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Applicability of penalties may be determined in partnership level proceeding

Petaluma FX Partners LLC, (CA DC 6/26/2015) 115 AFTR 2d ¶ 2015-863

In the latest in a long series of cases involving whether certain issues can be decided in partnership-level court proceedings, the Court of Appeals for the District of Columbia has held that the Tax Court, in a partnership-level proceeding, had jurisdiction to determine the applicability of accuracy-related penalties to partners.

Background. The Tax Equity and Fiscal Responsibility Act of ’82 (TEFRA) establishes a two-stage process for review of partnership tax issues, consisting of (i) a partnership-level proceeding concerning the partnership as a whole, followed by (ii) partner-level proceedings for each individual partner. With regard to the former, if IRS disagrees with a partnership’s return, it can bring a partnership-level proceeding in which it may adjust “partnership items,” (Code Sec. 6221), which are defined as items “more appropriately determined at the partnership level.” (Code Sec. 6231(a)(3))

A partnership-level proceeding culminates in IRS’s issuance of a Notice of Final Partnership Administrative Adjustment (FPAA), which is subject to judicial review in the Tax Court, the Court of Federal Claims, or federal district court. (Code Sec. 6226(a)) A reviewing court has jurisdiction to determine: “all partnership items”; the allocation of those items among the partners; and “the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item.” (Code Sec. 6226(f))

Code Sec. 6233 provides that, to the extent provided in regs, the provisions of TEFRA apply to an entity that files a partnership return for a tax year but that is later determined to not actually be a partnership for such year. A temporary reg (the Temporary Reg) prescribes that any FPAA or judicial determination resulting from a partnership-level proceeding may include a determination that “there is no entity for such tax year,” as well as “determinations with respect to all items of the entity which would be partnership items…if such entity had been a partnership in such tax year.” (Reg. § 301.6233-1T(a), Reg. § 301.6233-1T(c)(1))

Thereafter, IRS issued a final reg under Code Sec. 6233 (the Final Reg) that, while it withdrew the Temporary Reg, did not change the above-cited portion of the Temporary Reg. The effective date portion of the final reg states, for tax years beginning before Oct. 4, 2001, “see Reg. § 301.6233-1T.” Thus, the rules set forth in the Temporary Reg control for tax years beginning before Oct. 4, 2001.

In Woods, (2013) 112 AFTR 2d 2013-6974112 AFTR 2d 2013-6974, the Supreme Court held that: (i) courts have jurisdiction in partnership-level proceedings to determine that a partnership is a sham and will be disregarded for tax purposes, and (ii) courts lack jurisdiction in partnership-level proceedings to determine an individual partner’s basis in his partnership interest (outside basis). With respect to the latter determination, the Court went on to hold, however, that courts in partnership-level proceedings have jurisdiction to determine the applicability of accuracy-related penalties to a partner, “even if imposing the penalty would also require determining… items such as outside basis.”

Facts. Petaluma was a “Son of BOSS” partnership; R.T. Vanderbeek and R.S. Vanderbeek were the sole partners. A Son of BOSS shelter generally makes use of a series of offsetting financial transactions aimed to generate artificial financial losses, with those losses in turn artificially reducing taxable income. In Notice 2000-44, 2000-2 CB 255, IRS formally identified Son of BOSS tax shelters as abusive transactions.

IRS issued an FPAA to Petaluma and its partners for tax year 2000. The FPAA concluded that Petaluma lacked economic substance and was thus a sham that would be disregarded for tax purposes. The FPAA reduced to zero the Vanderbeeks’ outside bases. Finally, the FPAA determined that the accuracy-related penalties applied to the partners’ underpayments of tax.

Petaluma timely filed a petition for readjustment of the FPAA in the Tax Court. During the initial Tax Court proceedings, Petaluma stipulated to the correctness of most of the adjustments made by the FPAA but challenged the Tax Court’s jurisdiction. The Tax Court concluded that it had jurisdiction to determine: (i) that Petaluma was a sham; (ii) that the Vanderbeeks had no outside basis in Petaluma because “there can be no adjusted basis in a disregarded partnership”; and (iii) that accuracy-related penalties would be applicable to Petaluma’s partners. (Petaluma FX Partners LLC, (2008) 131 TC 84131 TC 84)

Petaluma appealed this holding, and the Appeals Court concluded that the determination of outside basis must await a subsequent partner-level proceeding. It remanded the case to the Tax Court to decide whether it could determine the applicability of penalties without taking into account the outside basis of individual partners. (Petaluma FX Partners LLC, (CA DC 2010) 105 AFTR 2d 2010-435105 AFTR 2d 2010-435) The Tax Court held that it lacked jurisdiction in a partnership-level proceeding to determine the applicability to the Vanderbeeks of accuracy-related penalties. (Petaluma FX Partners LLC, (2010) 135 TC 581135 TC 581)

IRS then appealed this Tax Court holding. The Appeals Court held the case in abeyance pending the Supreme Court’s holding in Woods.

Appeals Court finds that the Tax Court had jurisdiction. The Appeals court held that the Tax Court had jurisdiction to determine the applicability of accuracy-related penalties to the partners in its partnership-level proceeding.

The Court first concluded that, of the three jurisdictional questions raised by this case, it had previously resolved two—jurisdiction to make a sham determination and jurisdiction to determine the outside basis of individual partners—in a manner subsequently endorsed by the Woods Court. The remaining jurisdictional issue concerned whether jurisdiction exists in partnership-level proceedings to determine the applicability of penalties to the partners of a sham partnership, including penalties that relate to nonpartnership items such as outside basis. It concluded that, under Woods, the Tax Court had that jurisdiction.

However, Petaluma contended, notwithstanding Woods, that the Tax Court lacked jurisdiction in this partnership-level proceeding to make any determinations concerning Petaluma or its partners, including the determination that the partners were subject to accuracy-related penalties. Petaluma argued that: a) Code Sec. 6226(f)’s grant of jurisdiction extends to sham partnerships only if a reg promulgated under Code Sec. 6233(b) so provides; b) that extension came about by virtue of the Temporary Reg; c) the Temporary Reg is invalid; and therefore d) the Tax Court had no valid basis upon which to assert jurisdiction in this partnership-level proceeding.

Petaluma challenged the validity of the Temporary Reg on the ground that its promulgation failed to comply with both the Administrative Procedure Act’s (APA’s) “notice-and-comment” requirements and the APA’s mandate that agencies publish a substantive rule at least thirty days before its effective date.

In rejecting this argument, the Court first said that Petaluma’s challenge to the Temporary Reg presumes that the Tax Court would have jurisdiction in this partnership-level proceeding only if a valid reg grants jurisdiction over sham partnerships. But, the Court said, it is unclear whether a reg in fact is necessary to give the Tax Court jurisdiction to decide if a partnership is a sham and if penalties apply against the partners. The Supreme Court’s opinion in Woods concluded that jurisdiction exists over those matters in partnership-level proceedings; and in reaching that conclusion, the Woods Court relied solely on Code Sec. 6226(f) without referencing either Code Sec. 6233(b) or any reg. The Woods Court thus may have assumed that jurisdiction exists in the circumstances of this case by virtue of Code Sec. 6226(f) alone, without regard to regs implementing Code Sec. 6233(b).

Then, the Court said, even assuming arguendo that the Tax Court’s jurisdiction in this case depends on the existence of a valid reg issued under Code Sec. 6233(b) extending TEFRA’s provisions to sham partnerships, Petaluma challenged the validity of the Temporary Reg, but the pertinent reg was the later-promulgated Final Reg. While the Final Reg provides that the rule contained in the Temporary Reg applies to the year at issue (2000), the Final Reg controls for all tax years. Because the Final Reg is the operative reg, Petaluma’s procedural challenges to the now-obsolete Temporary Reg were misdirected. And, the Court said, it was not aware of any basis on which Petaluma could assert those same procedural challenges against the Final Reg.

References: For the unified audit rules for partnerships, see FTC 2d/FIN ¶  T-2100  ; United States Tax Reporter ¶  62,214  ; TaxDesk ¶  825,000  ; TG ¶  70400  .