  There are a few bankruptcy holdings of note, an interesting mitigation case, an interesting carryback Flora issue, and a handful of other important items.

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  • Near and dear to our heart, the IRS has issued regulations and additional guidance regarding litigation cost awards under Section 7430, including information regarding awards to pro bono representatives. The Journal of Accountancy has a summary found here.
  • The Bankruptcy Court for the Southern District of Florida in In Re Robles has dismissed a taxpayer/debtor’s request to have the Court determine his post-petition tax obligations, as authorized under 11 USC 505, finding it lacked jurisdiction because the IRS had already conceded the claim was untimely, and, even if not the case, the estate was insolvent, and no payment would pass to the IRS. Just a delay tactic?  Maybe not.  There is significant procedural history to this case, and this 505 motion was left undecided for considerable time as there was some question about whether post-petition years would generate losses that could be carried back against tax debts, which would generate more money for creditors.  This became moot, so the Court stated it lacked jurisdiction; however, the taxpayer still wanted the determination to show tax losses, which he could then carryforward to future years (“establishing those losses will further his ‘fresh start’”).  The Court held that since the tax losses did not impact the estate it no longer a “matter arising under title 11, or [was] a matter arising in or related to a case under title 11”, which are required under the statutes.
  • The Tax Court in Best v. Comm’r has imposed $20,000 in excess litigation costs on an attorney representing clients in a CDP case. The Court, highlighting the difference in various courts regarding the level of conduct needed, held the attorney was “unreasonable and vexations” and multiplied the proceedings.  Because the appeal in this case could have gone to the Ninth Circuit or the DC Circuit, it looked to the more stringent “bad faith” requirements of the Ninth Circuit.  The predominate issue with the attorney Donald MacPherson’s conduct appears to have been the raising of stated frivolous positions repeatedly, which the Court found to be in bad faith.
  • And, Donald MacPherson calls himself the “Courtroom Commando”, and he is apparently willing to go to battle with the IRS, even when his position may not be great…and the Service and courts have told him his position was frivolous. Great tenacity, but also expensive.  In May v. Commissioner, the Tax Court sanctioned him another seven grand.
  • The Northern District of Ohio granted the government’s motion for summary judgement in WRK Rarities, LLC v. United States, where a successor entity to the taxpayer attempted to argue a wrongful levy under Section 7426 for the predecessor’s tax obligation. The Court found the successor was completely the alter ego of the predecessor, and therefore levy was appropriate, and dismissal on summary judgement was proper.
  • I’m not sure there is too much of importance in Costello v. Comm’r, but it is a mitigation case. Those don’t come up all that frequently.  The mitigation provisions are found in Sections 1311 to 1314 and allow relief from the statute of limitations on assessment (for the Service) and on refunds (for taxpayers) in certain specific situations defined in the Code.  This is a confusing area, made more confusing by case law that isn’t exactly uniformly applied.  The new chapter 5 of SaltzBook will have some heavily revised content in this area, and I should have a longer post soon touching on mitigation and demutualization in the near future.  In Costello, the IRS sought to assess tax in a closed year where refunds had been issued to a trustee and a beneficiary on the same income, resulting in no income tax being paid.  Section 1312(5) allows mitigation in this situation dealing with a trust and beneficiary.  There were two interesting aspects of this case, including whether the parties were sufficiently still related parties where the trust was subsequently wound down, and whether amending a return in response to an IRS audit was the taxpayer taking a position.
  • The First Circuit has joined all other Circuits in holding “that the taxpayer must comply with an IRS summons for documents he or she is required to keep under the [Bank Secrecy Act], where the IRS is investigating civilly the failure to pay taxes and the matter has not been referred for criminal prosecution,” and not allowing the taxpayer for invoking the Fifth Amendment. See US v. Chen. I can’t recall how many Circuit Courts have reviewed this matter, but it is at least five or six now.
  • The District Court for the District of Minnesota in McBrady v. United States has determined it lacks jurisdiction to review a refund claim for taxpayers who failed to timely file a refund request, and also had an interesting Flora holding regarding a credit carryback. The IRS never received the refund claim for 2009, which the taxpayer’s accountant and employee both testified was timely sent, but there was not USPS postmark or other proof of timely mailing, so Section 7502 requirements were not met.  Following an audit, income was shifted from 2009 to other years, including 2008.  This resulted in an outstanding liability that was not paid at the time the suit was filed, but the ’09 refund also generated credits that the taxpayer elected to apply to 2008.  The taxpayers also sought a refund for 2008, arguing the full payment of the ’09 tax that created the ’08 credit should be viewed as “full payment”, which they compared to the extended deadline for refunds when credits are carried back.  The Court did not find this persuasive, and stated full payment of the assessed amount of the ’08 tax was needed for the Court to have jurisdiction over the refund suite under Flora.  Sorry, couldn’t find a free link.
  • The IRS lost a motion for summary judgement regarding prior opportunity to dispute employment taxes related to a worker reclassification that occurred in prior proceeding. The case is called Hampton Software Development, LLC v. Commissioner, which is an interesting name for the entity because the LLC operated an apartment complex.  The IRS argued that during a preassessment conference determining the worker classification the taxpayer had the opportunity to dispute the liability, and was not now entitled to CDP review of the same.  The Court stated the conference was not the opportunity, as the worker classification determination notice is what would have triggered the right under Section 6330(c)(2)(B), and such notice was not received by the taxpayer (there was a material question about whether the taxpayer was dodging the notice, but that was a fact question to be resolved later).  The Hochman, Salkin blog has a good write up of this case, which can be found here.
  • The IRS has issued additional regulations under Section 6103 allowing disclosure of return information to the Census Bureau. This was requested so the Census could attempt to create more cost-efficient methods of conducting the census.  I don’t trust the “Census”.  Too much information, and it sounds really ominous.  That is definitely the group in Big Brother that will start rounding up undesirables, and now they have my mortgage info.
  • The Service has issued Chief Counsel Notice 2016-007, which provides internal guidance on how the results of TEFRA unified partnership audit and litigation procedures should be applied in CDP Tax Court cases. The notice provides a fair amount of guidance, and worth a review if you work in this area.
  • More bankruptcy. The US Bankruptcy Court for the Eastern District of Virginia has held that exemption rights under section 522 of the BR Code supersede the IRS offset rights under section 533 of the BR Code and Section 6402.  In In Re Copley, the Court directed the IRS to issue a refund to the estate after the IRS offset the refund with prepetition tax liabilities.  The setoff was not found to violate the automatic stay, but the court found the IRS could not continue to hold funds that the taxpayer has already indicated it was applying an exemption to in the proceeding.   There is a split among courts regarding the preservation of this setoff right for the IRS.  Keith wrote about the offset program generally and the TIGTA’s recent critical report of the same last week, which can be found here.

 

 

Summary Opinions — Catch Up Part 1

Playing a little catch up here, and covering some items from the beginning of the year.  I got a little held up working on a new chapter for SaltzBook, and a supplement update for the same.  Both are now behind us, and below is a summary of a few key tax procedure items that we didn’t otherwise cover in January.  Another edition of SumOp will follow shortly with some other items from February and March.

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  • In CCA 201603031, Counsel suggests various procedures for the future IRS policy and calculations for the penalty for intentional failure to file electronically.  The advice acknowledges there is no current guidance…I wrote this will staring at my paper 1040 sitting right next to my computer.  Seems silly to do it in pencil, and then fill it into the computer so I can file electronically.
  • This item is actually from March.  Agostino and Associates published its March newsletter.  As our readers know, I am a huge fan of this monthly publication.  Great content on reducing discharge of indebtedness income and taxation.  Also an interesting looking item on representing real estate investors, which I haven’t had a chance to read yet, but I suspect is very good.
  • The IRS has issued a memo regarding its decision to apply the church audit restrictions found under Section 7611 (relating to exemption and UBI issues) to employment tax issues with churches also.
  • Panama Papers are all the rage, but I know most of you are much more interested in Iggy Azalea’s cheating problems (tax and beau).  Her Laker fiancé was recorded by his teammate bragging about stepping out and she had a sizable tax lien slapped against her for failure to pay.  She has threatened to separate said significant other from reproductive parts of his body, but it appears she has approached the tax debt with a slightly more level head, agreeing to an installment agreement.
  • I’m a rebel, clearly without a cause.  I often wear mismatched socks, rarely take vitamins, and always exceed the speed limit by about 6 MPH.  But, professionally, much of my life is about helping people follow the rules.  In Gemperle v. Comm’r, the taxpayers followed the difficult part of the conservation easement rules, and obtained a valid appraisal of the value, but failed to follow the simple rule of including it with his return.  Section 170(h)(4)(B)(iii) is fairly clear in stating the qualified appraisal of the qualified property interest must be included with the return for the year in question.  And, the taxpayers failed to bring the appraiser to the hearing as a witness, allowing the IRS to argue that the taxpayer could not put the appraisal into evidence because there was no ability to cross examine.  In the end, the deduction was disallowed, and the gross valuation misstatement penalty was imposed under Section 6662(h) of 40%.  The Section 6662(a) penalty also applied, but cannot be stacked on top of the 40% penalty pursuant to Reg. 1.6662-2(c).  The Court found that there was no reasonable cause because the taxpayer failed to include the appraisal on the return, so, although relying on an expert, the failure to include the same showed to the Court a lack of good faith.  Yikes! Know the rules and follow them. It is understandable that someone could get tripped up in this area, as other areas, such as gift tax returns, have different rules, where a summary is sufficient (but perhaps not recommended).
  • The Shockleys are fighting hard against the transferee liability from their corporation.  Last year we discussed their case relating to the two prong state and federal tests  required for transferee liability under Section 6901.  In January, the Shockleys had another loss, this time with the Tax Court concluding they were still liable even though the notice of transferee liability was incorrectly titled and had other flaws.  Overall, the Court found that it met and exceed the notice requirements and the taxpayer was not harmed.
  • The Tax Court, in Endeavor Partners Fund, LLC v. Commissioner, rejected a partnership’s motion for injunction to prevent the IRS from taking administrative action against its tax partner.  The partnership argued that allowing the IRS to investigate the tax matters partner for items related to the Tax Court case (where he was not a party) would “interfere with [the Tax] Court’s jurisdiction” because the Service could be making decisions on matters the Court was considering.  The Court was not troubled by this claim, and held it lacked jurisdiction over the matters raised against the tax matters partner, and, further, the partnership’s request did not fall within an exception to the Anti-Injunction Act.
  • Wow, a financial disability case where the taxpayer didn’t lose (yet).  Check out this 2013 post by Keith (one of our first), dealing with the IRS’s win streak with financial disability claims.  Under Section 6511(h), a taxpayer can possibly toll the statute of limitations on refunds with a showing of financial disability.  From the case, “the law defines “financially disabled” as when an “individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment … which has lasted or can be expected to last for a continuous period of not less than 12 months,” and provides that “[a]n individual shall not be considered to have such an impairment unless proof of the existence thereof is furnished in such form and manner as the Secretary may require.””  I’ve had some success with these cases in the past, but I also had my ducks in a row, and compelling facts.  So, not something the IRS would want to argue before a judge.  The Service gets to pick and choose what goes up, which is why it wins.  In LeJeune v. United States, the District Court for the District of Minnesota did not grant the government’s motion for summary judgement, and directed further briefing and hearing on whether the taxpayer’s met their administrative requirements.
  • Another initial taxpayer victory, which could result in an eventual loss, but this time dealing with TFRP under Section 6672.  In Hudak v. United States, the District Court for the District of Maryland dismissed the IRS’s motion for summary Judgement, finding that a jury could determine that a CFO (here Mr. Mules) was not a responsible person with the ability to pay.  The CFO admitted he knew the company wasn’t complying with its employment tax obligations, and knew other creditors were being paid.  He alleged, however, that he lacked the ability (as CFO) to make the required payments…seems like an uphill battle.  He could win though, as the contention is that the owner/CEO/President (Mr. Hudak) made those decisions, had that authority, and misled the CFO to believe the payments were made.  Neither side will likely be able to put much past the Court in this matter, as Judge Marvin Garbis is presiding (he who authored various books on tax, including Cases and Materials on Tax Procedure and Tax Fraud and Federal Tax Litigation).

 

Important New Partnership Audit Rules Change Taxation of Partnerships

Today’s guest post is written by attorneys from the San Antonio office of Strasburger & Price LLP, a Texas based firm with a strong tax practice area. Farley P. Katz is a partner at Strasburger who focuses his practice on civil and criminal tax controversies. He has written a variety of tax articles including The Art of Taxation: Joseph Hémard’s Illustrated Tax Code, 60 Tax Lawyer 163 (2007) and The Infernal Revenue Code, 50 Tax Lawyer 617 (1997). Joseph Perera represents clients on a variety of federal and state tax matters. Before joining Strasburger, he worked in the National Office of the Office of Chief Counsel. Katy David is a partner at Strasburger who counsels clients on tax matters, including federal income taxation and state margin and sales taxation.  We welcome these first time guest bloggers who provide an explanation of the new law impacting partnership tax procedures.  I always hoped that if I waited long enough I would not have to learn TEFRA.  Keith 

On November 2, 2015, the Bipartisan Budget Act of 2015 (BBA) became law. Buried in the BBA are new rules replacing the long-standing Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Electing Large Partnership rules that previously governed partnership audits. These new rules turn established partnership tax law on its head.

Under BBA rules, if a partnership understates its income or overstates its deductions, it is subject to income tax. Not only can the partnership owe income tax, the tax will not be based on the income for the year in question, but instead on one or more prior years’ income. Consequently, the economic burden of the tax could be borne by partners who had no interest in the partnership when the income was generated. Conversely, if a partnership overstated its income in a prior year, the benefit of correcting that overstatement will accrue to the current partners, not those who were partners in the earlier year. Finally, if a partnership elects out of the new provisions (assuming it is eligible), the IRS will no longer be able to conduct a centralized audit controlling each partner’s distributive share, but will instead have to audit each partner individually.

The BBA rules apply to partnership returns filed after 2017, although a partnership may elect to have these rules apply to returns filed before 2018. Not only will these new rules vastly complicate the audit of partnerships that elect out, but they will also require that virtually every partnership in existence consider electing out or revising its partnership agreement to address BBA.

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Who is subject to BBA?

All partnerships are subject to the new rules unless they elect out. Although TEFRA excluded partnerships with 10 or fewer individual (excluding NRAs), C corporation or estate partners, BBA has no such automatic exception. As a result, all partnerships are now covered: even those with as few as two individuals, family limited partnerships, LLCs treated as partnerships for tax purposes, and tiered partnerships. The only excluded partnerships are those that are eligible to elect out and do so on a timely basis.

What does BBA do?

BBA is similar to TEFRA in many respects. Like TEFRA, it requires that all items of income, loss, deduction or credit be determined at the partnership level. Like TEFRA, BBA provides that a partner’s tax return is consistent with the K-1 the partnership issued, unless the partner files a notice of inconsistent treatment. If a partner fails to file the notice, the IRS may treat any underpayment of tax resulting from the partner taking an inconsistent position as a mere mathematical or clerical error and assess the tax without issuing a deficiency notice.

Like the Tax Matters Partner under TEFRA, BBA’s “Partnership Representative” (who does not have to be a partner) is the point of contact for the IRS and can bind the partnership. Unlike TEFRA, however, BBA provides that all tax attributable to adjustments (called the “imputed underpayment”) is assessed against and collected from the partnership, along with interest (determined from the due dates for the reviewed years) and penalties. Also unlike TEFRA, BBA provides that penalties are exclusively determined at the partnership level; there is no partner-level defense. 

How does BBA calculate an underpayment?

Under BBA the years audited are called the “reviewed years,” and the year in which an audit becomes final is called the “adjustment year.” The imputed underpayment is determined by adding together or “netting” all adjustments to items of income, gain, loss and deduction and multiplying the result by the highest tax rate in effect for the reviewed years under section 1 (individuals) or section 11 (corporations). The imputed underpayment is calculated without regard to the nature of the adjustments; all positive or negative adjustments to capital gains, losses, whether long or short term, items of ordinary income or other types of income or loss, are netted. Nor does it appear to matter that items might be subject to restrictions on deduction at the partner level such as the “at risk” or “passive activity” limitations. If the audit adjusts tax credits, those adjustments are taken into account.

Changes in partners’ distributive shares are treated differently and are not netted. For example, if an audit reallocates income from one partner to another, BBA counts only the increase in income, not the decrease, and adds the increase to the partnership underpayment. This treatment will result in phantom income and tax to the partnership even though it does not change the net income reported on the Form 1065.

What if there would be less tax if the adjustments flowed through to the partners?

In many circumstances, the imputed underpayment will be less overall if the adjustments flowed through to the partners. For example, a partner might have a net operating loss that could absorb an adjustment. BBA provides that Treasury shall issue procedures allowing partners to elect to file amended returns for the reviewed years (i.e., the audited years). If the amended returns take into account all adjustments made, and if the tax is paid, then the adjustments will be removed from the partnership level adjustment. Reallocations of distributive shares will be removed only if all the partners affected file amended returns.

Treasury also will issue rules to reduce the partnership level tax rate without requiring amended returns from the partners in certain situations, such as where there are tax-exempt partners. A similar rule will apply lower tax rates if the adjustment includes ordinary income to a C corporation partner (which would pay a lower tax than an individual partner would) or if the adjustment includes capital gain or qualified dividends to an individual partner. Finally, Treasury may issue regulations that make other modifications to the imputed underpayment in similar circumstances.

A partnership seeking to reduce its imputed underpayment under this provision must supply supporting documentation to the IRS within 270 days of issuance of a Proposed Partnership Adjustment.

Can a partnership elect to make the partners liable for the adjustments?

A partnership may elect to have the adjustments shown in a Final Partnership Adjustment (FPA) flow through to its partners. The partners’ tax for the year of the election will be increased by the amount their tax in the reviewed years would have increased based on their distributive share of the adjustments made. In addition, the tax will include any tax that would have resulted from those adjustments in the years after the reviewed year and before the election year. All tax attributes, such as basis, will be affected by these adjustments.

The partnership must elect this flow-through within 45 days of issuance of the FPA. If it makes the election, the partnership will not be liable for any tax. Although the statute is unclear, it appears that the partnership can still contest the FPA in court.

The effect of this election is similar to a TEFRA adjustment, but instead of actually imposing tax in the earlier years, it imposes a tax in the year of the election. In addition to the tax, partners will liable for any penalties and interest, but the interest rate is increased by two percentage points and runs from the earlier years that generated the liability.

What if an audit reduces the tax reported?

If a partnership audit reduces the income originally reported or increases the net loss originally reported, these changes will constitute adjustments for the adjustment year (audit year) and will flow through to the partners for that year.

As under TEFRA, partnerships that have over reported their income may file an Administrative Adjustment Request (AAR), but the IRS will treat any decrease in income or increase in loss as occurring in the year the AAR is filed. If the partnership determines it underpaid its tax, it may file an AAR, but payment of tax is due on filing.

TEFRA provided that the Tax Matters Partner could file an AAR on behalf of the partnership or that any other partner could file an AAR on the its own behalf. However, under BBA, only the partnership can file an AAR; a partner no longer may file its own AAR.

Who can elect out? 

Partnerships with 100 or fewer partners can elect out, if the partners are all individuals (including NRAs), C corporations, foreign entities that would be treated as C corporations if they were domestic, or estates of deceased partners. An S corporation also may qualify, if it identifies all of its shareholders to the IRS. In that event, each of the S corporation’s shareholders counts as a partner for purposes of the “100 or fewer partners” test. A partnership that has even one partner that is itself a partnership cannot elect out, nor does it appear that a partnership could elect out if it has a trust as partner. Although TEFRA contained a provision that a husband and wife counted as one partner for the similar “10 or fewer” rule, BBA contains no such exception. 

How does a partnership elect out?

An election applies to one year only and must be made in a timely filed return for that year. The partnership must identify all the partners to the IRS and give the partners notice of the election.

What happens if a partnership elects out?

If a partnership elects out of BBA, the consistency provisions no longer apply. As a result, each partner may take an inconsistent position regarding partnership items reported on its K-1, without providing notice to the IRS of the inconsistent position.

If a partnership elects out, the IRS still could audit the partnership, but it must make all tax adjustments at the partner level. Accordingly, it would have to issue 30-day letters or notices of deficiency to the individual partners. We expect many partnerships that were subject to TEFRA to elect out of BBA, which will put the IRS in a bind. If the IRS issues a taxpayer a notice of deficiency and the taxpayer petitions the Tax Court, the IRS ordinarily is barred from issuing another deficiency notice if it later discovers additional adjustments. Accordingly, if a partnership elects out of BBA and the IRS makes adjustments on audit, it will have to decide whether to fully audit the returns of the partners (significantly increasing its workload) or issue notices of deficiency and thereby risk losing the opportunity to make further adjustments to those returns.

What are the procedural rules for audits? 

The procedural rules are similar to those under TEFRA. The IRS must give notice of the beginning of the audit. The IRS, however, is required to give notice of any Proposed Partnership Adjustment and then must wait at least 270 days before issuing a FPA. The 270 days gives the partnership time to produce documentation supporting lower tax rates for an imputed underpayment. The IRS must wait 90 days after issuing the FPA before assessing, and—if the partnership timely petitions in court—the IRS must wait until the decision is final to assess. Petitions in Tax Court do not require pre-payment, but a partnership filing in district court or the Claims Court requires payment of the estimated imputed underpayment.

There are, however, a number of procedural differences between BBA and TEFRA. For example, BBA requires that the IRS issue a Proposed Partnership Adjustment, which has legal consequences, whereas TEFRA did not require that an analogous 60-day letter be issued. TEFRA also provided that any partner could participate in the audit and many could bring suit, whereas BBA provides that only the partnership may take those actions. TEFRA also provided procedures by which the IRS or a partner could convert partnership items to partner-level items, effectively opting out of TEFRA, but BBA contains no such provisions. TEFRA provided that if an AAR is filed and the IRS did not act on it, the taxpayers could bring a suit in court, whereas BBA provides for such suit only if the IRS issues an FPA, apparently leaving taxpayers without remedy.

Statute of limitations 

BBA provides that an adjustment generally must be made (presumably “assessed”) within 3 years from the later of (1) the date the partnership return for the reviewed year was filed, (2) the due date for that return, or (3) the date the partnership filed an AAR for the year. However, if the partnership timely submitted documentation to support a reduced tax rate, the adjustment may also be made within 270 days of the date all such documentation was submitted, plus any extensions of time given to submit. Finally, even if the partnership did not request a reduced tax rate, an adjustment also will be timely if made within 270 days of the date a Proposed Partnership Adjustment was issued. An adjustment made within any of these periods is timely, and the partnership can extend the time to make the adjustment. The periods also are extended in other situations. If the amount of unreported income exceeds 25 percent of the gross income of the partnership for the reviewed year, the IRS has 6 years to make the adjustment. Moreover, if the partnership did not file a return or filed a fraudulent return, there is no limitation.

Will there be guidance? 

The BBA rules make fundamental changes in the tax treatment of partnerships and raise a multitude of new questions. Treasury has been directed to issue regulations, and the IRS is expected to issue additional guidance. Nevertheless, the rules undoubtedly will result in much confusion and litigation in the coming years.

What should partnerships do now? 

The BBA raises a number of issues that taxpayers should consider. Among them is whether partnership agreements need to be revised to address the BBA. Some partnerships, for example, might consider provisions that require electing out of the BBA (if that is possible). Under the BBA, the economic consequences of a tax audit of a given year or years will accrue in a subsequent year when the partnership might have different partners. Taxpayers might consider provisions addressing such possibilities and providing for appropriate tax sharing or allocation provisions. In any event, taxpayers using partnerships for businesses or investments and persons buying or selling partnership interests need to be aware of these provisions and should consult with their tax advisors.