Federal Income Taxation
| Publication year | 2023 |
Federal Income Taxation
Andrew Todd
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In 2022, the United States Court of Appeals for the Eleventh Circuit issued two published opinions involving U.S. federal income tax issues.1 The first opinion, Sarma v. Commissioner,2 addressed procedural issues arising under the unified partnership audit procedures that were added to the Internal Revenue Code3 by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).4 The second opinion, Kroner v. Commissioner,5 addressed an issue of first impression in this circuit concerning supervisory review of tax penalties.6 This Article surveys both of those opinions.
Different procedures govern how the Internal Revenue Service (IRS) conducts audits of partnership tax returns based on the taxable year involved.7 In Sarma v. Commissioner, the Court of Appeals for the Eleventh Circuit considered procedural issues under the TEFRA's
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unified partnership audit procedures.8 Agreeing with the United States Tax Court, the court of appeals found for the IRS on all issues presented on appeal.9
A. Overview of TEFRA Partnership Audit Procedures
Prior to the enactment of the TEFRA, the Internal Revenue Code did not provide a mechanism for the IRS to conduct audits of items attributable to partnerships in a single, unified proceeding.10 Instead, the IRS was required to audit each partner individually under normal deficiency proceedings.11 This led to inconsistent results among partners due to duplicative proceedings involving the same items.12 By the late 1970s, the partnership had emerged as the vehicle of choice for financing and investment vehicles—in addition to syndicated tax shelters—with many unrelated partners.13 Conducting partner-by-partner audits imposed significant administrative burdens on the IRS, which Congress sought to alleviate by enacting new partnership audit provisions in the TEFRA.14
The TEFRA regime features a two-tiered structure for resolving partnership tax matters.15 First, a single partnership-level proceeding is used to adjust or determine "partnership items."16 "[P]artnership-related item[s]" are items that are required to be taken into account for the partnership's taxable year17 and are more appropriately determined at the partnership level (rather than at the partner level).18 When challenging a partnership item, the IRS will commence an administrative proceeding against the partnership and provide notice to the partnership (and possibly certain partners) of the commencement of such proceeding.19 At the conclusion of the partnership-level proceeding, the IRS notifies the partners of adjustments to partnership items by
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issuing a notice of final partnership administrative adjustment (FPAA).20 Adjustments made to partnership items are subject to judicial review in a partnership-level proceeding.21
Once partnership-level adjustments become final, the IRS determines whether any partner-level adjustments are required.22 If an adjustment does not require partner-level factual determinations, the IRS can directly assess the adjustment against the partner without going through the normal deficiency procedures, leaving the partner without a prepayment right to judicial review.23 However, if an adjustment to an affected item24 requires partner-level factual determinations, the IRS must issue the partner an affected item notice of deficiency (AIND) and follow the normal deficiency procedures.25 Partners have a prepayment right to judicial review of an AIND.26
The TEFRA regime applied to all partnerships that filed partnership returns.27 However, for purposes of the TEFRA regime, the term "partnership" does not include "small partnerships."28 A "small partnership" is a partnership with ten or fewer partners consisting only of individuals, C corporations, or the estate of a deceased partner.29 A partnership cannot be a small partnership if it has a partner that is classified as a partnership for U.S. federal income tax purposes.30 The determination of whether a partnership is a small partnership is made each taxable year.31 If a partnership is a small partnership, then the TEFRA regime does not apply absent an election to the contrary, and such partnership's tax items are challenged through partner-level deficiency proceedings.32
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B. Facts of the Case
Raghunathan Sarma,33 a business owner, realized an $80.9 million capital gain in 2001 when he sold a division of his company.34 In an attempt to avoid paying tax on that gain, Sarma participated in a tax avoidance scheme called "Family Office Customized Partnership," or "FOCus."35 FOCus was marketed by Bricolage Capital, LLC (Bricolage) and the accounting firm KPMG to wealthy individuals with recent large liquidity events. At a high level, FOCus involves using multiple partnership tiers to generate artificial gains and losses.36
Sarma's FOCus vehicle consisted of three partnerships: Nebraska Partners Fund, LLC (Nebraska), Lincoln Partners Fund, LLC (Lincoln), and Kearney Partners Fund, LLC (Kearney) (referred to collectively as the Partnerships).37 Nebraska owned a 99% interest in Lincoln, which owned a 99% interest in Kearney. A Bricolage-affiliated C corporation owned the remaining 1% interest in each Partnership.38
Kearney executed a series of offsetting foreign currency exchange forward contracts (the Straddles).39 Kearney closed the gain legs of its Straddles, generating a gain of $79.1 million. The proceeds were placed in certificates of deposit. The loss legs of the Straddles were not closed out, but the unrealized losses in those legs were effectively locked in.40
Mr. Sarma purchased a 99% interest in Nebraska on December 4, 2001.41 This triggered a technical termination of the Partnerships, resulting in each partnership having a short taxable year that ended on December 4, 2001.42
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On December 14, 2001, Nebraska sold its 99% interest in Lincoln to Sarma, triggering a technical termination of Lincoln and Kearney.43 Lincoln and Kearney each reported short tax periods from December 5—14, 2001. Application of the technical termination rule resulted in the deemed formation of two new partnerships for U.S. federal income tax purposes: (1) Lincoln, with Sarma as 99% partner and the Bricolage-affiliated C corporation as 1% partner; and (2) Kearney, with the new Lincoln as 99% partner and the Bricolage-affiliated C corporation as 1% partner. Lincoln filed a partnership tax return with Sarma as a partner for the short tax period of December 15—31, 2001 (the Dec. 31, 2001 tax period), as well as for the years 2002 through 2004.44
On December 19, 2001, Lincoln sold its interest in Kearney to a Bricolage-related entity for $737,118 (the Kearney Sale).45 At the time of the sale, Lincoln reported its outside basis46 in Kearney as $79,110,062, resulting in a $78,392,194 short-term capital loss. Lincoln allocated $77,608,272 of this loss to Sarma as its 99% partner. Taxpayers deducted this loss on their 2001 joint U.S. federal income tax return and carried portions of the loss forward to 2002, 2003, and 2004.47
The IRS examined the Partnerships' tax returns for the short periods, as well as the Taxpayers' 2001 tax return.48 It concluded that the transactions lacked economic substance and should be disregarded for U.S. federal income tax purposes. The IRS issued numerous FPAAs to the Partnerships for several of the short tax years. However, Lincoln was not issued an FPAA for the December 31, 2001 tax period because it was a small partnership during that time.49
The Partnerships challenged the FPAAs in the United States District Court for the Middle District of Florida.50 The district court found that the transactions involving the Partnerships and the Straddles were completed only for tax avoidance purposes, lacked economic substance and a legitimate business purpose, were not entitled to respect for tax purposes, and that Kearney was a sham and should be disregarded for
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tax purposes.51 Accordingly, the district court sustained the IRS's adjustments, reducing Kearney's gain and loss from the Straddles to zero.52 Kearney unsuccessfully appealed the district court's decision,53 and "[t]he partnership-level proceeding became final on January 11, 2016."54
The results of the Kearney partnership-level proceeding affected Lincoln's outside basis in Kearney.55 Under TEFRA, courts lack authority to adjust a partner's outside basis during partnership-level proceedings, so a partner-level proceeding was required to adjust Lincoln's outside basis in Kearney.56
On September 9, 2016, the IRS issued an AIND to the Taxpayers (the 2016 Notice).57 In that notice, the IRS disallowed the $77.6 million loss deduction that Lincoln allocated to Sarma following the Kearney Sale. Taxpayers challenged the notice of deficiency in the Tax Court. The Tax Court decided three main issues, finding for the IRS on all three.58
C. Issues Presented59
1. Was the Assessment Barred by the Statute of Limitations?
Generally, the statute of limitations for the assessment of U.S. federal taxes is three years from the date of payment of the tax or the date on which the associated tax return was filed, whichever is later.60 However, a special statute of limitations applies with respect to "partnership items" and "affected items" under the TEFRA regime.61
With respect to "partnership items" and "affected items" of partnership returns subject to the TEFRA regime, the limitations period
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is triggered upon the filing of a partnership return.62 The timely mailing of an FPAA under the TEFRA regime suspends the running of the limitations period until one year following the final resolution of the proceedings.63 However, for small partnerships, the limitations period is generally triggered by filing the partner's tax return (rather than the partnership's return).64 The Tax Court found that Lincoln's outside basis in Kearney was...
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