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, 2010-October31, 2011), 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. In addition, as part of health care legislation, Congress codified the economic substance doctrine. (1)

TEFRA Issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (2) 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 the correct statute of limitation period. Last year, the IRS noted in a chief counsel advice that a payment from a partnership to a partner other than in the partner's capacity as a partner under Sec. 707 would be a partnership item for TEFRA purposes. (3) Several court cases also addressed this and related issues.

In Petaluma FX Partners, (4) a partner 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 a final partnership administrative adjustment (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 jurisdiction to determine that the partner's outside basis was zero. The Tax Court also held that it had jurisdiction to determine whether accuracy-related penalties applied and that the valuation misstatement penalties did not apply.

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In 2010 the taxpayer appealed the decision. (5) The D.C. Circuit 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 court set aside the Tax Court's holdings regarding the penalties until it could be determined whether the taxpayers owed any additional tax.

On remand, the Tax Court (6) had to determine whether it had jurisdiction over the accuracy-related penalties. In this case, none of the adjustments were items that flowed directly to the partner-level deficiency computation as computational adjustments. Therefore, any deficiencies had to be determined against the partners as affected items and must be resolved in separate partner-level deficiency procedures, the Tax Court held. Based on the D.C. Circuit's decision, the Tax Court would have jurisdiction over a penalty at the partnership level only if it related to an adjustment of a partnership item. The adjustment also had to be capable of being computed without partner-level proceedings, leading at least potentially to only a computational adjustment to the partners' returns. Thus, the Tax Court determined that, since none of the FPAA adjustments were partnership-level adjustments, it did not have jurisdiction to levy any penalties on the partner.

In a case of who may appeal an FPAA, (7) the Third Circuit Court of Appeals affirmed a Tax Court decision that a partner who was not a tax matters partner (TMP) could file a petition for readjustment with respect to an FPAA only if the TMP did not file a readjustment petition within the 90-day period allowed under Sec. 6226(a). In this case, the Tax Court had determined that the TMP for the partnership was another partner, and because that partner had filed a readjustment petition, the court lacked jurisdiction to hear the other partner's petition.

Statutes of Limitation

Several cases concerned the appropriate statute of limitation, especially where taxpayers had, arguably, understated gross income by overstating basis. In Carpenter, (8) the IRS argued that the six-year limitation period in Sec. 6229(c) (2) and Sec. 6501(e) (1)(A) applied, while the taxpayer asserted that the general three-year limitation period in Sec. 6501(a) governed the timeliness of the FPAA. At issue was a transaction that the IRS determined to be a variant of the son-of-boss tax shelter. Thus, it disallowed a step-up in basis for an asset that was sold. Consequently, the IRS determined that the taxpayer had underreported gain on the sale of the asset.

The IRS contended that the appropriate statute of limitation should be six years because the omission of income exceeded 25% of gross income. The taxpayers argued that the overstatement of basis did not constitute an omission from gross income, so the extended limitation period should not apply. The Tax Court determined that it could not speculate on how the Congress that enacted Sec, 6501(e) (1) (A) in 1954 would have meant it to apply in the present-day context. The court said it could not even ask what the statute meant; instead, it merely asked what the Ninth Circuit and the U.S. Supreme Court told it the statute meant. The Ninth Circuit had concluded (9) that Colony, Inc., (10) controlled the meaning of the phrase "omits from gross income," as it had appeared in a predecessor to Sec. 6501(e) (1) (A) (where it also appears). The Supreme Court in Colony determined that the phrase did not include an overstatement of basis. Thus, the Tax Court in this case held that only a three-year limitation period under Sec. 6501(a) applied. Consequently, the FPAA issued after the expiration of the three-year period was untimely, and the taxpayer's and the partners' consents to extend the period were invalid.

The same issue arose in Home Concrete & Supply LLC. (11) The taxpayers filed a 1999 tax return that reported a sale of partnership assets, the basis of which had been stepped up under Sec. 734, resulting in a loss on the sale. The information about the step-up was included in the tax return. The IRS did not audit the return until 2003 and did not issue an FPAA until 2006. In the FPAA, the IRS disallowed all losses from the sale of the assets because it classified the formation and activity of the partnership as a tax sham that had no economic substance.

A district court ruled in favor of the government, holding that the taxpayer's overstatement was an omission from gross income and that it could not invoke the disclosure safe-harhor provision under Sec. 6501 (e)(1)(A)(ii).(12) Thus, the FPAA was timely filed under the six-year limitation period of Sec. 6501(e)(1)(A), the district court held.

On appeal last year, the Fourth Circuit reversed the decision based on Colony, concluding that the overstatement of basis in property was not an omission from gross income that extended the limitation period under Sec. 6501(c)(1)(A), and the taxpayers' overstated basis did not trigger the six-year statute of limitation. Instead, the general three-year statute of limitation applied; therefore, the FPAA was untimely, the court held.

The IRS had argued that Regs. Sec. 301.6501(c)-1, which the IRS issued after litigation in Home Concrete began, required the application of the six-year statute. The IRS further argued that the court must apply the regulation because, under the Chevron (13) standard, which the Supreme Court held in Mayo (14) applied to all tax regulations, the court was required to give deference to IRS regulations that interpret ambiguous statutes, as long as the IRS's interpretations are not arbitrary or capricious. According to the Fourth Circuit, however, the Chevron standard should not be applied in this case because Sec. 6501(e) (I )(A) called for a three-year limitation period, and the Supreme Court had held in Colony that the predecessor statute to Sec. 6501(e)(1)(A) was not ambiguous.

Another case involving the same issue in the Tenth Circuit came to a different conclusion. Originally, in Salman Ranch Ltd., (15) the Tax Court relied on Colony and held that an overstatement of basis was not an omission of income and therefore the extended limitation period (six years) did not apply. In response to the losses in this and other prior cases regarding whether the overstatement of basis constituted an omission of income, Treasury issued the final regulations, which provide that, except in the context of income from the sale of goods and services by a trade or business, "an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income." (16)

Last year, when the Tenth Circuit (17) heard the Salman Ranch appeal, it held that a partnership's gross income included gain that required calculating the excess of the amount realized over adjusted basis; thus, an omission from gross income included an overstatement of the basis figure used to derive the gain. Therefore, the partnership's full report of the amount received from the sale was not by itself sufficient to preclude an omission from gross income.

In coming to this conclusion, the court reasoned that Sec. 6501(e)(1)(A) was ambiguous as to Congress's intent for...