TEFRA partnership procedural issues are a mess and the cases are complex. The law is uncertain, and the courts have taken different views on fundamental questions concerning the Tax Court’s jurisdiction to hear disputes stemming from shammed partnerships.
Late last month, the Tax Court decided the case of Thompson v Commissioner on remand from the 8th Circuit. The case sheds light on the Tax Court’s view of TEFRA in light of last year’s Supreme Court Woods opinion.
TEFRA Basics
Before discussing the current Thompson decision, here is the basic TEFRA scheme as Judge Holmes discussed in his dissent in the original Thompson Tax Court case:
Partnerships don’t pay income tax; partners do. This means that there has to be another step after a partnership case is over before the Commissioner can figure out an individual partner’s tax bill. The Code calls this a “computational adjustment,” which is just the bottom-line “change in the tax liability of a partner which properly reflects the treatment* * * of a partnership item.” Sec. 6231(a)(6). To make computational adjustments, however, the IRS must follow certain procedures: Sometimes the IRS has to send each partner a notice of deficiency, sometimes the IRS can just directly assess each partner and send him a notice of computational adjustment, and sometimes the IRS has to do some combination of both….
Figuring out which adjustments fall into which baskets has proven to be a major legal problem. The Code’s test is easy to state: When a computational adjustment is attributable to an affected item that requires a determination at the partner level, the Commissioner has to send the partner a notice of deficiency, which gives him a chance to come to Tax Court before paying.
The Code and regulations also have a rule that when a partnership-level determination leads to a computational adjustment that does not require a partner-level determination, the Commissioner is to assess the increase in tax summarily, send the partner a notice of computational adjustment, and leave him to pay and sue for a refund: No ticket to Tax Court for him. (many citations omitted).
What the Fight is All About: Woods and Jurisdiction
So, with that useful primer, here is what Thompson is all about, as I described last year[links to my prior TEFRA posts are below]:
The Thompson case from the Tax Court and 8th Circuit is instructive. Grossly simplifying (and I will do that throughout this post to hopefully make the procedure points without sacrificing too much; I borrow liberally from Judge Holmes’ dissenting opinion in Thompson v Comm’r), a related and earlier partnership case, RJT Investments X v. Comm’r involved a Son of Boss shelter. In that case, the Tax Court found that the partnership was “formed and/or availed to overstate artificially the basis of the interest of Randall Thompson in RJT Investments X, LLC in the amount of $22,006,759 for purposes of tax avoidance.” The Tax Court also upheld penalties. The 8th Circuit affirmed.
IRS proceeded to take two somewhat inconsistent actions. It issued an affected item statutory notice to Thompson individually making four adjustments—the main adjustment being a disallowance of the loss on liquidation of the partnership. The day after issuing the stat notice, IRS then assessed tax relating to the adjustments in the stat notice. Uh? This is inconsistent because the stat notice is supposed to allow the partner the opportunity to petition and get pre-assessment and pre-payment review of the adjustments in the affected item stat notice.
The original Thompson Tax Court decision (in a fully reviewed divided opinion) took the view that the IRS’s notice did not confer jurisdiction on the Tax Court because there were no partner-level determinations necessary to reduce outside basis to zero in a shammed partnership. The 8th Circuit disagreed, and found in the facts at hand that additional determinations were necessary to get to a partner’s outside basis even in the particular shammed partnership in the case.
In my post on Thompson from last year, I noted that the 2013 Woods Supreme Court opinion (decided after the 8th Circuit case), and footnote 2 from Woods in particular would cast a long shadow over TEFRA and likely support the Tax Court majority approach to the issue. Woods, as readers know (at least those who like me have an appetite for suffering through TEFRA) was not directly on point, because in that case what was at issue was whether the Tax Court had jurisdiction in the partnership level proceeding to consider the applicability of the gross valuation misstatement penalty. The Supreme Court held that it did have jurisdiction to consider the applicability of the penalty, though partners could raise individual defenses in separate refund suits. Here’s what I said about Woods last year and how it relates to underlying partner liabilities in shammed partnerships:
I might add that footnote 2 in the Woods Supreme Court case from last week suggests that Justice Scalia thinks that the IRS can assess without a stat notice following a partnership level sham determination[Reminder—this is the very issue in Thompson]. Here is what Justice Scalia said in response to an amicus brief raising the possible procedural oddity of penalty determinations made at the partnership level in refund suits and underpayment determinations at the partner level in pre-payment Tax Court matters:
Some amici warn that our holding bodes an odd procedural result: The IRS will be able to assess the 40-percent penalty directly, but it will have to use deficiency proceedings to assess the tax underpayment upon which the penalty is imposed. See Brief for New Millennium Trading, LLC, et al. as Amici Curiae 12–13. That criticism assumes that the underpayment would not be exempt from deficiency proceedings because it would rest on outside basis, an “affected ite[m] . . . other than [a] penalt[y],” 26 U. S. C. §6230(a)(2)(A)(i). We need not resolve that question today, but we do not think amici’s answer necessarily follows. Even an underpayment attributable to an affected item is exempt so long as the affected item does not “require partner level determinations,” ibid.; see Bush v. United States, 655 F. 3d 1323, 1330, 1333–1334 (CA Fed. 2011) (en banc); and it is not readily apparent why additional partner-level determinations would be required before adjusting outside basis in a sham partnership. [some citations omitted, emphasis mine]
Thompson on Remand
Last month, Judge Wherry penned a non-reviewed memorandum opinion in Thompson. Footnote 4 in the Thompson remand discusses Woods’ footnote 2 and the specific italicized language above. Right after referring to the Woods’ “it is not readily apparent” language why additional partner-level determinations are needed, Judge Wherry matter of factly notes that “[i]n the sham partnership at issue here, the Court of Appeals concluded that such additional determinations were required, and we proceed in accordance with that mandate.” Moreover, in footnote 3 of the Thompson remand opinion, Judge Wherry gave his view of outside basis in a shammed partnership: “We had thought that to claim or find any tax basis in a disregarded “sham” partnership was an oxymoron. What petitioners actually had, when the dust cleared, was their cash which they had purported to have invested in the disregarded “sham” partnership and in which they already had a tax basis equal to its face value.”
Footnote 3 thus is Judge Wherry’s response to the 8th Circuit opinion which said that the original Tax Court order failed to explicitly state that the outside basis was zero. As I suggested in my original post on Thompson, and as Judge Gruender’s concurring opinion in the 8th Circuit case also suggests, it is possible that the 8th Circuit approach can be read as allowing for immediate assessment if the Tax Court order explicitly stated that the result of the sham determination was a zero basis. Here’s what the 8th Circuit said about the order in the original Tax Court matter:
A careful reading of the order, however, reveals that the Tax Court concluded, as relevant here, (1) that RJT was formed and/or availed of to artificially overstate Thompson’s basis in RJT; and (2) that Thompson’s purported basis in RJT—$22,006,759—was overstated. It does not necessarily follow, however, that Thompson’s entire purported basis was overstated, or in other words, that Thompson’s outside basis in RJT was zero. Because the Tax Court did not determine Thompson’s outside basis in RJT, the IRS properly issued a notice of deficiency under § 6230(a)(2)(A)(i).
So, perhaps the 8th Circuit left the door open for a partner level zero basis determination. Yet, the next sentence in the circuit court opinion somewhat inconsistently cites to cases in other circuits that concluded outside basis was an affected item: “[W]e agree with the other circuits to have addressed the issue that outside basis is an affected item that must be determined at the partner level.” (citing to Jade Trading in the Federal Circuit and Petaluma in the DC Circuit).
All this is to say that I think the 8th Circuit might have some wiggle room if it wanted to ever back-track from its earlier Thompson holding. For instance, if the earlier Tax Court decision/order had determined outside basis to be zero, would further determinations have been necessary? I think the 8th Circuit would say yes, but the majority does not squarely address this issue and cites to authority which suggests otherwise.
Where Does This Leave Taxpayers?
So where does this leave taxpayers and IRS? Well, in Thompson on remand Judge Wherry stated that the taxpayers and IRS had stipulated the amount of the deficiency so the Tax Court did not have to go through the formality of making an outside basis determination. Case over, with the Tax Court soon to be entering a decision allowing the IRS to assess, despite the Tax Court’s original view is that it did not have jurisdiction.
What about with others facing this issue? IRS policy is generally to issue protective stat notices and then assess. This duplicate procedure is necessary because if the notice turned out to be unnecessary (because partner-level determinations were not needed, as the Tax Court originally held in Thompson) and the Service had not assessed, the limitations period would probably expire before resolution of the proceeding arising from the notice.
Even if the Tax Court has jurisdiction over the underlying liability stemming from the shammed partnership, it will not have jurisdiction to consider a partner’s individual penalty defenses, and taxpayers will have to litigate the merits of penalty cases in separate refund cases. The IRS (and Tax Court) view that IRS can assess a partner’s liability stemming from a shammed partnership without issuing a stat notice finds support in Woods, and I suspect that the Tax Court will stick to its guns that it does not have jurisdiction, along the lines of its approach in Thompson that the 8th Circuit rejected.
The uncertainty and complexity makes for bad tax administration. It is time for a legislative fix though I would not be surprised if the Supreme Court returns to the TEFRA quagmire.
PRIOR POSTS ON TEFRA AND OUTSIDE BASIS ISSUES
TEFRA is hard to understand. For readers wanting to learn more, I have previously discussed Woods and the uncertain state of the law in cases involving assessments relating to TEFRA partnerships. My most recent post on the issue TEFRA Outside Basis and Tax Court Jurisdiction from this past May and involved the case Greenwald v Commissioner, where the Tax Court held that a partner’s outside basis in a nonshammed partnership was an affected item requiring partner-level determinations and thus the issuance of a notice of deficiency to the partners before the IRS could assess an underlying tax liability. Prior to that post, I discussed the procedures for shammed partnerships. My post TEFRA and Affected Items Notices Of Deficiency discussed how the 8th Circuit reversed and remanded the case of Thompson v Commissioner, which the Tax Court had held it had no jurisdiction to consider a partner’s liability stemming from a shammed partnership.
UPDATE 8.7
I neglected to include as reference Professor Andy Gerwal’s piece from earlier this year TEFRA Jurisdiction and Sham Partnerships-Again That post explores the consequences of Treasury relying on 13 year old temporary regulations in effect in the Petaluma case currently on appeal in the DC Circuit.