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Tenth Circuit Holds Partner Can Raise Reasonable Cause Defense in Partner Proceeding

Posted on Sep. 8, 2016

TEFRA holds a special place in my tax procedure loving heart. Working with a recently-married colleague of mine (who did the heavy lifting), we rewrote the content on TEFRA in Saltzman and Book a couple of years ago. Digging deeply into its nooks and crannies, we dutifully update it now, while at the same time preparing to write fresh content on the new regime ushered in by the Bipartisan Budget Act of 2015.

Lest I whine too much about Congress replacing TEFRA after putting all that time in, it will still have relevance for many years. There are still plenty of unresolved TEFRA issues that courts are struggling with, including one that the Tenth Circuit tackled this week in McNeill v US. That case involved the question as to which party, the partnership or the managing partner, could raise a reasonable cause/good faith penalty defense. The penalty arose from the disallowance of losses in a shelter that artificially shifted losses from non-US partners, who contributed low value high basis securities, to retiring executive McNeill, who contributed some cash but had many millions in gains he was looking to offset with the other parties’ unusable losses.

One of the issues we struggled with/wrote about in Saltz/Book was the reasonable cause/good faith defense, and in particular who (the partnership or the partner) is the proper party to make that argument. There are a number of cases that essentially now stand for the proposition that the reasonable cause/good faith defense may be a partner- or partnership-level defense, depending on who is asserting it. So, while a partnership as a pass through entity is not a taxpayer in the sense that it has no separate income tax liability, it does, often through its managing partner, have the ability to raise at the partnership level a reasonable cause/good faith defense.

In  McNeill, in a federal district court in Wyoming, the government successfully argued that since the partnership in an administrative proceeding had consented to the penalties then McNeill, as the managing partner, was precluded from arguing in a partner level proceeding from raising a separate partner-level reasonable cause good faith defense. This was not based on judicial preclusion doctrines such as issue or claim preclusion; rather, the district court looked to TEFRA itself and in particular Section 6230(c)(4), and the interplay of the second sentence and third sentence in the statute.

The second sentence states that “the determination under the final partnership administrative adjustment or under the decision of the court (whichever is appropriate) concerning the applicability of any penalty . . . which relates to an adjustment to a partnership item shall also be conclusive.” The next sentence states that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.”

McNeill appealed, and at the Tenth Circuit the government argued that the issue was resolved by the second sentence, i.e., that penalty determinations “must be conclusive not just against the partnership itself but also against the managing partner in any later partner level refund action.” The circuit court found some appeal in that argument but not enough to carry the day:

It’s an argument that is sound as far as it goes but one that doesn’t go quite far enough. It fails to account for the statute’s very next and last sentence, which expressly says that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.” Here, then, Congress pretty clearly seemed to contemplate a regime in which any partner may assert any “partner level defenses” that may apply. And by statute the reasonable cause/good faith defense appears to be one available at the partner level: after all, it applies when (among other things) the “taxpayer” can show he acted in good faith and (again) under TEFRA it is usually the partner who is the taxpayer. Id. § 6664(c)(1).

(emphasis added)

Parting Thoughts

There is more in the opinion, including a spirited dissent that essentially adopts the district court’s reasoning, the majority’s discussion as to why the government’s efficiency argument might have been misguided, and a walk-through of precedents that while not on point support the Tenth Circuit’s conclusion. The opinion is also noteworthy though for it suggests that if there were a judicial proceeding on the merits of the penalty defense (as opposed to just an administrative determination) then the government could have argued that issue preclusion would prevent the managing partner from raising a separate defense.

I also note that in many instances the analysis as to reasonable cause/good faith as to the partnership and managing partner overlaps so much that the difference may not matter much on the merits. Lawyers and accountant letters attempting to justify the tax position likely do not differ that much in terms of recipient, especially as here there was very little space between the managing partner and the partnership itself. Yet the majority opinion suggests that were differing opinion letters, and McNeill will now be able to get the lower court to look at those. The result is not quite a clean victory, but it at least gets him in the door.

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