COURT DENIES REFUND SUIT SEEKING RETURN OF VALUATION MISSTATEMENT PENALTY.

The Krauses filed their claim for a refund of the penalties with the IRS on March 6, 2008. Am. Compl. at ¶ 3; Ex. A. They contend the IRS cannot assess a valuation misstatement penalty under § 6662(h) for disallowing a deduction. Pl. Mot. Ex. A. The IRS did not respond, and so the Krauses brought this suit. Id. at ¶ 10. The U.S. contends the Krauses are barred from challenging the applicability of the penalty by I.R.C. § 7422(h) because this is an individual action for a refund attributable to partnership items. Def. Mot. at 2. The parties filed cross-motions for summary judgment.

Both parties bear burdens of production in the summary judgment process. Celotex Corp. v. Catrett, 477 U.S. 317 (1986). The moving party has the initial burden of showing there is no genuine issue of any material fact and judgment should be entered as a matter of law. FED. R. CIV. P. 56(c); Celotex, 477 U.S. at 322-23; Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247-48 (1986). The nonmoving party must then come forward with competent evidentiary materials establishing a genuine fact issue for trial, and may not rest upon mere allegations or denials of its pleadings. Anderson, 477 U.S. at 256-57; Matsushita Elec. Indus. Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 586-87 (1986). Neither "conclusory allegations" nor "unsubstantiated assertions" will satisfy the non-movant's burden. Wallace v. Tex. Tech Univ., 80 F.3d 1042, 1047 (5th Cir. 1996).

A. Partnership Adjustments under TEFRA

Partnerships are not taxable entities. I.R.C. § 701. Therefore, rather than file tax returns, partnerships simply file informational returns. Id. § 6031. Each partner then reports all of the partnership items on his tax return.²See id. §§ 701-704. Prior to 1982, adjustments to partnership items were determined at the level of the individual partners, resulting in duplicative litigation and inconsistent results.

To solve this problem, Congress enacted the unified audit and litigation procedures of TEFRA which created a single unified procedure for determining the tax treatment of all partnership items at the partnership level. See id. §§ 6221-6233. TEFRA requires the IRS to notify partners when it undertakes an administrative proceeding to adjust a partnership item. Id. § 6223(a)(1). If the IRS decides to adjust any partnership items, it issues an FPAA to the partners reflecting the adjustments and any penalties. Id. § 6223(a)(2). If no partner files a petition contesting the FPAA within 150 days, the FPAA adjustments become final and the IRS may adjust the tax liability of the partners accordingly. See id. § 6225; § 6230(a); Randell v. United States, 64 F.3d 101,108 (2nd Cir. 1995) ("When no valid petition is filed, the tax treatment of partnership items as set forth in the partnership return and as administratively adjusted by the IRS becomes conclusively established and may not thereafter be contested.").

Once the FPAA has become final, if a partner has a reasonable cause defense to any penalty, or believes the IRS has made a computational error in applying the partnership adjustment to him, the partner may bring a refund suit. See id. § 6230(c). If a partner has a dispute regarding the FPAA adjustment and penalty itself, however, "TEFRA requires the treatment of all partnership items to be determined at the partnership level" not the refund suit. Weiner v. Commissioner, 389 F.3d 152, 154 (5th Cir. 2004); see also Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 547 (5th Cir. 2009) ("Under TEFRA, the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item) shall be determined at the partnership level") (citing I.R.C. § 6221).

In this case, the IRS issued the FPAA in October, 2006, indicating it was adjusting the deductions the KAAS partnership claimed in 2002 and 2003 and applying accuracy-related penalties. Def. Mot. App. [#21], Ex. 13. Specifically, the FPAA determined the adjustments were "attributable to a tax shelter" and imposed a forty percent penalty for the underpayments. Id. at ¶ 14. The Krauses admit they did not contest the FPAA. Pl. Mot. at ¶ 10. The IRS then adjusted the tax liability of the Krauses, based on the FPAA, increasing their tax owed and assessing the penalty identified in the FPAA. See Pl. Mot. ¶¶ 9-11.

B. The Refund Suit

While it seems clear a penalty is a partnership item, properly addressed in the TEFRA proceeding or in the finalized FPAA if it goes unchallenged, section 6230(c)(1)(C) muddies the waters a bit. If a partner believes a penalty was incorrectly assessed against him following a determination at the partnership level, section 6230(c)(1)(C) provides that the partner may file a claim for refund on the grounds "the Secretary erroneously imposed any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item." While this seems to validate suits like this one, section 6230(c)(4) clarifies what components may actually be contested during a refund claim filed under section 6230(c)(1).

Under section 6230(c)(4), there is no review of substantive issues relating to penalties. "The determination under the [FPAA] . . . concerning the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item shall be conclusive." I.R.C. § 6230(c)(4) (emphasis added). However, "the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment." Id. Read together, sections 6221 and 6230 thus provide that a partner is only allowed to raise partner-level defenses to a penalty imposed during a partnership-level proceeding in a refund action later filed under section 6230(c). See New Millennium Trading, L.L.C. v. Commissioner, 131 T.C. No. 18, 2008 WL 5330940 at *4 (T.C. 2008); Ackerman v. United States, 643 F.Supp.2d 140, 149-151 (D.D.C. 2009).

In Heasley v. Commissioner, the Fifth Circuit held "[w]henever the IRS totally disallows a deduction or credit, the IRS may not penalize the taxpayer for a valuation overstatement included in that deduction or credit. In such a case, the underpayment is not attributable to a valuation overstatement. Instead, it is attributable to claiming an improper deduction or credit." 902 F.2d 380, 383 (5th Cir. 1990). The Krauses rely on this case, and others reinforcing its holding, to assert the valuation misstatement penalty is not appropriate. There is a significant problem with this argument, which is decisive in this case: These cases did not deal with partnership penalties and the accompanying body of TEFRA law and thus do not apply.

The Krauses did not make any of these arguments at the partnership-level. In fact, as discussed above, the Krauses did not dispute the IRS adjustments or penalties in the FPAA before it was finalized. Pl. Mot. at ¶ 10. The Court thus does not address the merits of their Heasley argument, because they did not challenge it at the partnership level.³ All partnership-level defenses must be presented at the partnership level, and the applicability of a penalty is a partnership-level defense. See I.R.C. § 6221; § 6230.

The Krauses seem to imply they are bringing this case on partner-level defenses for the "14 different bases on which Defendant sought to disallow a loss deduction as compared to the smaller number of separate grounds which relate to any partnership adjustment." Pl. Resp. at ¶ 12. The Krauses miss the point. Once the partnership adjustment is made, the IRS does not need to separately adjudicate how that adjustment applies to the partners. It merely calculates the effect of the partnership adjustments and penalties on the partners' taxes. Thus, partners can bring refund suits alleging computational errors, or their own reasonable cause defense, but they cannot bring refund suits alleging the penalty applied to the partnership in the FPAA was illegal because of its effect on them. See I.R.C. § 6230(c)(4). The Krauses do not assert a reasonable cause defense, nor claim there was a computational error in passing the partnership adjustment onto them. Rather, they assert the penalty is illegal because "the IRS may not legally assess a valuation misstatement penalty in cases where all that occurred was the disallowance of a deduction." Id. ¶ 12.

This is the exact sort of multiple litigation and possible inconsistent results TEFRA sought to eliminate. The Krauses could have made this argument at the partnership level, contending the partnership could not legally be penalized in this manner. It is a partnership-level argument. Merely because they chose not to contest the FPAA, does not allow them to assert partnership-level arguments at the later refund suit. By definition, all of these issues were conclusively determined when the FPAA was finalized. See I.R.C. § 6225; § 6230(a). Unless the Krauses wish to raise partner-level defenses, none of which are raised in this case, the partnership-level hearing was the time to dispute the penalties. Congress wanted to eliminate multiple litigation of the same issues by multiple partners and chose to do so by making the TEFRA hearing the place where most challenges occur, except those personal defenses of computational error or reasonable cause good faith. Id.

IT IS ORDERED that Defendant the United States' Motion for Summary Judgment [#20] is GRANTED;

IT IS FURTHER ORDERED that Plaintiffs J. Winston Krause and Sheri S. Krause's Motion for Summary Judgment [#15] is DENIED.

SIGNED this the 22nd day of January 2010.

² Partnership items are defined not only as any item related to calculating partnership income, loss, deductions, and credits, but also legal and factual determinations of the amount, timing, and characterization of those items. See I.R.C. § 6231(a)(3); Treas. Reg. § 301.6231(a)(3)-1.

³ The Court notes, however, the Fifth Circuit is in the distinct minority, even in its application of this rule to non-partnership cases. See Clearmeadow Investments, LLC v. United States, 87 Fed. Cl. 509, 532 (Fed. Cl. 2009) (discussing this rule as applied to individual taxpayers throughout the country -- the Fifth and Ninth Circuits are the only two to adopt this interpretation).