Current developments in partners and partnerships.

• Author: Burton, Hughlene

This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, income allocations, and basis adjustments. During the period of this update (Nov. 1, 2011--Oct. 31, 2012), Treasury and the IRS worked to provide guidance for taxpayers on numerous changes that had been made to subchapter K over the past few years. The courts and the IRS issued various rulings that addressed partnership operations and allocations. This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, income allocations, and basis adjustments.

TEFRA Issues

In 1982, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (1) was enacted to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. Two questions that continue to arise during audits are whether an item is a partnership item and the correct statute of limitation period. This year, several cases addressed these issues.

In the past couple of years the courts have ruled on the issue of whether basis was a partnership item or not in the Petaluma cases, which held that determining whether a partnership was a sham was a partnership item, but that determining the partners' outside basis was not. (2) This year, in the Tigers Eye Trading (3) case, the IRS successfully disallowed losses in a son-of-boss transaction. The partnership claimed that Petaluma established that outside basis was not a partnership item that could be determined in a final partnership administrative adjustment (FPAA) and therefore the IRS did not have jurisdiction to make the adjustment. However, the court rejected the ruling in Petaluma and focused instead on the Supreme Court's Mayo Foundationd (4) holding and other recent cases, such as Chevron. (5)

The court based its reasoning that Petaluma did not apply on a number of factors. First, it asserted that Petaluma was based on a government concession that should not apply in other cases. Second, since Tigers Eye Trading had filed a partnership return, it determined that TEFRA applied and the court had jurisdiction to find that it was not a partnership and to determine all items that would have been partnership items. Third, as Tigers Eye Trading acted as an agent for its partners, its disregarded entity status afforded a basis for computational adjustments disallowing losses and credits claimed in connection with it and adjustments of all such items to zero. Next, any partner's basis in distributed property was the partnership's cost basis therein. Lastly, it was proper to apply TEFRA regulations that satisfied the Chevron analysis rather than the contrary Petaluma ruling and to decide "outside basis" given these facts. Thus, the IRS was correct in making the determination of outside basis and could disallow the losses.

In a case (6) that involved two lower-tier source partnerships held by a family partnership, the partners engaged in the short-sale variant of a son-of-boss tax shelter. They used several newly formed entities, arranged in a tiered structure, each of which sought to be characterized as a partnership for tax purposes. The entities engaged in tax shelter transactions, which generated large losses. The family partnership claimed a loss from overstating its basis in the partnership interests upon their sale. These overstated bases supposedly flowed through to the family partnership, which used them to generate the losses.

The IRS issued an FPAA to the family partnership that included the adjustments shown on the two source partnership FPAAs, but the FPAA was issued to the family partnership before the completion of the two source partnership proceedings. The court determined that the family partnership's FPAA was invalid because it was issued before the partnership-level proceedings in the source partnership cases were completed. It should be noted that the court did not address whether the IRS's assessment was correct or not because it found that the FPAA was issued too early.

In another case, (7) a taxpayer challenged a deficiency issued by the IRS, claiming that the IRS should have issued an FPAA to the partnership rather than a notice of deficiency to the individual taxpayer. The taxpayer, a U.S. citizen, filed territorial income tax returns with the Virgin Islands Bureau of Internal Revenue (BIR). The taxpayer did not file tax returns with the IRS, claiming that he qualified for the gross income tax exclusion under Sec. 932(c)(4).

Because he did not file a federal return, the IRS conducted a nonfiler examination and determined that for those years, the taxpayer did not qualify for the exclusion. The IRS, therefore, issued a notice of deficiency. In a turnaround from the normal case, the taxpayer maintained that this case involved a partnership item and therefore the IRS should have issued an FPAA to the tax matters partner of the entity instead of issuing a notice of deficiency to the taxpayer. The court held that the TEFRA procedural rules did not apply in this case because the entity did not file a partnership return with the IRS and was not classified as a partnership for TEFRA purposes. The entity's return filed with the BIR did not constitute the filing of a return with the IRS. Thus, the notice of deficiency to the taxpayer was valid.

In Superior Trading LLC, (8) the taxpayers requested the court reconsider or vacate earlier judgments that upheld the IRS's adjustments to partnership items in an FPAA. The IRS had denied tax benefits from distressed asset/debt (DAD) tax shelters that involved a Brazilian retailer and an offshore entity that serviced distressed consumer receivables. The IRS had argued that the tax shelters were devices to transfer high-basis/low-value assets from "tax-indifferent" to "tax-sensitive" parties. The court had previously held (9) that the two entities had not formed a bona fide partnership for federal tax purposes, that no valid contribution of receivables had occurred, that carryover basis treatment per Sec. 723 was improper, and that the claimed contribution and subsequent redemption was properly collapsed into a single transaction and treated as a sale of the receivables. The taxpayers sought post-judgment relief, which the court denied. The court characterized the motions as a curious mixture of "a regurgitation of unfounded assertions and half-baked theories" (10) that the court had already rejected, combined with a criticism of the court's holdings and baseless claims of newly discovered evidence.

Statute of Limitation

There was also a case in 2012 that concerned the appropriate statute of limitation. In Gaughf Properties, (11) the IRS assessed a tax on income from the expiration of a currency option that the partnership had not included in gross income. The partnership argued that the statute of limitation had expired before the assessment of the tax. The IRS argued, and the court agreed, that the statutory period for assessing tax attributable to partnership items was still open on the day the FPAA was issued because the partnership's indirect partners had failed to satisfy the requirements of Sec. 6229(e) by not listing certain information identifying themselves as partners on the partnership's tax return. Because the partners treated partnership items on their personal returns in a manner that was inconsistent with their treatment on the partnership return, and they did not notify the IRS of this inconsistent treatment, the indirect partners also failed to comply with Sec. 6222(b). The court also found that the information required by Sec. 6229(e) and its regulations identifying the indirect partners was not furnished to the IRS, and the fact that the IRS obtained and used this identifying information during the investigation did not trigger the running of the one-year period described in Sec. 6229(e). Thus, the statute of limitation was still open, and the taxpayers were liable for the additional taxes assessed.

Definition of a Partnership and a...