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Petaluma v. Commissioner: TEFRA for Everyone?

Posted on Nov. 24, 2014

Today we welcome back guest blogger Andy Grewal. Andy is an Associate Professor at University of Iowa Law School and has a keen eye for TEFRA issues. Those of you willing to brave this dark corner of tax procedure will enjoy this insightful post. Keith

I have previously written about the TEFRA issues of first impression raised in Petaluma FX Partners v. Commissioner, pending in the D.C. Circuit (Docket #12-1364).  The taxpayers in that case argue that TEFRA procedures do not extend to their tax shelter controversy because their transaction involved a sham partnership, not a bona fide one.  The various provisions of TEFRA, including the Section 6226(f) jurisdictional provision, explicitly refer to matters relating to a partnership, not a sham partnership.   Section 6233 authorizes regulations extending TEFRA to sham partnerships, but the taxpayers argue that the relevant regulations were defectively issued.

Oral arguments held recently might have been expected to address the validity of the Section 6233 regulations.  But the D.C. Circuit panel did not offer any questions to either party regarding procedural defects.  Most of the argument time was spent sorting out an argument proffered by Judge Sri Srinivasan that would render the Section 6233 issue moot.

As best as I could tell from the sometimes-muffled audio recording, Judge Srinivasan believed that Section 6226(f) by itself established jurisdiction over sham partnerships, regardless of anything under Section 6233.  That line of argument was apparently motivated by the Supreme Court’s holding in United States v. Woods, in which the Supreme Court held that Section 6226(f) establishes TEFRA jurisdiction to determine the applicability of the valuation misstatement penalty for the inflation of outside basis in a sham partnership.

Judge Srinivasan observed that Section 6226(f) established jurisdiction over the determination of partnership items, and he believed that a partnership item includes the determination that a partnership does not exist.  Consequently, Section 6226(f) took the jurisdictional question “all the way home”;  whether the Treasury properly promulgated regulations under Section 6233 was beside the point.

That argument enjoys some superficial appeal, and I understand how a judge would want to explore that question as he takes on the unenviable task of learning about TEFRA.  It seems almost sadistic to require generalist judges to decide TEFRA-related issues, and we should thank the dedicated public servants who produce thoughtful opinions on the statute.  However, Judge Srinivasan’s suggested argument does not comport with the TEFRA regime.

First, Section 6226(f) simply does not extend to sham partnerships.  Under Section 6226(f), a court determines partnership items “of the partnership,” and the quoted language refers to an actual partnership, not a sham partnership.  Section 6231(a)(1)(A) specifically defines “partnership” for TEFRA statutes by reference to Section 761(a)’s definition, which includes only bona fide partnerships.  Consequently, Section 6226(f) presupposes the existence of a real partnership.  If Section 761(a) actually reaches sham partnerships, we are all in a lot of trouble – that would invite abuse of Subchapter K.

Second, although Section 6226(f) allows the determination of partnership items, and the status of an entity reflects a partnership item, that does not provide backdoor jurisdiction for TEFRA jurisdiction over sham partnerships.  A partnership item, under Section 6231(a)(3)’s definition, refers to an item “with respect to a partnership,” not an item with respect to a sham partnership.  Consistent with the statute, the relevant regulations provide definitions of partnership items that presuppose the existence of a partnership.  See Treas. Reg. § 301.6231(a)(3)-1.  Section 6226(f) and 6231(a)(3) allow a TEFRA court to determine whether a partnership exists, as required by those statutes, but they do not establish further jurisdiction to determine items related to a sham partnership. This makes perfect sense, given that TEFRA originally did not apply to sham partnerships and that the Section 6231 regulations were drafted before Section 6233 came along.  See 48 Fed. Reg. 1759 (1983) (proposed Jan. 14, 1983)(available upon request to PT).

Consistent with the statutory regime, guidance under Section 6231 indicates that sham partnership items become partnership items only via the Section 6233 regulations.  In explaining the partnership item regulations, the Treasury acknowledged regulations under Section 6233 would provide the TEFRA “extension” to sham partnerships.  T.D. 8082 (Apr. 18, 1986) (available upon request to PT).  This is consistent with Section 6233’s purpose.  Congress added Section 6233 because of the practical difficulties that would arise under existing statutes when a purported partnership turned out to be a sham, because the IRS or a court would suddenly realize that TEFRA could no longer apply.

The Section 6233 temporary regulations, if valid, establish TEFRA jurisdiction to determine items “which would be partnership items” if the entity weren’t a sham.  See Temp. Reg. 301.6233-1T(a) & (b).  So, even if one dismissed Section 6226(f)’s limitation to actual partnerships and dismissed the scope of partnership items under Section 6231(a)(3), the Section 6233 regulations remain necessary to establish TEFRA jurisdiction over a sham partnership.  One simply cannot extend TEFRA to non-partnerships without the Section 6233 regulations.

The D.C. Circuit previously recognized the integral relationship between Section 6233 and the partnership item regulations.  In an earlier opinion, the D.C. Circuit specifically acknowledged that the “jurisdiction . . . over this case is governed by Section 6233.”  The court then relied on “Section 6233, its implementing regulations, and the regulations elucidating the meaning of ‘partnership item,’” to conclude that the partnership sham determination reflects a partnership item.

Judge Srinivasan seemed bothered that the Supreme Court in Woods made no reference to Section 6233, and he believed that that statute was not even on the “radar screen” in that case.  But the Supreme Court’s review was limited to whether the gross valuation misstatement penalty for inflation of outside basis “relates to” a partnership item, not to whether TEFRA applied at all to sham partnerships.  Also, Judge Srinivasan wondered why the government did not mention Section 6233 in its briefs in Woods.  But of course it did.  Its brief explicitly acknowledged that Section 6233 and its regulations extend TEFRA to sham partnerships.  But the government cited the “more readily accessible regulations” rather than the temporary regulations, and the taxpayer missed the opportunity to present a procedural challenge.

The narrow briefing on the jurisdictional question in Woods should not be surprising.  Both parties completely missed the jurisdictional issues at the district court and the circuit court level.  Jurisdiction was first mentioned in a footnote in the government’s certiorari-stage reply brief, and the parties finally argued jurisdiction only when the Court, on its own, added that issue to the question presented in the government’s petition for certiorari.

Judge Srinivasan also thought it strange that administrative regulations, like those under Section 6233, could establish or deny a court’s jurisdiction over a taxpayer.  But that improperly frames the issue.  Of course courts enjoy jurisdiction to determine the tax liabilities of participants in a sham partnership.  Any regulations simply go to whether jurisdiction must be exercised in a partnership-level proceeding or instead in a partner-level proceeding.  Section 6233 does not allow the Treasury to arbitrarily determine the jurisdiction of Article III courts.

To her immense credit, the government’s attorney, Ms. Joan Oppenheimer, did not embrace Judge Srinivasan’s suggested argument, even though the court’s adoption of that argument would secure an IRS victory.  Instead, Oppenheimer attempted to explain, consistent with the government’s brief, that Section 6233 reflects a necessary component to the extension of Section 6226(f) to sham partnerships.  After some prodding, Oppenheimer acknowledged that she would not resist a holding along the lines suggested by Judge Srinivasan.

Perhaps she should have.  If Judge Srinivasan’s suggested argument were accepted, then TEFRA would necessarily attach to sham partnerships, regardless of the discretion conferred by Section 6233.  TEFRA jurisdiction would also extend to C corporations, REITs, trusts, and every other entity because, under Judge Srinivasan’s approach, partnership items include determinations over whether an entity is a partnership or instead a C corporation, REIT, trust and so on.  In the long run, the Treasury would likely want to exercise its discretion under Section 6233 to determine the scope of entities that fall under TEFRA, and not allow Section 6226(f) to establish TEFRA procedures for every entity imaginable.

The most dangerous part of Judge Srinivasan’s suggested argument relates to the elimination of the partnership tax return requirement.  That is, Section 6233 allows for the jurisdictional extension of TEFRA to sham partnerships and non-partnership entities only when a partnership tax return has been filed.  Section 6226(f), however, contains no return limitation.  Thus, if that statute independently establishes TEFRA jurisdiction over sham partnerships and non-partnership entities, the IRS can pull taxpayers into the TEFRA regime even when they never represented themselves as partnerships.  Or perhaps taxpayers will seek strategic advantage and argue that the IRS failed to comply with TEFRA notice requirements under Section 6223 regarding their sham partnerships or non-partnerships.  Simply put, holding that Section 6226(f) extends TEFRA jurisdiction to sham partnerships opens up the door to unending mischief.  It’s thus no surprise that Congress used Section 6233 to make that extension, and it wisely conditioned TEFRA jurisdiction on the filing of a partnership tax return and the promulgation of regulations.

Judge Srinivasan’s argument also raises problems because it contemplates that a sham partnership qualifies as a bona fide partnership under Section 6226(f) and, by extension, under Section 761(a).  Any suggestion that a sham partnership qualifies as a real one threatens to open the door to abuse of the partnership tax regime.  I do not mean to suggest that any reputable practitioner would allow her client to play games with Subchapter K simply because sham partnerships are recognized as bona fide partnerships under Sections 761(a) and 6226(f).  But tax cheats come in two classes – those who simply hide their money under their mattresses (or in offshore accounts), and those who seize on some hyper-technicality to establish that “they are just beating the IRS at their own game.”  Treating a sham partnership as a real partnership, even if only indirectly via a TEFRA ruling, potentially provides the protective rationalization needed for the second miscreant to justify his abuse.

Of course, as long as we are talking about general policies and not the command of the law, we must balance that potential for abuse against any ruling in favor of the taxpayers in Petaluma.  The taxpayers in that case surely engaged in improper behavior.  Maybe, if we are not concerned about applying statutes, it will be better for the court to adopt a creative argument that goes beyond TEFRA’s plain language and denies the taxpayer the right to present its jurisdictional challenge, so as to discourage improper behavior in the future.

In the end, it’s impossible to tell whether the D.C. Circuit will address the merits of the taxpayer’s challenge.  On the one hand, the taxpayer’s argument goes to jurisdiction and is generally non-waivable.  On the other hand, under Judge Srinivasan’s suggested line of analysis, the Section 6233 issue is non-jurisdictional and can be waived.  But the government has itself waived Judge Srinivasan’s argument.  So, to reject the taxpayer’s argument on waiver grounds, the court would have to use an argument that the government waived and is contrary to its briefs.  That seems weird.

Ultimately, I hope that the D.C. Circuit addresses the validity of the Section 6233 regulations.  Questions over how to address improper tax shelters should be left to Congress and the Treasury.  The D.C. Circuit should simply focus on reaching the correct interpretation of the law.

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