Partnership Seeks Supreme Court Review of D.C. Circuit Decision on Basis Overstatement

A Notice of Final Partnership Administrative Adjustment ("FPAA") is the Commissioner's notice stating his adjustments to a partnership's return. Here, the Commissioner issued an FPAA to a partnership more than six years after the filing of the partnership's return, but used it to toll the limitations period for an individual partner in the partnership, whose individual return was filed less than six years before the FPAA's issuance.

Under Section 6229(a) of the Internal Revenue Code, the period for assessing tax attributable to partnership items "shall not expire" until three years after a partnership files its tax return. Section 6229(d) of the Internal Revenue Code provides that the timely issuance of an FPAA "suspends the running of the period specified in subsection (a)."

The questions presented are:

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DDM Management, Inc. ("DDM") and UTA Management owned UTAM. (A79, ¶ 61). DDM held a one percent general partnership interest. (A75, ¶ 29). UTA Management held a 99 percent limited partnership. (A79, ¶ 61). Later in 1999, Morgan sold all of his UTA Management stock to American Annuity Group, Inc., for $27,848,493. (A82-83, ¶ 69). Under 26 U.S.C. § 338(h)(10), UTA Management elected to treat the sale of its stock as a deemed sale of its assets, which included its interest in UTAM. (A96, ¶ 124). UTA Management reported the sale of its UTAM interest on its 1999 tax return, including the $27,848,493 sales price, UTA Management's $41,103,132 basis, and UTA Management's $13,256,639 loss on the sale.

2. During 1999, UTA Management increased the basis of its UTAM interest to the amount reported on UTA Management's Form 1120S. (A97, ¶ 129). This increase arose from the following transactions, which the Commissioner stipulates did not trigger the fraud exception to the ordinary limitations period. (A97, ¶ 129; A72-73, ¶ 20; A78-79, ¶ 55). On September 23rd, UTA Management contributed cash to UTAM, along with short sale positions in U.S. Treasury Notes. (A90-91, ¶ 102). UTA Management increased its basis in UTAM by the principal portion of short sale proceeds, without adjustment for the short sale position. (A97, ¶ 130-131). UTA Management did not recognize the transfer of the short sale position as the transfer of a liability, consistent with then-extant court decisions, such as Helmer v. Comm'r, T.C. Memo 1975-160.

Upon closing the short sale position, UTAM incurred a loss of $83,134. UTAM reported the transaction and the loss on its 1999 tax return. (A94-95, ¶ 118).

3. UTAM filed its partnership return on August 15, 2000. The Morgans filed their return on October 16, 2000. (A72, ¶ 13; A77, 49).²

4. The Commissioner issued a Notice of Final Partnership Administrative Adjustment ("FPAA") to UTAM on October 13, 2006, over six years after UTAM filed its return, but less than six years after the Morgans filed their return. (A70, ¶ 1). The Commissioner never issued notices of deficiency to the Morgans. (A78, ¶ 52).

The Commissioner concedes that 26 U.S.C. § 6229(a)'s three-year limitations period expired before he issued the FPAA (A72, ¶ 17). The Commissioner also concedes that he will not assert that any exception to or extension of 26 U.S.C. § 6229(a) applies, including the six-year extended limitations period of 26 U.S.C. § 6229(c)(2) (A72-73, ¶ 20).

5. UTAM timely challenged the FPAA by filing a Petition for Readjustment of Partnership Items under 26 U.S.C. § 6226. The petition challenged both the timeliness and the merits of the FPAA. (A6-34).

UTAM filed a motion for summary judgment, arguing, among other grounds, that the three-year statute of limitations barred the FPAA and that the FPAA is invalid because issuing an FPAA to UTAM did not toll limitations as to the Morgans, including the nonpartnership items that the FPAA adjusted (the Morgans' individual tax basis in UTAM). (A269-277). The Commissioner objected to UTAM's summary judgment motion (A339-344) and cross-moved for partial summary judgment. (A345-354).

On September 24, 2009 -- while the summary judgment motions were pending and after two adverse decisions in the Courts of Appeals, one adverse Court of Claims decision, and at least seven adverse decisions in the Tax Court -- the Commissioner issued temporary Treasury regulations, which interpreted the "omits from income" phrase construed in The Colony, Inc. v. Comm'r, 257 U.S. 28 (1958) ("Colony") to extend the limitations period for understatements of income based on overstatements of basis. 26 C.F.R. §§ 301.6229(c)(2)-1T, 301.6501(e)-1T, T.D. 9466 (2009). Later, without having brought the regulations to the Tax Court's attention while the case was under submission, the Commissioner made the temporary regulations final.

6. The Tax Court granted UTAM's motion and denied the Commissioner's. (A402-411). It concluded that an overstatement of basis does not trigger an extension of the three-year limitations period. (A410). The court did not reach UTAM's alternative argument that the FPAA did not toll the Morgans' limitations period. The Tax Court denied the Commissioner's post-trial motion to reconsider in light of the new regulations. (A459-461).

7. The Court of Appeals for the District of Columbia Circuit reversed the Tax Court. It held, based on its decision in Intermountain Insurance Service of Vail, LLC v. Comm'r, 650 F.3d 691 (D.C. Cir. 2011), that reporting overstated basis on the face of a federal income tax return equates to omitted gross income that may trigger the 26 U.S.C. § 6501(e)(1)(A)'s extended limitations period.

8. The Court of Appeals also found that, even in the absence of a notice of deficiency to the Morgans, the FPAA tolled their individual limitations period despite the fact that the FPAA was issued to UTAM more than six years after UTAM filed its return. It held that the reference in 26 U.S.C. § 6229(d), identifying the "period specified in subsection (a)" as the suspended limitations period, means that an FPAA to a partnership suspends the 26 U.S.C. § 6501 limitations period for an individual partner in the partnership. The court rested this holding on Andantech, LLC v. Comm'r, 331 F.3d 972 (D.C. Cir. 2003), in which it construed 26 U.S.C. § 6229(a) to provide a minimum assessment period, not an independent limitations period.

9. The Commissioner stated in his Home Concrete petition that the case presents the question of whether the "six-year assessment period applies to a tax-avoidance scheme that operated by overstating a taxpayer's basis in property." Home Concrete Pet. at 2. However, Congress definitively resolved that narrow question for the future when it enacted 26 U.S.C. § 6501(c)(10) in 2004. There, Congress enacted a separate statute of limitations for all "listed transactions" entered into after 2004. Listed transactions are those identified by the Secretary of the Treasury as tax avoidance transactions for the purposes of 26 U.S.C. § 6011.

The tax administration issue presented in this petition's third question is whether a partnership notice issued more than six years³ after the partnership filed its tax return serves to suspend an individual partner's otherwise unexpired limitations period when the Commissioner never issues a notice adjusting the individual's tax return during the limitations period.

A. BACKGROUND

However, since 1982, the law has provided special procedures for changing partnership returns. These procedures include a special notice for changes to partnership returns, known as a Notice of Final Partnership Administrative Adjustment, or "FPAA." See 26 U.S.C. § 6226(a). The law requires these special procedures because, although partnerships themselves do not pay income taxes, they still must file informational tax returns each year. See 26 U.S.C. §§ 701, 6031. The individual partners report and pay tax on their distributive shares of the partnership's income on their individual income tax returns. 26 U.S.C. §§ 701-702, 704.

Before 1982, if the Commissioner disagreed with the way a partnership treated an item on its return, he had to change that item on each individual partner's return in separate proceedings against each partner. H. Conf. Rept. 97-760, at 599 (1982), 1982-2 C.B. 600, 662. This sometimes resulted in inconsistent treatment of these items among the partners. Petaluma FX Partners, LLC v. Comm'r, 591 F.3d 649, 650 (D.C. Cir. 2010).

In 1982, Congress enacted the Tax Equity and Fiscal Responsibility Act ("TEFRA") to remedy this issue. Pub. L. No. 97-248, 96 Stat. 324. The tax writing committees explained TEFRA's goal as follows: "The tax treatment of items of partnership income, loss, deductions, and credits will be determined at the partnership level in a unified partnership proceeding rather than in separate proceedings with the partners." H. Conf. Rept. 97-760, at 599 (1982), 1982-2 C.B. 600, 662.

Under TEFRA, when the Commissioner wishes to change items in a partnership's return, he issues an FPAA. 26 U.S.C. § 6226(a). The law limits the scope of TEFRA proceedings to "partnership items."⁴See 26 U.S.C. § 6221, 6226(f); 26 C.F.R. § 301.6226(f)-1. The partners may challenge the change in court. 26 U.S.C. §§ 6226(b)(1), (f). Afterwards, if the IRS prevails, the IRS assesses additional tax against each individual partner consistent with the results of the proceeding. See 26 U.S.C. § 6225(a).

TEFRA provided a special limitations period for the IRS to assess tax related to these partnership items and items they affect. As codified, it provides that the period for assessing tax related to these items "shall not expire" until three years after a partnership files its tax return. 26 U.S.C. § 6229(a). TEFRA also includes a provision that tolls this limitations period during a TEFRA proceeding. 26 U.S.C. § 6229(d) states that a timely FPAA suspends "the period specified in subsection (a)" during the proceeding and for one year after the proceeding concludes. Thus, the language of Section 6229(d) provides that an FPAA only tolls the period specified in Section 6229(a), not an individual partner's limitations period.

Six Tax Court judges disagreed with this holding, disputing whether an FPAA can suspend an individual partner's assessment period after the 26 U.S.C. § 6229(a) partnership limitations period has expired. In a concurring opinion joined by two other judges,⁶ Judge Halpern notes the two major problems with the majority's approach: (1) it directly contradicts Section 6229(d)'s plain language, 114 T.C. at 560; and (2) it contradicts the policies underlying TEFRA proceedings, 114 T.C. at 561, 564.

On the question of Section 6229(d)'s plain language, the concurrence observes that, by its own terms, 6229(d)'s suspension is only as to "the period specified in subsection (a)" of Section 6229, making no cross-reference indicating suspension of the individual limitations period specified in Section 6501. Id. Subsection (a) of Section 6229 states:

The concurrence also details how the majority's approach contradicts the policy underlying TEFRA proceedings. It reasons that Congress enacted TEFRA to create one unified partnership proceeding that binds all partners equally. 114 T.C. at 561. The majority's approach, it argues, "is antithetical to the unified nature of a partnership proceeding" because it would require a court to consider each partner's individual limitations period, which is unique to each partner, in a partnership proceeding. 114 T.C. at 561, 564. Therefore, Congress intended for only a statutory notice of deficiency to suspend a partner's individual limitations period. 114 T.C. at 561. Consistent with Congress's intent, when the partnership limitations period has expired, but individual partners' limitations periods remain open, the IRS should issue statutory notices of deficiency to those partners. 114 T.C. at 562. According to Judge Halpern, only the statutory notices of deficiency suspend the partners' individual limitations. Id.

The court of appeals below adopted the Rhone-Poulenc majority's position, following the statement that holding otherwise would transform Section 6229(a)'s minimum period into a separate limitations period. UTAM, Ltd. v. Comm'r, 645 F.3d 415, 420 (D.C. Cir. 2011). However, this is not the case, as Judge Halpern's opinion recognizes. Rhone-Poulenc, 114 T.C. at 559-564. Honoring Section 6229(d)'s plain language does not make Section 6229(a) a separate limitations period. Rather, it simply alters the procedures the Commissioner must follow to toll limitations -- which is precisely what Congress intended in TEFRA.

The Commissioner has struck off in the direction mapped out by the Rhone-Poulenc majority, using indirect and late notice to a partnership to toll limitations as to an individual partner. The point will come when the obvious tension between this approach and the plain language of the governing statutory provision will lead to a judicial fracturing of this aspect of federal tax administration. Better to resolve the tension now, before the confusion that would come from such a fracture. This case presents the ideal vehicle for resolving the issue.⁷

B. DETERMINING THE PROPER SCOPE OF 26 U.S.C. § 6229(d) NOW WOULD PROMOTE JUDICIAL EFFICIENCY AND ECONOMY.

The Court's contemporaneous review of the issues raised here and in Home Concrete will also promote judicial efficiency and economy. The basic question is whether the Commissioner's assessments are timely. The answer depends upon two inquiries: (1) what constitutes a valid notice; and (2) when is the extended limitations period (6 years) justified? The Home Concrete case concerns the second issue. This case, in its third question, additionally concerns the first. Addressing these issues -- one before you now, the other sure to come soon -- together now would require less of the Court's time and resources than addressing them independently at different times. That is because these issues have overlapping questions of fact and law.

² According to UTAM's uncontroverted expert report, a reasonable revenue agent would have selected the returns for audit. See Expert Report of Jerry L. Hamilton, CPA (A311-355) ("Hamilton Report").

³ While this case concerns 26 U.S.C. § 6501(e)(1)(A)'s six-year limitations period, this issue also applies to 26 U.S.C. § 6501(a) regular three-year limitations period.

⁴ A "partnership item" is any item a partnership must take into account that Treasury Regulations state is more appropriately determined at the partnership level rather than at the partner level. 26 U.S.C. § 6231(a)(3). A "nonpartnership item" is any item that is not a partnership item. 26 U.S.C. § 6231(a)(4). A partner's tax basis in her partnership interest (outside basis) is a nonpartnership item. Petaluma FX Partners, LLC v. Comm'r, 591 F.3d 649, 654 (D.C. Cir. 2010).

⁵ In contrast to Rhone-Poulenc, the FPAA here was not timely issued to the partnership, and a notice of deficiency was never issued to the individual partners.

⁶ Judge Halpern's Rhone-Poulenc opinion was concurring instead of dissenting because, in Rhone-Poulenc, the IRS had issued a notice of deficiency to the individual partner. 114 T.C. at 558-559.

⁷ The issue has been squarely presented and squarely addressed by the court of appeals.