TEFRA and Affected Items Notices of Deficiency

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So, what happens when the IRS comes knocking to collect taxes attributable to an unwinding of basis-fueled transactions subject to the TEFRA procedures?

In this post, I will attempt to give readers a map as to how IRS can move from shamming a partnership-based tax shelter to assessing tax against the partner or partners that were attempting to game the system.  After all, the partners, not partnerships, are the real taxpayers, and a finding that a partnership is a sham is only the first necessary step in ultimately truly unwinding the effects of the transaction.

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 Thompson—More Background and the Tax Court View

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.

Judge Holmes in his dissent does a very nice job of describing the context:

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)

Perhaps the understatement of the day was Judge Holmes stating that the task of basket sorting is a major legal problem.

The majority Tax Court opinion concluded that even though a notice of deficiency had been timely issued and there was a timely filed petition, the Tax Court did not have jurisdiction because the partner level adjustments “follow directly from the treatment of partnership items determined in the partnership-level proceeding” and did not require any partner level determinations. Judge Holmes disagreed. So did a separate dissenting opinion by Judge Goeke, though Judge Goeke concluded that the stat notice, even though incorrect, conferred jurisdiction on the Tax Court.

 So What is Going On Here?

In Thompson, IRS issued a stat notice but assessed tax the day after it issued the notice, apparently believing it did not need to issue the stat notice. But, since the law is not clear as to what requires a partner-level determination, IRS, consistent with Chief Counsel Notice 2009-11, issued a protective notice, just in case a court concluded differently.

The protective notice makes sense, as under Section 6229(d) the IRS has only one year to send an affected item notice from the end of partnership level proceedings. If the IRS skips the stat notice and only assesses (thinking no partner level determinations are needed), and a court later determines, as the Eighth Circuit held in Thompson, discussed below,  that the partner-level determinations were needed and thus a notice was necessary, the one year period would likely be up. Then, IRS will be out of time to assess, unless perhaps the IRS can shoehorn in an unlimited sol due to fraud of a third party, along the lines the Court of Federal Claims rejected in BASR, as we described in an earlier post.

The Tax Court majority found that the stat notice was invalid and therefore the Tax Court did not have jurisdiction, and IRS could effectively disregard the stat notice it issued. If the taxpayer wanted, he could bring a refund suit in federal district court or the court of federal claims to challenge the amount or existence of the assessment, subject to potential collateral estoppel issues.

Judge Holmes’ dissent disagreed with the majority’s conclusion that the partner level adjustments did not require partner level determinations. To that end, Judge Holmes emphasized that the disallowed outside basis was only step one in determining additional tax at the partner level.  I commend readers who are still with me to read the opinion directly –especially pages 46-49—but what troubled Judge Holmes was that the individual return also reflected some cash that Thompson received, and thus the precise amount of disallowed loss was not apparent from the partnership return:

 The notice of deficiency zeroed out the Thompsons’ outside basis by substituting zero for the more than $22 million basis that they had reported, and then increasing their taxable income by $22,006,759 of “Short-Term Capital Gain/Loss.”  Although the $22,006,759 [Editor’s note: the disallowed outside basis] amount does appear on the Thompsons’ return, that was not the amount of the loss that they reported for the disposition of their interest in RJT….

Essentially, Judge Holmes tells us that the disallowed basis—which triggered the increased tax liability reflected in the stat notice—is a necessary but not sufficient step to get to the actual increased liability, because the partner’s tax is dependent upon computations that were required to be made from the partner’s return itself.

The Eighth Circuit and Musings from the Supremes in Woods

On appeal, the Eighth Circuit reversed and remanded, concluding that the Tax Court’s earlier order in the partnership-level proceeding (finding the relevant partnership was a sham) did not determine the proper amount of the partner’s outside basis. Though the Eighth Circuit said at “first glance” the zero basis determination was made in the original Tax Court order:

 [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

What is not clear in the majority opinion is whether the original Tax Court order, if drafted differently and more precisely, could have specifically obviated the need for partner level computations.  Two concurring circuit court opinions in Thompson suggest that the wording of the order would not be sufficient to obviate the need for partner-level determinations, but I think the main opinion can be fairly read as stating that a better-worded order clearly stating that the partner’s outside basis was zero could have been enough to allow assessment without issuing an affected item stat notice.

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. 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. Cf. Petaluma FX Partners, LLC v. Commissioner, 591 F. 3d 649, 655 (CADC 2010) (“If disregarding a partnership leads ineluctably to the conclusion that its partners have no outside basis, that should be just as obvious in partner-level proceedings as it is in partnership-level proceedings”).

The oddity arises because while under Woods the provisional applicability of the penalty arises at the partnership level, the penalty determination is ultimately made at partner level in a refund suit (assuming a partner challenges it), where a partner can still raise whatever partner level defenses it may have, e.g. reliance on advisor. But as the Eighth Circuit’s Thompson opinion provided, in the deficiency proceeding, the Tax Court will have jurisdiction to determine the underpayment, not partner level defenses to the applicability of the penalty itself, which is a partnership item, not an affected item.

Well, while note 2 from Woods is not controlling, I suggest that it will cast a long shadow, and the Tax Court majority approach in Thompson may find favor, especially if an original order in the partnership case more precisely addresses the complete disallowance of the partner’s outside basis.

It is fair to say that we have not heard the last on this issue, though the issue is calling for clarification—if not from the Supremes then maybe from Congress, where there are rumblings that it is time to overhaul TEFRA. I strongly agree with Judge Holmes’ statement in the Thompson dissent that “[i]t is usually not a good idea to make jurisdiction this confusing, and courts have had to make do with what they can to try to make this cranny of the Code as clean as possible.” Until there is more guidance, taxpayers, courts and IRS alike are all likely to struggle with the cranny that is TEFRA.

About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

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