Partnership Argues to Federal Circuit that Government Appeal Barred by Law-of-the-Case Doctrine

More than eight years have elapsed from the time the IRS issued a Notice of Final Partnership Administrative Adjustment ("FPAA") for Jade Trading, on April 15, 2003. (A.72) The FPAA shifted trading losses to the partner level but left the partnership income and expenses as reported. (A.77) The FPAA made no adjustment to the contributions as reported on Jade's return, but adjusted the distributions to zero. (A.78) Neither the contributions nor distributions affect the tax owed by Jade's partners. 26 U.S.C. §§ 721(a) and 736(b).⁴ The FPAA focused on the outside basis that three of Jade's five partners reported on their individual income tax returns (Forms 1040). (A.79)⁵ No place exists on a partnership return to report outside basis (A.233-34), and it is not a partnership item.⁶

In September 2003, one of Jade's five partners, Robert Ervin, and his wife Laura Kavanaugh Ervin, brought an action on behalf of Ervin Capital, LLC in the Court of Federal Claims ("CFC") to contest the FPAA. (A.46) The TEFRA⁷ partnership case was assigned to Judge Mary Ellen Coster Williams.

Six years ago in 2005, a three week trial was held in Atlanta and Washington D.C., preceded and followed by extensive briefing and oral argument.⁸ In December of 2007, the CFC issued its opinion. Jade Trading LLC v. United States, 80 Fed. Cl. 11, 34 (2007), and supplemented, 98 Fed. Cl. 453, 463 (2011).⁹ The CFC recognized the partnership and the interests held by the partners, held that the net cost of the spread options represented their economic substance, and imposed a 40% gross valuation penalty due to the outside basis that three of the five partners reported on their individual income tax returns.¹⁰ (A.288)

Jade appealed the economic substance and penalty rulings. The IRS did not appeal the CFC's recognition of Jade or the partner status of its members.

On appeal in Jade II, this Court affirmed the CFC's finding as to the economic substance of the spread options, but adopted the D.C. Circuit's jurisdictional opinion in Petaluma and remanded "for a determination as to whether some of the penalties could have been assessed without partner-level computations." (A.375) (Emphasis added) This Court directed the CFC to determine "whether any part of the penalties could have been assessed without relying on the Ervins' outside bases. . . ." (A.377) The IRS chose not to appeal this Court's opinion nor ask for any form of reconsideration.

The parties addressed the issues on remand by way of cross-motions for summary judgment.¹¹ On January 12, 2011, the CFC heard almost five hours of oral argument by the parties.¹² Following that hearing, the CFC issued its opinion -- following this Court's mandate and finding no basis for the imposition of penalties in the Jade partnership proceeding. (A.15-16) Because the CFC found that the IRS failed to establish that any penalties could be computed without resort to partner-level computations, the Court never reached the invalidity of Temp. Treas. Reg. §§ 301.6221-1T(c) and (d) (barring the Ervins from asserting reasonable cause with respect to the penalties they alone faced) or the proof of that reasonable cause through the CFC fact findings in Jade I cataloging their efforts and reliance upon advisors. The IRS appealed the jurisdictional ruling.

The FPAA recognized the partnership income and shifted Jade's Section 988 trading losses to the partners.¹⁵ At no time before remand did the IRS make an issue of those losses. As the CFC observed, "Until this [post-trial, post-appeal, remand] phase of the proceeding, the Section 988 transactions were of no import to anyone." (A.13)

In the FPAA, the IRS adjusted the distributions reported on Jade's return from the partnership's actual cost to zero. As previously mentioned, that adjustment has no effect on the income or tax of Jade or its partners.

The IRS admitted that the Ervins became members of Jade. (A.3, 110) While the FPAA (alternatively) asserted that Jade was a sham, the IRS conceded at trial that Jade was not a sham¹⁶ (A.238-43), and the CFC's many findings supported the existence of Jade for tax purposes.¹⁷ The IRS did not reverse its sham concession in post-trial briefing or on appeal in Jade II. Regrettably typical of the IRS approach throughout this excruciatingly long proceeding, the IRS reversed field on remand and resurrected its sham contention.

At trial, the IRS Rule 30(b)(6) designated party representative admitted that a partnership return contains no place to report outside basis. (A.233-34) He also admitted that the Ervin's capital losses reported on their returns were not and should not have been reported on the partnership return. (A.236-37) Thus, on remand, the IRS could point to no error on the partnership return that would give rise to a deficiency or penalties on a deficiency.

In its Statement of Material Facts, the IRS fails to mention those jurisdictionally critical facts. It fails to note that Jade consisted of five partners and that the IRS only asserts penalties in this partnership proceeding against three out of the five partners, although the IRS admits (A.233-34) that those three partners (the three Ervin brothers) reported the outside basis and resulting loss (upon sale of their Xerox stock) on their individual returns.

Moreover, the IRS fails to mention that the IRS FPAA simply deems the partnership trading losses ($292,015) as incurred directly by the partners and therefore, would also be reportable on their individual returns -- a transposition that generates no tax deficiency and supports no penalty at any level.

While the IRS points on remand to the inside basis of the spread options to justify penalties, the IRS fails to warn this Court that the FPAA never adjusted contributions, that the IRS failed to prove the amount of the inside basis (much less any inaccuracy), or that the distributions reported by Jade result in no income, tax deficiency, adjustment, or penalty to anyone at any level.

The IRS also fails to mention that the CFC found that Jade reported the distribution of the Xerox stock at the partnership's actual cost in accordance with Section 1012 of the Code. (A.235, 323) That is, no inaccuracy penalty applies at the partnership level because the partnership accurately reported the items belatedly disputed on remand, they generate no deficiency foundation for any penalty, and/or any deficiency ultimately turns on the outside basis that requires completion of the partner-level affected-item proceeding that still looms in the future. In lieu of those jurisdictionally important facts, the IRS relies largely upon judgment-laden aspersions as a distraction.

Unlike most partnership proceedings which involve disputed losses or income reported by the partnership itself, the real dispute here is over the outside basis and resulting losses reported solely by three out of five partners on their three individual returns. On remand and in this appeal, the IRS computes no partnership level penalties on the Jade return: it bases those penalties on the basis and resulting losses in the three individual returns -- the fruit forbidden by this Court.

To force penalties on the "forbidden fruit" of outside basis, the IRS resorts to the scare tactic that a holding adverse to the IRS would deprive a court of penalty jurisdiction in ALL partnership proceedings. IRS Br. at 27-28. As the IRS knows better than anyone, that tactic defies the norm: the applicability of penalties can always be determined in the typical partnership dispute over partnership income, losses, and credits reported on the partnership return.

What the IRS actually seeks is the tactical advantage of imposing penalties on those three partners at the partnership level where, according to the IRS regulations, they are jurisdictional^ barred from defending themselves. To that end, the IRS also raises the specter that it may not be able to assert penalties at the partner level. The CFC answered that question on remand: the penalty could be raised in the affected-item proceeding (A.661-62) where the taxpayers can defend themselves, a point that the CFC found "comforting." (A.603)

Following the oral argument, the CFC issued its opinion in Jade III, concluding, "Nothing brought forth in the remand proceedings has altered this need to rely upon outside basis to apply the penalties." (A.15)

The IRS now admits that it bases its partnership-level penalty computation on the jurisdictionally barred outside basis and resulting losses (IRS Br. at 35-36) -- precisely what this Court prohibited in its first opinion. Without timely appealing or seeking reconsideration of the "partner-level computation" test in this Court's earlier opinion, the IRS rejects it and argues that penalties need only be "abstractly" related to partnership items for them to be imposed at the partnership level -- an argument contradicted by this Court's opinion in Jade II, the language of the controlling statutes, and common sense. The "law of the case" bars dragging this Court and the Ervins through the years of added delay and expense before the Ervins can begin to defend themselves in the looming partner-level trials.

The IRS badly wants to impose penalties at the partnership level against three out of the five Jade partners where the overreaching regulations bar them from defending themselves with reasonable cause facts previously found by the CFC. In sum, the IRS insists upon "hang-'em-now/try-'em-later."

To refresh the Court's recollection from the last appeal, allow us to set this case in its statutory context. As part of the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), Congress adopted the Unified Partnership Procedures (26 U.S.C. §§ 6221-6231). Those procedures divide the determination of partnership-related tax consequences into three sequential stages.

First, the partnership proceeding determines "partnership items." 26 U.S.C. §§ 6221, 6226(f). Section 6231(a)(3) and its regulations define "partnership items" as "required to be taken into account for the taxable year of a partnership" and "more appropriately determined at the partnership level." Treas. Reg. § 301.6231(a)(3)-1. Such items generally include the items which the partnership maintains in its books and reports on its Form 1065 partnership return. Id. They relate to global items that impact all partners, as opposed to items peculiar to some but not all partners. Blonien v. Commissioner, 118 T.C. 541 (2002) supplemented, T.C. Memo 2003-308 (existence of partner, but not identity, constitutes partnership items where it impacts distributive share of all partners); Grigoraci v. Commissioner, T.C. Memo 2002-202.

Partnership jurisdiction excludes all nonpartnership items (defined by Section 6231(a)(4)), such as "affected items" (defined by Section 6231(a)(5)). Jade II (A.375); Petaluma II, 591 F.3d at 655; Maxwell v. Commissioner, 87 T.C. 783, 788 (1986). Affected items consist of items that are affected by both partnership items and items peculiar to a given partner. As this Court and the D.C. Circuit confirmed, a partner's tax basis in his partnership interest (called "outside basis") constitutes the classic example of an affected item. Id. In 1997, Congress amended Sections 6221, 6226(f), and 6230 to include within partnership-level jurisdiction "the applicability of any penalty . . . which relates to an adjustment to a partnership item." Prior to 1997, all penalties constituted affected items. Congress chose to carve out only those penalties that "relate to an adjustment of a partnership item." As a dispositive matter here, the jurisdiction for any "penalty that relates to an adjustment of an affected item" remains excluded from partnership jurisdiction. Jade II (A.375); Petaluma II, 591 F.3d at 655.

As to the "applicability" of the Section 6662 "Imposition of Accuracy-Related Penalty on Underpayments" asserted here, Section 7491(c) imposes the burden of production for any penalty on the IRS. 26 U.S.C. § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 499 (2001) (Section 7491(c) requires IRS to produce sufficient evidence to establish essential elements of prima facie penalty case).

"Numerical" considerations dominate the "applicability" of a Section 6662 penalty -- numerical accuracy, numerical underpayment, numerical thresholds, numerical-tested conduct, and numerical deficiency-based percentage penalty. Congress reiterated that numerical aspect by specifying "adjustment to a partnership item," as opposed any aspect of a partnership item or a penalty that relates to an adjustment to an affected item. The "Schedule of Adjustments" in the FPAA on which this case is based proves that an "adjustment" is numerical. (A.77-78) Following that, the FPAA confirms the same point by providing the "[non-numerical] Explanation of [numerical] Adjustments." (A.79-80) Related statutes turn on the numerical nature of "adjustment." 26 U.S.C. § 6227(c); Treas. Reg. § 301.6227(c)-1(a)(3); Internal Revenue Manual, 8.19.7 ("Administrative Adjustment Request" requires a statement of the "numerical" impact on the partners). Never before has the IRS suggested an adjustment was "non-numerical" or that a "computational adjustment" does not involve "computations."

That brings us to the second stage, sometimes called the "Computational Adjustment" stage. It arises upon the determination of the partnership items by the parties or a court. Section 6231(a)(6) defines "computational adjustment" as a change in the tax liability of a partner -- always numerical. Section 6230(a)(1) and (2) draw a distinction depending on whether unresolved partner-level factual questions remain and therefore require a partner-level affected-item (Subchapter B) deficiency proceeding before the tax underpayment (and any penalty based on that tax) can be computed. The first Section 6230 category covers the norm of adjustments to partnership income, losses, and credits reported on the partnership return which require no partner-level factual determinations. There, Congress directs the IRS to compute and assess the tax (and any applicable penalty that relates to an adjustment to those partnership items) via a "computational adjustment," generally within one year of the conclusion of the partnership proceeding. 26 U.S.C. § 6229(d)(2). Obviously, that computation, assessment, and the resulting collection all involve "numerical" processes. Just as obvious, no underpayment penalty can be computed where the underpayment computation must await the resolution of the affected item factual issues in the subsequent partner-level proceeding -- the second category under Section 6230(a)(2).

That triggers the third stage of partner-level proceedings. In that instance, Congress provides the partner with the opportunity to litigate those partner-specific issues, any resulting tax, any penalties related to the affected items, and any partner-level defenses to those penalties in a deficiency proceeding. 26 U.S.C. 6230(a)(2); Jade II (A.375); Petaluma II, 591 F.3d at 655.

Consistent with the numerical lines of demarcation fixed by this statutory structure, this Court correctly established that penalties cannot be imposed at the partnership level where they require partner-level computations.

A. THE "LAW-OF-THE-CASE" DOCTRINE BARS THE IRS ATTEMPT TO REVERSE THIS COURT'S OPINION.

The sequence begins with the opinion by the D.C. Circuit in Petaluma II. In that case, the IRS sought, as it does here, to have it both ways. On the one hand, the IRS argued that it could impose penalties at the partnership level on some partners based on their outside basis because the sham partnership-item characterization rendered the elimination of that basis a foregone conclusion. At the same time, the IRS argued that those partners were jurisdictionally barred from defending themselves prior to the imposition of those penalties.

That Court held that affected items (such as the outside basis) remained jurisdictionally forbidden in the partnership proceeding, even though the partnership-item sham determination rendered them "low hanging fruit." Petaluma, 591 F.3d at 655-6. From that conclusion, the D.C. Circuit held that penalties based on deficiencies that require partner-level affected-item proceedings relate to adjustments of affected items, not partnership items.

The Court concluded that those penalties must be resolved at the partner level. In language later embraced by this Court, the Court of Federal Claims, and the en banc Tax Court, the D.C. Circuit held:

Within months, this Court reached the exact same conclusion in this very case, quoted the Petaluma II analysis at length, confirmed that outside basis falls outside partnership jurisdiction, and held that penalties requiring those partner-level computations also must await the partner-level proceeding:

With this unaltered mandate, this Court remanded the penalty question back to the Court of Federal Claims. The parties agreed no evidentiary hearing was needed (or appropriate) and filed cross-motions for summary judgment that were argued during an extensive hearing on January 12, 2011. In its filings and during its argument, Plaintiff repeatedly pressed the IRS unsuccessfully for an answer to the burning question framed by this Court's mandate:

Bolstered by the en banc Tax Court opinion in Petaluma III, the Court of Federal Claims then rendered its opinion, carefully tracking the mandate by this Court barring jurisdiction on Section 6662 penalties that could not be computed prior to the partner-level affected-item proceeding.

With little subtlety, the IRS now seeks to reverse this Court's prior holding which the IRS chose not to appeal or ask to be reconsidered. Though peppered with pejoratives, the IRS admits that it bases every penalty on the exact same argument this Court rejected as low-hanging but forbidden fruit -- that economic substance and sham (a contention the IRS previously conceded here) reduce the outside basis and losses three of the partners reported on their individual returns, thereby resulting in the individual deficiencies on which the IRS bases the penalty:

Every Circuit applies the "law-of-the-case" doctrine to repetitive appeals. See, e.g., Suel v. Secretary of Health and Human Services, 192 F.3d 981, 984-5 (Fed. Cir. 1999) ("a litigant given one good bite at the apple should not have a second"); United States v. Thomas, 572 F.3d 945, 948 (D.C. Cir. 2009) (first appeal bars second appeal on decided issues); LaShawn, 87 F.3d at 1393 (D.C. Cir. 1996) ("When there are multiple appeals taken in the course of a single piece of litigation, law-of-the-case doctrine holds that decisions rendered on the first appeal should not be revisited on later trips to the appellate court.").

Only under extraordinary circumstances should a court entertain a second appeal of the same issue. Christianson, 486 U.S. at 817. Such circumstances are limited to instances where the initial decision was clearly erroneous and would work manifest injustice, the evidence in a subsequent trial differed substantially, or controlling authority changed. Perkin-Elmer Corp v. Computervision Corp., 732 F.2d 888, 900 (Fed. Cir. 1984); Laffey v. Northwest Airlines, Inc., 740 F.2d 1071, 1102-3 (D.C. Cir. 1984); White v. Murtha, 377 F.2d 428, 431-2 (5th Cir. 1967).

None of those circumstances apply here. This Court's "partner-level computation" test is correct, not clearly erroneous. It cures the injustice of the IRS simultaneously punishing the Ervins alone on their partner-specific options and barring them from proving their ample reasonable cause (prevailing authority on critical issues, reliance upon longtime and specialized advisors, and novel questions of law). The IRS offered no new evidence on remand and the subsequent authority in this area (such as the en banc Tax Court opinion) favors this Court's conclusion.

The IRS simply does not like the unavoidable consequences of the mandate or losing the advantage of imposing penalties on the three partners at the partnership level before they can defend themselves.

Under the mandate rule, "a trial court, upon receiving the mandate of an appellate court, may not alter, amend, or examine the mandate, or give any further relief or review, but must enter an order in strict compliance with the mandate." Piambino v. Bailey, 757 F.2d 1112, 1119 (11th Cir. 1985). See also, In re Sanford Fork & Tool Co., 160 U.S. 247, 255 (1895) ("The circuit court is bound by the decree as the law of the case, and must carry it into execution according to the mandate."). Here, the CFC was obligated to follow the unaltered holding by this Court, both express and implied. Piambino, 757 F.2d at 1119; Nixon v. Richey, 513 F.2d 430, 435-6 (D.C. Cir. 1975) ("[A] lower court is bound to respect the mandate of an appellate tribunal; it is without power to do anything contrary to either the letter or spirit of the mandate . . ."). The "law-of-the-case" requires that this duplicative IRS appeal with its senseless delays and expense be rejected.

B. THIS COURT'S MANDATE CORRECTLY FOLLOWS THE LAW AND THE CFC CORRECTLY FOLLOWED THE MANDATE.

This Court's opinion in the first appeal properly comports with the decision tree Congress planted in Section 6230. That statute distinguishes between the normal circumstance (adjustments to items on partnership returns that result in tax consequences that can be computed and assessed with no need for partner-level proceedings) and circumstances such as this (unresolved affected-items that require a partner-level proceeding before a deficiency -- and any penalty on that deficiency -- can be determined). Hence, this Court's mandate honors the Congressional mandate in Section 6230(a)(2) that determination of any underpayment (on which the Section 6662 underpayment penalty is based) must await conclusion of the partner-level affected-item proceeding; it respects the delineation between the two types of affected items (Treas. Reg. § 301.6231(a)(6)-1(a)(2) and (a)(3)); and it avoids requiring a trial court to do the impossible.¹⁸

With this decision, the Tax Court gave full voice to Sections 6221 and 6226(f), which Congress amended in 1997 so that penalties relating to adjustments to partnership items would be determined at the partnership level. Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 1238, 111 Stat. 788, 1026. As noted, Section 6221 now states that "the tax treatment of any partnership item (and the applicability of any penalty . . . which relates to an adjustment to a partnership item) shall be determined at the partnership level." (Emphasis added.) Defendant would like to change the Code to read "the applicability of any penalty . . . which relates to [ any aspect ] of a partnership item."¹⁹

Because all affected items contain a partnership item element, the IRS litigation position here eliminates ALL "penalties related to affected items" -- again reversing this Court's earlier opinion. Some determinations at the partnership level do not result in an "adjustment." A sham partnership determination can be one of those. Petaluma, 135 T.C. at 587. While conceptual determinations that lack a numerical impact cannot be assessed as a computational adjustment, they may be significant in a later "affected item" proceeding. The IRS (when it is in non-combat mode) recognizes the distinction:

In that case, the Tax Court analyzed the two types of affected items, those that do not require partner-level determinations and those that do. "Petitioner asserts that his bases in the partnership securities are of the first type, which requires a strictly computational adjustment to record the change in a partner's tax liability resulting from the proper treatment of partnership items." The Court continued: "Computational affected items are generally those items on a partner's return that vary if there is a change in the individual partner's adjusted gross income, for example, the threshold dollar limit for the medical expense deduction under section 213." Napoliello, T.C. Memo. 2009-104; 26 U.S.C. § 6230(a)(1); Treas. Reg. § 301.6231(a)(6)-1T(a)(1). The IRS blurs the dispositive difference.

The other type of affected item requires partner-level determinations: "Respondent was required to make partner level factual determinations regarding petitioner's losses" for, among other things, "the number and identity of securities petitioner received from the partnership, the price at which petitioner sold the respective securities, and any other associated allowable costs of the sale." Napoliello, T.C. Memo. 2009-104. The Ninth Circuit affirmed the Tax Court's holding, noting that the opposite holding would deprive a taxpayer of "procedural safeguards" and would simultaneously jeopardize the IRS ability to make proper assessments following an affected-item proceeding. 2011 WL 3673124 at *5.

The Jade III and Petaluma III remand decisions provide the only rational application of these facts to Congress' TEFRA construct as expressed in Sections 6221 and 6226(f), and as confirmed by this Court and the D.C. Circuit Court of Appeal. If no partnership adjustment generates a computational adjustment to tax following a partnership proceeding, no underpayment yet exists for a penalty. See Section 6662, "Imposition of Accuracy-Related Penalty on Underpayments" ("If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies"). Section 6662(a).

In sum, 20% (or 40%) of nothing is still nothing.

C. THE IRS IS WRONG: NO PENALTY CAN BE IMPOSED AT THE PARTNERSHIP LEVEL ON A TAX COMPUTATION THAT REQUIRES PARTNER-LEVEL DETERMINATIONS.

In normal partnership disputes, the IRS adjusts partnership income, deductions, gains, losses, and credits reported on the partnership return. Those partnership adjustments flow through to the partners via Section 6230(a)(1) computational adjustment assessments without requiring a partner-level deficiency proceeding. 26 U.S.C. §§ 6230(a)(1), (a)(2)(A); Treas. Reg. § 301.6231(a)(6)-1(a); Olson v. United States, 172 F.3d 1311 (Fed. Cir. 1999).

This case differs from the norm. The IRS seeks to impose penalties at the partnership-level on the disallowance of losses reported on the individual returns of three of the five partners -- not losses reported on the partnership returns. The IRS disallows those individual losses by disallowing the asset basis that creates those losses -- the basis that the partners reported on their individual returns and that partnerships do not report on their partnership returns. By statute, that basis is derived from the partners' outside basis in their partnership interests -- which again no partnership reports on its partnership return. 26 U.S.C. § 732(b).

All the world agrees that outside basis constitutes a partner-level affected item that must be determined in a partner-level affected-item proceeding. See, e.g., IRS Br. at 9 and 11. In this unusual situation, this Court captured the jurisdictional integrity of barring the IRS from overreaching -- especially given the IRS' litigation tactic of racing to a penalty assessment against some but not all partners and simultaneously barring those select partners from defending themselves.

The IRS seeks to force partner-level penalties into this partnership proceeding that are five steps removed from the partnership (IRS Br. at 38-39):

The IRS would have this Court believe that penalties five steps removed from a partnership proceeding must still be determined at the partnership level (IRS Br. at 22) because the IRS is authorized to assess penalties that "relate to adjustments to partnership items" as a Section 6230(a)(1) computational adjustment. That begs the question as to penalties that "relate to adjustments to affected items" -- the heart of the Jade II and Petaluma II mandates.

Indeed, it highlights the self-destructive damage inflicted by the IRS' "abstract" penalty determination. Unless the IRS intends to usurp the partner-level affected-item deficiency jurisdiction as we believe, the "abstract" partnership-level penalty determination will float in ether until time-barred by Section 6229(d).

In contrast to that numerically driven penalty section and the computational statutory scheme reflected in Sections 6221, 6226(f), and 6230, not one of those statutes use any word so gossamer as "abstract." Worse, it works a mathematical impossibility. Through oral argument, Jade begged the IRS to explain how percentage-underpayment-penalties could possibly be computed at the partnership level when Section 6230(a)(2) barred the determination of that underpayment until the conclusion of the partner-level affected-item proceeding. During the hearing, the CFC put the same question to the IRS and was told, in so many words, that the IRS intended to compute and assess the penalties by the IRS treating the outside basis as zero before the required partner-level affected items proceeding. (A.616) To flip the affected item penalty determination in front of the affected-item proceeding puts the proverbial "cart before the horse" or, to invoke the Court's metaphor, requires a court to "pick the forbidden fruit." (A.374)

The IRS mystifies the conundrum it creates with this (IRS Br. at 29):

The caselaw and regulations recognize the dichotomy between substantive affected items which require partner level determinations and mathematical computational adjustments which do not. Maxwell, 87 T.C. at 793 (1986); Treas. Reg. § 301.6231(a)(6)-1. As one leading authority explains:

Instead, the IRS advanced a second or variant of that argument: that the Section 988 trading losses (approx. $300,000) included the close out of the options, that Jade must have used an "inside basis" greater than zero, and so the trading losses would support a penalty at the partnership level.²¹ The CFC asked the IRS (which bears the burden of production as to penalties), "Well what was the basis?" The IRS counsel conceded, "The record does not reflect what basis was assigned to those options." (A.630) The CFC again pressed the IRS on the options, and the IRS again alluded to the Section 988 trading losses (which counsel for Jade represented was a composite of hundreds of individual trades.) (A.670-71) Finally, IRS counsel admitted, "I suspect that Mr. Aughtry's right that there are other transactions included in that total amount, the approximately $300,000 loss that was disallowed" (A.674) -- another failure of proof by the IRS.

The IRS also advanced the theory that the penalties must be sustained at the partnership level based on the twin arguments that Jade was a sham (a contention the IRS conceded at trial and did not press on appeal: (A.240-43) and that the options did not have economic substance. The CFC recognized these arguments as a "rehash." (A.13) At oral argument, the CFC could not get the IRS to break down any inaccurate partnership elements. Repeatedly, in one way or another, the IRS always returned to outside basis as its penalty foundation. (A.640)

The CFC similarly dispatched the IRS' contributions argument:

Every aspect of that statute and its legislative history opposes the litigation tactic the IRS seeks to apply here -- imposing underpayment penalties at the partnership level on select partners with respect to the partner-specific options, basis, and losses they reported on their individual returns BEFORE they can defend themselves. That tactic offends even the traditional tax safeguard of prepayment resolution.

Congress traditionally assured taxpayers the opportunity to litigate income tax questions in a pre-payment forum. 26 U.S.C. § 6201(e). If the IRS asserts an income tax deficiency, it must send a notice of deficiency to the taxpayer. The taxpayer has a right to contest the deficiency in Tax Court and during that period, the IRS cannot assess the deficiency. 26 U.S.C. § 6213(a).

Even so, the IRS argues the opposite point it urged upon the Ninth Circuit:

D. THE IRS FAILED TO CARRY ITS TWIN BURDENS: PROVING THE ESSENTIAL ELEMENTS OF ANY PENALTY AND PROVING THE ESSENTIAL ELEMENTS OF PARTNERSHIP JURISDICTION.

Seventy-five years ago, the Supreme Court decided that the proponent of jurisdiction -- here the IRS -- must "justify his allegations by a preponderance of evidence." McNutt, 298 U.S. at 189. Citing McNutt, this Court agrees that the proponent of jurisdiction "bears the burden of establishing subject matter jurisdiction by a preponderance of the evidence." Reynolds, 846 F.2d at 748.

Similarly, Section 7491(c) imposes on the IRS the burden of production with respect to penalties.²²See Evans v. Commissioner, T.C. Memo. 2010-207. The Court of Federal Claims recently determined that Section 7491(c) applies in the partnership context. Alpha I, L.P. v. United States, 93 Fed. CI. 280, 306 (2010) ("Defendant has the burden of production with regard to penalties.").²³

As the CFC found, the IRS utterly failed to offer evidence as to the penalty elements for partnership jurisdiction -- without relying on the prohibited outside basis. (A.15) The fact findings of the CFC are reviewed for clear error (ACS Hosp. Sys., Inc. 732 F.2d at 1578) and the record demonstrates the CFC got it right.

All that remains is the non-valuation, non-basis FPAA sham-partnership contention (i) that pushes the partnership transactions down to the jurisdictionally barred partner level and (ii) that the IRS repeatedly conceded.

Yet, the numerical thresholds for application of the overvaluation penalty are determined on a property by property basis. Treas. Reg. §§ 1.6662-5(e) and (f). The regulation gives an example of a return that reports a value for properties A and B of $110 and $100, when the correct values of A and B are $60 and $40. The regulation imposes a valuation misstatement for property B because the claimed value exceeds 200% of the correct value, but no substantial valuation misstatement for A because the value falls short of the 200% mark. Even if the aggregated overvaluations exceeded the 200% threshold, no penalty applies to property A because the properties are not aggregated. Treas. Reg. § 1.6662-5(f)(1). The IRS' failure to produce evidence of the asset basis component bars the penalty.

² The opinion of the Court of Federal Claims, on remand, is included in the Appendix beginning at A.2. The Judgment is at A.1.

³ Jade objects to the IRS Statement of the Case as plagued by pejoratives and the omission of critical elements.

⁴ Unless indicated otherwise, all section references are to the Internal Revenue Code of 1986 (26 U.S.C.) ("Section "), as amended through October 6, 1999.

⁵ "Outside basis" refers to a partner's basis in his partnership interest, while "inside basis" refers to the partnership's basis in its assets. William S. McKee, et al, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS, ¶ 6.01 (4th ed. 2007).

⁶ The IRS admits that outside basis is a partner-level affected item, and not a partnership item. Brief for the Appellant ("IRS Br.") at 9, 11.

⁷ TEFRA is an acronym that refers to the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324, that added the unified partnership audit provisions (Sections 6221-6231) to the Code.

⁸ The justification for the penalties asserted in the FPAA (A.89) and at trial focused on the IRS disagreement with the outside basis that the Ervins reported on their individual income tax returns (Forms 1040). (A.12, 14, 15)

⁹ The first opinion of the CFC, as amended and corrected, is referred to as "Jade I." It is found in the Appendix beginning at A.285.

¹⁰ In Jade II, this Court was clear that the only rationale for the CFC's holding was "the underpayment of income tax due to the gross valuation misstatement of the partners' outside basis in the partnership." (A.375)

¹¹ No evidentiary hearing was held.

¹² That oral argument transcript is found in the Appendix beginning at A.529.

¹³ Jade disputes the IRS Summary of Facts, again on grounds of substituting judgment-laden invectives for jurisdictionally significant facts.

¹⁴ On its partnership return, Jade Trading reported the capital contributions by the three Ervin brothers at the net market value on the date of contribution of $236,918 each ($75,000 cash plus appreciated net options value of $161,918). (A.254, 263, 267, 275) The fair market value reporting of those capital accounts was correct and was not adjusted by the FPAA. See Testimony of IRS Agent Hogue at A.234. By comparison, the CFC also netted the cost of the options and held that "each [Ervin] LLC's adjusted basis [in Jade Trading] must be reduced from some $15 million to $225,002" (A.4, 288) and that "this Court determined that each Ervin LLC's basis in its partnership interest should have been $225,002." (A.349)

¹⁵ The FPAA (without any alteration by the IRS pleadings) determined "that all transactions engaged in by Jade Trading, LLC [ e.g., the Section 988 foreign currency transactions] are treated as engaged in directly by the purported partners." [FPAA, Expl. Adj. ¶ [1]. The FPAA simply shifts those un-litigated transactions out of the partnership proceeding and onto the individual returns of the partners, removing one more pillar from the IRS argument.

¹⁶ The CFC relied upon that concession, as well as the record as a whole, in finding that, by way of economic substance, the cost basis of each of the three Ervin brothers was $225,000 in their respective partnership interests. That finding cannot be reconciled with a nonexistent/sham partnership.

¹⁷ The CFC never held Jade constituted a sham. In recognizing the $225,002 basis each Ervin LLC held in its Jade partnership interest, this Court necessarily recognized Jade's existence. Jade, 80 Fed. Cl. at 14-15. Two out of three of the actual adjustments in the FPAA recognized Jade's existence. See Jt. Ex. 109. The IRS knows how to disregard a partnership if it wants to. It did so in Petaluma. See Petaluma FX Partners, LLC v. Commissioner, 131 T.C. 84, 87 (2008) (where the FPAA adjusted to zero the contributions, distributions of property, outside partnership basis, distributions of money, assets-cash, liabilities and capital, and partners' capital accounts). Here, the FPAA explicitly accepted Jade's partnership expenses and affirmatively asserted additional partnership income. See Jt. Ex. 109 (FPAA adjusts "Other Income" to $22,401 and accepts "Other Deductions" of $11,273, and makes no adjustment to "Contributions").

¹⁸ At the remand hearing, Judge Williams reacted to the IRS argument:

²⁰ The respected BNA Tax Portfolio series on "Audit Procedures for Pass-Through Entities," commented on the Domulewicz case: "This is at least the third time the Tax Court has made literally defensible but conceptually suspect interpretations of the TEFRA rules." Mather, supra, at A-25.

²¹ CFC observed in her opinion on remand, the IRS at trial never made an issue of the trading losses or put forth evidence as to the components of those losses: "Until this phase of the proceedings, the Section 988 transactions were of no import to anyone." (A.13)

²² Section 7491(c) imposes the burden of production on the Government "in any court proceeding with respect to the liability of any individual for any penalty. . . ."

²³ Other courts have declined to reach the issue. See LKF X Investments, LLC v. Commissioner, T.C. Memo. 2009-192 (declining to resolve whether section 7491(c) applies in the partnership setting); Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 199 (D. Conn. 2004) (same).

²⁴ An adjustment to partnership capital contributions creates no change at the partner level in any event, since the capital contributions do not affect the partner's taxable income. Section 721.