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, 2012--Oct. 31, 2013), 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.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (1) was enacted in part 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 come up during audit are whether an item is a partnership item and the correct statute of limitation period. In 2013 and late 2012, several cases addressed these issues.
In Estate of Albert Simon, (2) the Tax Court had to decide whether it had jurisdiction to hear a case involving a deficiency the IRS had assessed against a taxpayer's estate and his widow pertaining to a partner-level affected-items proceeding under TEFRA. The court held that it had jurisdiction to hear and resolve the IRS's decision assessing a deficiency against the taxpayers because the IRS gave them proper notice of a final partnership administrative adjustment (FPAA) as required by Sec. 6223(a). However, the court lacked jurisdiction to redetermine any accuracy-related penalties under Sec. 6662 because the deficiency procedures did not apply to the assessment of penalties determined at the partnership level, regardless of whether partner-level determinations had to be made to assess the penalty.
In Rovakat, LLC, (3) a partnership challenged the disallowances of losses it attributed to Swiss francs transactions as well as the 40% accuracy-related penalties levied in an FPAA. The Third Circuit, affirming the Tax Court, found that the redemption of stock from a company for U.S. dollars and Swiss francs was a sale of common stock, as opposed to a transfer of partnership interests, as asserted by the partnership. Both the other entities in the transactions were corporations. Because one corporation could not transfer a partnership interest in exchange for dollars and Swiss francs, it could not carry over its basis in the other corporation's class A stock to the Swiss francs that ultimately were transferred to the partnership. The partnership asserted a basis in the Swiss francs that exceeded 400% of the correct amount, triggering a 40% penalty for a gross valuation misstatement. The appellate court found that the Tax Court did not err in finding that the partnership lacked reasonable cause and did not act in good faith, and thus, the partnership could not avoid the gross misstatement penalties.
In the past couple of years, courts have addressed whether basis was a partnership item. They have consistently disallowed losses from "son-of-boss" transactions.
In 2012, Rawls Trading (4) involved two lower-tier source partnerships and an interim family partnership, with partners engaged in a short-sale variant of the 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 sheltering transactions that generated large losses. The interim family partnership claimed a loss on the sale of its partnership interest. The IRS claimed these losses resulted from transactions overstating the bases of partnership interests in the source partnerships. These overstated bases supposedly flowed through to the family partnership, which used them to generate the losses. The IRS issued an FPAA to the interim family partnership that included only the impact of the adjustments shown on the two source partnership FPAAs. However, the IRS issued the FPAA to the family partnership before the completion of the two source partnership proceedings. The Tax Court determined that the interim family partnership's FPAA was invalid because the IRS issued it before the partnership-level proceedings in the source partnership cases were completed.
Subsequently, in the same case, (5) the court had to determine whether the IRS's determinations in the FPAA notices were correct and whether the taxpayers were liable for penalties related to the understatement of income from these transactions. The taxpayers failed to meet their burden of proving the IRS's determinations were incorrect, but they established a reasonable-cause and good-faith defense under Sec. 6664(c) against the accuracy-related penalties. They had relied upon the advice of the attorneys that sold the taxpayer the transaction and an accountant recommended to the taxpayer by the attorneys in concluding the transactions were valid for federal income tax purposes. The IRS argued that the taxpayers could not rely on the experts because the attorneys and the accountant had promoted the tax shelter. The court found that the attorneys were promoters but that the accountant was not a promoter. Thus, it held that the taxpayers relied in good faith on a competent adviser who had accurate and necessary information. This result should be good news to tax advisers, since it was a win for taxpayers that relied on professional guidance for a tax position.
In another case, (6) a partnership moved to dismiss the case against it for lack of subject matter jurisdiction to determine applicability of an accuracy-related penalty wider Sec. 6662. The partnership sheltered income from tax by offsetting currency options in a son-of-boss shelter. The court determined that although it lacked jurisdiction to consider an accuracy-related penalty related to the outside basis of the partners in their partnership interests, it had jurisdiction to determine the applicability of any penalty to the partnership's losses or deductions.
In 2012, in Superior Trading, LLC, (7) the taxpayers sought reconsideration and/ or orders vacating earlier judgments that had upheld the IRS's adjustments to partnership items in an FPAA. In the FPAA, the IRS denied tax benefits in connection with 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 DAD shelters were devices to transfer high-basis/low-value assets to tax-sensitive parties. The Tax Court had previously held (8) 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 were properly collapsed into a single transaction and treated as a sale of the receivables. The taxpayers sought postjudgment relief, which the court denied. The court characterized the motions as a "curious admixture of a regurgitation of unfounded assertions and half-baked theories" that the court had already rejected, combined with a criticism of the court's holdings and baseless claims of newly discovered evidence. Undeterred, the taxpayers appealed to the Seventh Circuit.
In 2013, that court (9) affirmed the Tax Court's holdings and held that as a sham partnership motivated by no joint business goal, the taxpayer was entitled to none of the Internal Revenue Code's benefits of partnerships. One party aimed to extract value from its otherwise worthless receivables, and the other party sought to make the losses a tax bonanza, the court held. The court, in an opinion by Judge Richard Posner, further reasoned that even if the taxpayer had been an actual, rather than fake, partnership, the cash transfer from the partnership to a company within two years of that company's contribution of assets to the taxpayer would have created a presumption that the company had sold the assets to the partnership and received the cash distribution as delayed payment. Because the partnership was a sham without a business purpose, the penalty was affirmed because the valuation misstatement had been gross and the taxpayer had not proved it had reasonable cause to deduct the built-in losses.
Statutes of Limitation
Two cases in 2013 and late 2012 concerned the appropriate statute of limitation. In BASR Partnership, (10) the taxpayer filed a petition for a readjustment of taxes and a refund of federal taxes paid because, it asserted, an FPAA was time-barred by the three-year limitation period of Sec. 6501(a) and that the fraud exception of Sec. 6229(c)(1) did not apply because none of the partner taxpayers had the requisite intent to trigger the extended statute of limitation period in Sec. 6.501(c)(1).
The Court of Federal Claims held that Secs. 6501 and 6229(a) should be read together. The three-year baseline statute of limitation is in Sec. 6501, but Sec. 6229(a) provides a "minimum period for assessments of partnership items" that may be extended. Thus, "when an assessment of tax involves a partnership item or an affected item, section 6229 can extend the time period that the IRS otherwise has available under section 6501 to make that assessment. (11)
1' There was no question that BASR's partnership return included false or fraudulent items, but the IRS did not contend that the partners possessed an intent to evade tax within the meaning of Sec. 6501(c)(1). The court found that the legislative history of Sec. 6501(c)(1) supports the view that it is the taxpayer who must have the intent to evade tax. Therefore, the court determined that the meaning of "intent to evade tax" is limited to instances in which the taxpayer has the requisite intent to commit fraud. Because the IRS conceded that the taxpayers in this case did not have that intent, Sec. 6501(a) governed the period in which the IRS could assess tax by an...