Periodically, like a kid forced to eat spinach, I will tackle TEFRA developments. Last year, we overhauled the TEFRA content in Saltzman and Book (Chapter 8). On the heels of the rewrite, in US v Woods the Supreme Court addressed TEFRA partnership audit procedures, and its opinion, as I stated in my post TEFRA and Affected Items Notice of Deficiency, and in particular its footnote 2, will “cast a long shadow” over future TEFRA cases.
Last week in Greenwald v Commissioner, the Tax Court confronted a basic jurisdictional TEFRA issue that courts, taxpayers and IRS have been wrestling with: does an adjustment to outside basis require deficiency procedures? In this post, I will summarize the contours of the case’s TEFRA jurisdictional issues, and discuss and briefly analyze the Tax Court’s Greenwald decision, including how it fits in with Woods and the shadow of footnote 2.
In a case involving a partnership (that notably was not shammed), in Greenwald the Tax Court held that it had jurisdiction to consider adjustments to affected items requiring partner-level determinations. Because under the facts of the case determining outside basis required making determinations at the partner level, the court held it had jurisdiction.
The taxpayer in Greenwald argued that the adjustment was a partnership item that had to be raised in a prior partnership-level proceeding. Why does it matter whether the adjustment is a partnership or partner item? Here is where we start to get into some TEFRA complexity. In TEFRA, IRS audits partnerships and after that audit it issues a Notice of Final Partnership Administrative Adjustments (an “FPAA”). Under section 6223(f), the IRS may generally only issue one FPAA, meaning it really only has one bite at the apple to make adjustments at the partnership level.Presumably in Greenwald the taxpayer took the position that the adjustment to outside basis was a partnership item to take advantage of this one FPAA rule which would presumably prevent the IRS from making any further adjustments at the partnership-level.
To understand what is going on here, one must understand some key terms and the way TEFRA works after there has been an adjustment flowing from an FPAA. Judge Buch wrote the Greenwald opinion. His discussion of TEFRA’s scheme is succinct:
Section 6221 provides that the tax treatment of all “partnership items” is determined at the partnership level. The Secretary must mail each notice partner whose name and address is furnished a notice of the beginning of an administrative partnership-level proceeding and an FPAA. [recall my summary of FPAA above]. Sec. 6223(a). The determination of partnership items in a partnership-level proceeding (either through a defaulted FPAA or a final court decision) is conclusive. Once adjustments are made at the partnership level, the IRS will make any necessary partner-level changes, including changes to “affected items”. If the adjustment to an affected item is merely computational and can be made without making additional partner-level determinations, the IRS can directly assess the tax due without having to follow the usual deficiency procedures. However, if an adjustment to an affected item requires a partner-level factual determination, the IRS must follow deficiency procedures.
Woods and the TEFRA Scheme
Woods dealt with a shammed partnership and addressed as a threshold matter whether at a partnership level proceeding following the issuance of an FPAA, a court could consider the applicability of gross valuation misstatement penalties. The Supreme Court nicely summarized TEFRA’s workings:
Under the TEFRA framework, a court in a partnership level proceeding like this one has jurisdiction to determine not just partnership items, but also “the applicability of any penalty . . . which relates to an adjustment to a partnership item.” §6226(f). As both sides agree, a determination that a partnership lacks economic substance is an adjustment to a partnership item. Thus, the jurisdictional question here boils down to whether the valuation misstatement penalty “relates to” the determination that the partnerships…were shams.
The taxpayers in Woods argued that because partners would have independent grounds to challenge penalties in their circumstances (such as reasonable cause), the penalty determination did not “relate to” the sham determination. The Court rejected the taxpayer’s position:
Yet notwithstanding that every penalty must be imposed in partner-level proceedings after partner-level determinations, TEFRA provides that the applicability of some penalties must be determined at the partnership level. (emphasis in original) The applicability determination is therefore inherently provisional; it is always contingent upon determinations that the court in a partnership-level proceeding does not have jurisdiction to make. Barring partnership-level courts from considering the applicability of penalties that cannot be imposed without partner-level inquiries would render TEFRA’s authorization to consider some penalties at the partnership level meaningless.
In Woods, the Supreme Court stated that “TEFRA gives courts in partnership-level proceedings jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or nonpartnership items such as outside basis.”
So in shammed partnerships Woods provides that courts in partnership level proceedings can determine if the penalty would provisionally apply to partners who could assert individual defenses to the penalty in separate partner-level refund proceedings.
Woods dealt with the penalty and did not directly address the procedures applicable to the IRS’s attempting to impose tax liability attributable to the sham determination. In footnote 2, Justice Scalia offered his views that when there has been a determination that the partnership is a sham, it seemed reasonable to conclude that the IRS could assess additional tax against the partners without issuing a notice of deficiency because the tax computations would likely flow from the zero outside basis conclusion that was part of the original partnership level sham determination. In TEFRA speak that means that the IRS could make a computational adjustment (adjusting outside basis to zero) without making further partner level determinations, and therefore, assess tax directly, without following deficiency procedures.
The musings of Scalia in Woods footnote 2 (whether the partners’ tax that flows from a zero outside basis/sham determination) I characterize as dicta because it was not essential to the main TEFRA holding—that the penalty related to an adjustment to a partnership item—thus freeing the Supreme Court to get to the circuit split as to whether the gross valuation misstatement could apply at all.
I might add that Scalia’s suggestion in note 2 in the context of shammed partnerships has practical appeal. If one concludes that the partner’s tax liability determination in a shammed partnership scenario requires a partner-level determination, partners are left with the oddity of challenging the penalty determination in a refund suit (recall Woods only allows the provisional determination of the penalty in the partnership proceeding) and the underlying tax liability in Tax Court.
Back to Greenwald
So how does Greenwald fit in with the above? The Tax Court’s summary of the case’s posture frames the issue:
These cases involve affected items deficiency proceedings that follow from previous partnership-level proceedings in this Court. Petitioners filed a motion to dismiss for lack of subject matter jurisdiction, and their argument is that outside basis is a partnership item that had to be raised and determined in the prior partnership-level proceedings. Respondent argues that this Court has jurisdiction because outside basis is an affected item that requires partner-level determinations. (citations omitted).
The Tax Court essentially agrees with the IRS position in the case though it did also state that the respondent and petitioner’s argument were “off the mark.” I will discuss what I think the Court is suggesting by holding for the IRS but not explicitly finding that outside basis is always an affected item.
Many cases have discussed the use of partnerships to house all sorts of bs tax shelters; prior to Woods, there was some incentive to agree with an IRS determination that a partnership was a sham because a sham determination generally in the Tax Court, Fifth and Ninth Circuits allowed taxpayers to avoid the imposition of the 40% gross valuation misstatement penalty. In Woods, the Supremes resolved the circuit split and put an end to that ruse.
In Greenwald, unlike Woods, the partnership was no sham. The limited partnership owned apartment buildings, and ran into hard times in the mid-90s. The potential income inclusion for partners in Greenwald stemmed from a discharge of partnership liabilities, not a variation of the offsetting options shelter at play in Woods. As Judge Buch noted, the outside basis of the partners (unlike the sham in Woods) was not tethered to the sham determination, but depended on partner-specific level facts. He included an example to illustrate the point:
[I]f a partner incurred litigation costs in the defense of the ownership of the partnership interest, those costs would be added to the partner’s outside basis, but they would not be taken into account as part of a section 754 election [there was a 754 election in place–Les] or any other partnership- level determination.
Greenwald’s discussion of the taxpayer’s argument is relatively brief and I include it below:
In their motion to dismiss, petitioners rely heavily on Tigers Eye Trading, LLC v. Commissioner, 138 T.C. 67 (2012). In Tigers Eye the parties stipulated that the partnership was a sham. Id. at 102. Accordingly, “[n]o additional facts [were] required to determine the absence of an outside basis” because the partnership did not exist for Federal tax purposes. Id. at 119. Because no further determinations were necessary, outside basis was a partnership item. Id. Moreover, that outside basis determination also resulted in a determination of the applicability of a gross valuation misstatement penalty. See section 6226(f) (giving the Court jurisdiction to determine “the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item” for taxable years ending after August 5, 1997). No further partner-level determinations were required in that instance.
Greenwald ties in Woods to reject the taxpayer’s argument:
The Supreme Court recently addressed this same issue in United States v. Woods, 571 U.S. __, 134 S. Ct. 557 (2013), and came to the same conclusion. Again, the Court stated that where the partnership is a sham, no partner-level determinations are needed to determine outside basis because “once the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim an outside basis greater than zero.” United States v. Woods, 571 U.S. __, __, 134 S. Ct. 557, 565-566 (2013). This flows from the fact that there can be no basis in an asset that does not exist, such as nonexistent partnership interest. The Court went on to say that “the basis misstatement and the transaction’s lack of economic substance are inextricably intertwined.” Id. at __, 134 S. Ct. at 567 (quoting Bemont Invs., LLC v. United States, 679 F.3d 339, 354 (5th Cir. 2012)). Thus, as with Tigers Eye, the Court held that outside basis is a partnership item when the partnership is held to be a sham, and the applicability of the gross valuation misstatement penalty arises as a preliminary determination. Even then, the penalty determination is “provisional”. United States v. Woods, 571 U.S. at __, 134 S. Ct. at 564. Notwithstanding this type of isolated situation in which outside basis is determined at the partnership level, the Supreme Court acknowledged that a court may otherwise need to determine “affected or non-partnership items such as outside basis.” Id.
Their outside basis is not fixed by partnership-level determinations, even in the case of a section 754 election. The Tax Court in Tigers Eye and the Supreme Court in Woods held that outside basis was a partnership item because the partnerships were shams and thus no other determinations were necessary to preliminarily determine that a gross valuation misstatement penalty applied. That is not the case before us. The TEFRA proceeding regarding Regency Plaza did not determine that the partnership was a sham, and thus in these proceedings we must treat it as a bona fide partnership.
So What Does This Mean?
I am not sure that Greenwald precisely describes Woods when it states “that Woods held that outside basis was a partnership item because the partnerships were shams and thus no other determinations were necessary to preliminarily determine that a gross valuation misstatement penalty applied.”
Recall that the Supreme Court referred to its holding as allowing “courts in partnership-level proceedings jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or non partnership items such as outside basis.“ (emphasis added). In Woods, in note 2, the Supreme Court suggested (but did not hold) that courts may dispel with deficiency procedures when making subsequent adjustments to the partners’ tax liabilities following a partnership level sham determination. That suggestion does not, I believe, convert outside basis in shammed partnerships to a partnership item; rather, I think Woods’ dicta provides for treating the adjustment to outside basis in a shammed partnership as a computational adjustment that doesn’t require partner-level determinations. Under either interpretation, we end up in the same place: assessments without deficiency procedures and the loss of a prepayment forum, which may not be the most inappropriate result in cases concerning partnerships manipulated as bs tax shelters.
I might add that I am not sure why in Greenwald Judge Buch took issue with the government’s characterization as outside basis as an affected item that requires partner-level determinations; perhaps the government was suggesting a per se rule, and Judge Buch believes, at least in shammed partnerships, that outside basis is purely a partnership item. For readers still with me, and who have a thought, I would be curious as to your views.
When there are adjustments flowing from partnerships that are not shammed though it seem that the IRS should generally issue a notice of deficiency to the affected partners. Those partners will have the chance in Tax Court to dispute the amount of existence of any underlying liability that stems from prior partnership-level adjustments. When the underlying partnership is a sham, we get back to note 2 and my reading between the lines in Greenwald and the still unresolved issue as to whether courts will conclude that there will be a need for partner-level inquiries in computing the partners’ liabilities or perhaps whether the outside basis is a partnership item and therefore automatically zero. Stay tuned for more TEFRA fun.