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Supreme Court won’t review case on partner’s ability to make partial election out of TEFRA

JT USA LP; JTR-LLC; Tax Matters Partner, (CA 9 11/14/2014) 114 AFTR 2d 2014-6608, cert denied 10/5/2015

The Supreme Court has declined to review a decision of the Court of Appeals for the Ninth Circuit that held that unless a partner elects to have all of his or her partnership items treated as nonpartnership items, the partner cannot elect out of a partnership administrative proceeding under TEFRA.

Background. Under the unified partnership audit rules (i.e., the so-called TEFRA rules because they were introduced in the Tax Equity And Fiscal Responsibility Act of ’82), the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) is generally determined at the partnership level. (Code Sec. 6221) If IRS decides to adjust any partnership items, it must notify the individual partners through a final partnership administrative adjustment (FPAA). (Code Sec. 6226) For 90 days after issuing an FPAA, the tax matters partner (TMP) has the exclusive right to file a petition for readjustment of the partnership items in the Tax Court, the Court of Federal Claims, or a U.S. District Court. (Code Sec. 6226(a)) After that period expires, other partners have 60 days to file a petition for readjustment. (Code Sec. 6226(b)(1))

Code Sec. 6223(a) provides that IRS must notify certain partners of the beginning and end of a partnership audit. For an indirect partner owning an interest in the partnership through a pass-thru partner who would otherwise be entitled to notice, IRS must give notice to the indirect partner, in lieu of the pass-thru partner, if IRS is properly furnished with information as to the indirect partner’s name, address, and indirect profits interest in the partnership.

Except as provided in the next sentence, if (A) IRS fails to mail to a notice-entitled partner timely notice of the beginning of a partnership-level administrative proceeding, or timely notice of a FPAA, and (B) the Code Sec. 6223(e)(2) rules relating to the options and elections available to partners where IRS fails to send them timely notices of proceedings, and the proceedings are finished, don’t apply, then (C) the partner’s automatically a party to the proceeding. (Code Sec. 6223(e)(3), Reg. § 301.6223(e)-2(c) ) The exception applies if that partner elects:

1. to have a “consistent settlement agreement” with respect to the partnership tax year to which the proceeding relates, apply to him; (Code Sec. 6223(e)(3)(A)) or
2. “to have the partnership items of the partner for the partnership taxable year to which the proceeding relates treated as nonpartnership items.” (Code Sec. 6223(e)(3)(B))

If he makes either election (1) or (2), a partner won’t be a party to the proceeding.

Facts. John Ross Gregory and his wife, Rita, founded a business selling motocross and paintball accessories which became JT USA, LP. In disposing of their business, the Gregorys used what IRS alleged was a tax shelter to create losses large enough to offset their gain. Early in 2000, prior to the sale, the Gregorys held interests in JT, LP both directly and indirectly, through JTR-LLC (general partner) and JTR-Inc. (limited partner). At the time of the sale, late in 2000, JT USA was wholly owned by the Gregorys indirectly through the aforementioned entities.

In its challenge to these losses, IRS made procedural errors. Some time after JT USA timely filed its 2000 tax return, IRS sent the wrong notice to JT USA just before the statute of limitations expired. IRS issued a FPAA to partnership JT USA and its partners without providing a notice under Code Sec. 6223(a). The Gregorys responded by attempting to opt out of the partnership-level proceeding in their capacity as indirect partners.

Tax Court sided with taxpayers. In holding for the taxpayers, the Tax Court concluded that a taxpayer owning both direct and indirect interests in a partnership may elect under Code Sec. 6223(e)(3)(B) not to be bound by the results of a partnership proceeding — or partnership audit — as to some, but not all, of those interests held during the relevant tax year. In other words, the Tax Court held that Code Sec. 6223(e)(3)(B) permits the taxpayers to opt out of the partnership proceeding with respect to their indirect interests but to leave in that proceeding their alleged remaining direct partnership interests. Under the Tax Court’s holding, the assessment of deficiencies flowing from IRS’s disallowance of the tax-shelter losses would be time-barred. (JT USA, (2008) 131 TC 59131 TC 59)

Ninth Circuit reversed. The Ninth Circuit pointed out that Code Sec. 6223(e)(3)(B) provides that a “partner” may elect “to have the partnership items of the partner for the partnership year to which the administrative proceedings relate treated as nonpartnership items.” The Code specifies “the partner,” not an indirect partner or any other subset of the term “partner” as defined in Code Sec. 6231(a)(2). Moreover, it noted that Code Sec. 6223(e)(3)(B) allows the partner to have “the partnership items” (plural) of that partner treated as nonpartnership items, not some of that partner’s items to be treated as such. (For more details on the Ninth Circuit’s decision, see Weekly Alert ¶  45  11/20/2014.)

The Ninth Circuit held that the meaning of the Code Sec. 6223(e)(3)(B) language was clear and unambiguous, and it means — as IRS argued — that unless a partner elects to have all of his or her partnership items treated as nonpartnership items, the partner cannot elect out of the TEFRA proceeding. Accordingly, a partner in a TEFRA proceeding such as the one at issue is limited under Code Sec. 6223(e)(3)(B) to a single election: either all in or all out.

The Ninth Circuit cited legislative history, as well as relevant regs, to shore up its conclusion that the Tax Court’s reading of Code Sec. 6223(e)(3)(B) was incorrect. It also held that IRS’s sloppy administrative errors, including mailing the wrong form letter to the taxpayers, were not sufficient either to require a different outcome or to stop IRS from pursuing the matter and its claims. Thus, because it held that the taxpayers’ disputed elections to opt out were invalid, the Ninth Circuit remanded for further proceedings consistent with its opinion. (One dissenting judge, however, would have affirmed the Tax Court, reasoning that since TEFRA allows one partner to make one election and another partner to make a different election, a partner who has both direct and indirect interests should have the same option, at least where IRS fails to timely notify the taxpayer that a bifurcated election is not allowed.)

The Ninth Circuit subsequently denied a request for rehearing on Mar. 17, 2015, and a petition for Supreme Court review was filed on June 12, 2015.

Decision now final. The Supreme Court has declined to review this case. Accordingly, the Ninth Circuit’s decision is now final.

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.

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