Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, debt and income allocations, distributions, passive activity losses, and basis adjustments. During the period of this update (November 1, 2009-October 31, 2010), 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. Treasury issued proposed partnership regulations regarding the deferral of cancellation of debt (COD) income with respect to the reacquisition of applicable debt. The courts and the IRS issued various rulings that addressed partnership operations and allocations. In addition, as part of health care legislation, Congress codified economic substance.

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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 under audit are whether an item is a partnership item and what is the correct statute of limitation period. This year several cases addressed both of these issues.

In Alpha I L.P., (2) the taxpayer transferred its interests in a limited partnership (LP) to four charitable remainder trusts (CRTs). One of the assets owned by the LP was marketable securities. After the transfer of the interest, the LP sold the stock for a loss that it allocated to all the members. The IRS issued a final partnership administrative adjustment (FPAA) in which it reduced the LP's basis in the stock. The adjustment's effect was to convert the loss on the sale to a gain. In addition, the IRS determined that the transfer of the LP interests to the CRTs should be disregarded as an economic sham and that the original owners, not the CRTs, should be treated as the members of the LP.

The members contended that the court lacked jurisdiction to consider whether the transfers to the trusts were shams because the transfer was not a partnership item. The IRS argued that the identity of partners in a partnership was a partnership item or at the very least an affected item. The court found that the identity of partners was neither a partnership item nor an affected item and thus was improperly determined in the FPAA because the transfer of an interest has no effect on either the partnership's aggregate or each partner's separate share of partnership income or loss. Last year the government filed a motion for reconsideration of the issue. (3) However, the Court of Federal Claims denied this motion.

This year the taxpayers conceded that they owed taxes as a result of the sham transaction but contested whether they owed penalties. (4) In this case the partnerships argued that they had substantial authority for the position in their initial tax returns and that they had relied in good faith on the advice of tax professionals. The court concluded that the partnerships had not established that there was substantial authority for the position they took and that they did not act in good faith. The partnerships based their good-faith defense on their reliance on an opinion letter from a tax lawyer. However, the court held that reliance on the opinion letter did not protect the partnerships because the firm that designed the tax shelters referred them to the tax lawyer and the lawyer was not told that the firm was being paid a percentage of the tax savings. Thus, the court held that the partnerships were engaged in a tax shelter and that the substantial understatement penalty of Sec. 6662(b)(1) and the negligence penalty of Sec. 6662(b)(2) applied.

In Krause, (5) the IRS issued an FPAA that disallowed a deduction for a loss at the partnership level. The taxpayers agreed to the loss disallowance but sued, seeking a refund of the penalties imposed regarding the underpayment of taxes related to the disallowed loss. The IRS argued that Sec. 7422(h) barred the taxpayers from challenging the applicability of the penalty because this case was an individual action for a refund attributable to partnership items. The taxpayers argued that they should be allowed to recover the penalties based on Heasley (6) and other cases, which deal with penalties for valuation overstatements.

The court rejected the taxpayer's argument, stating, "These cases did not deal with partnership penalties and the accompanying body of TEFRA law and thus do not apply." Moreover, the taxpayers had not disputed the IRS adjustments or penalties in the FPAA before the IRS finalized it. Thus, the court did not address the merits of the taxpayers' argument because they had not raised it at the partnership level. In addition, the taxpayers did not assert a reasonable cause defense or claim that there was a computational error in passing the partnership adjustment on to them. Rather, they were alleging that the penalty was illegal because of its effect on them. The court found that this was a partnership-level argument that the taxpayers should have raised before the IRS finalized the FPAA.

The issue in the original Bush case (7) (and approximately 30 other cases) concerned the interpretation of two sentences in partnership closing agreements. The pertinent sentences allowed losses suspended under Sec. 465 to offset any income earned by the partnership. The suspended losses in question were from passive activities. The taxpayers interpreted the closing agreements to mean that Sec. 469 would not apply if the partnership created income, so they could offset the suspended passive activity losses against any type of income. The IRS disagreed. The court determined that the sentences in the closing agreement did not explicitly prohibit the application of Sec. 469 and that it was unreasonable to read the closing agreement as allowing the passive partners to use the suspended passive activity losses to offset any type of income.

During the proceedings to determine the tax liability of the partnerships, (8) the taxpayers entered into closing agreements with the IRS, and the IRS assessed deficiencies based on the agreements. However, it did not send a written deficiency notice to the partnerships. The IRS contended that deficiency notices were not required because the assessments were computational adjustments. The taxpayers argued that notices were required because the amount of the taxpayers' at-risk capital required a further partner-level determination. The appellate court agreed with the taxpayer that, regardless of whether partner-level determinations were necessary, the IRS was required to issue notices of deficiency since the assessments were not computational adjustments. However, the court noted that the omission of the deficiency notices was harmless because the taxpayers had voluntarily paid the taxes prior to collection proceedings, and there was no showing that challenging the deficiencies in the Tax Court would have made a difference. Thus, the taxpayers were liable for the taxes due on the additional income.

In Petaluma FX Partners, (9) a taxpayer contributed offsetting long and short foreign currency options to a partnership. He increased his basis to reflect the contribution of the long options but did not decrease the basis by the liability related to the short options. The partner withdrew from the partnership two months later by receiving cash and marketable securities. The taxpayer reported a loss on the sale of the marketable securities because he did not adjust his basis for the contribution of the short options. The IRS later issued an FPAA that treated the partnership as a sham and reduced the basis of all assets in the partnership to zero, eliminating the loss on the stock sale. The taxpayer claimed that the Tax Court lacked jurisdiction to consider what he characterized as nonpartnership items, including the partner's outside basis. The court ruled that whether the partnership was a sham was a partnership item, so the court had the jurisdiction to determine that the partner's outside basis was zero.

The taxpayer appealed the Tax Court's decision this year. (10) The appellate court determined that the Tax Court did have jurisdiction to determine that the partnership was a sham that should be disregarded for tax purposes. However, the appellate court reversed the Tax Court's ruling that it had jurisdiction to determine that the partners had no outside basis in the partnership. In addition, the Tax Court's holding that it had jurisdiction to determine whether accuracy-related penalties applied and that the valuation misstatement penalties did not apply was set aside until it could be determined if the taxpayers owed any additional tax.

In another case, (11) the partnership filed a tax return reporting that the partnership was not subject to TEFRA. When the IRS audited the return, it did not initiate the standard TEFRA procedures but rather applied its normal deficiency procedures for entities not subject to TEFRA. Based on this audit, the IRS issued an FPAA notifying the partnership that no adjustment would be made. Later the IRS agent realized that the partnership was subject to TEFRA and issued a second FPAA, which included an adjustment to income. The taxpayer sued, claiming that the second FPAA was invalid and that the first FPAA should be the only closing agreement used in the process. The IRS countered that the second FPAA should be considered because the partnership misrepresented that it was not subject to TEFRA and, under the rules of Sec. 6223(f), the IRS is allowed to send a second FPAA if there is a showing of either "fraud or malfeasance...