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What Happened to My Prepayment Forum? The Penalty Problem in TEFRA Partnership Audit Cases

WHAT HAPPENED TO MY PREPAYMENT FORUM? The Penalty Problem in TEFRA Partnership Audit Cases Elliot Pisem Roberts & Holland LLP Since 1924, when Congress established the Board of Tax Appeals, predecessor of the Tax Court, it has been a fundamental principle of our Federal income tax structure that a taxpayer “is entitled to an appeal and to a determination of his liability for the tax prior to its payment.” This principle has been consistently applied as well to additions to tax and penalties with respect to income taxes, beginning with the addition to tax for negligence imposed by the Revenue Act of 1924, and continuing right down to the present-day penalty for underpayment of tax required to be shown on a return by reason of negligence, “substantial understatement,” or other causes. Statutory amendments made by the Taxpayer Relief Act of 1997, however, limit taxpayers’ access to such a “prepayment forum,” in the case of “partner-level” defenses to income tax penalties attributable to “partnership items,” and may permit the IRS to assess and to collect such penalties even before a taxpayer has the opportunity to obtain a judicial determination of the validity of the taxpayer’s “partner-level” defenses. The 1997 rules have added yet further confusion to the already complex procedural rules governing audits and litigation concerning “partnership items.” Some very recent decisions highlight this confusion, reveal a degree of judicial discomfort with the 1997 rules, and raise some uncertainty regarding just how broadly they will be applied. BACKGROUND Before looking at the recent cases, it will be helpful to review the statutory and regulatory context. Accuracy-Related Penalties Internal Revenue Code (“Code”) section 6662 imposes an “accuracy-related penalty” on certain underpayments of tax liability. The penalty applies to the portion of any underpayment which is attributable to one or more of: (1) negligence or intentional disregard of rules or regulations; (2) any substantial underpayment of income tax; (3) any substantial valuation misstatement under chapter 1 of the Code; (4) any substantial overstatement of pension liabilities; or (5) any substantial estate or gift tax valuation misstatement. The penalty is normally equal to 20% of the portion of the underpayment to which section 6662 applies. For “gross valuation misstatements,” the penalty rate is increased to 40%. Code section 6664(c), however, provides an important exception: “No penalty shall be imposed under section 6662 ... with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” Pre-Assessment Review of Tax and Penalties Under TEFRA A taxpayer’s entitlement to obtain a judicial determination of liability for tax and penalties prior to payment is now contained in Section 6213(a), which provides, in part, that “no assessment of a deficiency in respect of any tax imposed by subtitle A or B, chapter 41, 42, 43, or 44 and no levy or proceeding in court for its collection shall be made, begun, or prosecuted until [a notice of deficiency] has been mailed to the taxpayer, nor until the expiration of such 90-day ... period [for filing a petition with the Tax Court after a notice of deficiency has been mailed], ... nor, if a petition has been filed with the Tax Court, until the decision of the Tax Court has become final.” In title IV of TEFRA, Congress provided that tax treatment of the “partnership items” of certain partnerships should be determined at the partnership level. In partnership proceedings subject to the TEFRA provisions, the Service, in lieu of sending a notice of deficiency, is required to send a “notice of final partnership administrative adjustment” (“FPAA”) to each partner. If a petition is filed in the Tax Court challenging the FPAA, no assessment of a deficiency attributable to any partnership item may be made before the decision of the Tax Court has become final. If the IRS wishes to assert a deficiency against a partner attributable to items “affected by” partnership items (“affected items”), other than items that are purely computational, it must wait until the partnership proceeding is completed, either by the partners’ failure to file a petition in any court with respect to the FPAA or by the resolution of the partnership-level litigation. After the partnership proceeding has been completed, the Service must then issue a notice of deficiency to the partner, which then gives the partner the right to file a petition with the Tax Court and thereby bar assessment and collection of the asserted deficiency until the Tax Court decides the case. Under the TEFRA provisions, as originally enacted, penalties attributable to partnership items were considered “affected items.” Thus, the penalties could be asserted against a partner only following completion of partnership-level proceedings, and then only by means of application of partner-level deficiency procedures – including the partner’s ability to challenge the partner-level notice of deficiency on a pre-payment basis by filing a petition with the Tax Court. Even if a petition challenging the FPAA were filed in a court other than the Tax Court, with the effect that any deficiency in tax attributable to the adjustments made in the FPAA could be assessed without further judicial review, penalties attributable to partnership items still required application of the deficiency procedures after completion of partnership-level proceedings. TRA ’97: Limitations of Prepayment Review of Penalties Congress became dissatisfied with this regime and made significant statutory changes in TRA ’97. The legislative history of TRA ’97 explains the reasons for change and provides an overview of the new provisions: “Many penalties are based upon the conduct of the taxpayer. With respect to partnerships, the relevant conduct often occurs at the partnership level. In addition, applying penalties at the partner level through the deficiency procedures following the conclusion of the unified proceeding at the partnership level increase the administrative burden on the IRS and can significantly increase the Tax Court’s inventory. … “The bill provides that the partnership level proceeding is to include a determination of the applicability of penalties at the partnership level. However, the provision allows partners to raise any partner-level defenses in a refund forum.” In order to implement this new system, TRA ’97 amended three provisions of the Code, as shown in italics below. (1) Section 6221 was amended as follows: “Except as otherwise provided in this subchapter, the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item) shall be determined at the partnership level.” (2) Section 6226(f) was amended to read: “A court with which a petition [for judicial review of an FPAA] is filed in accordance with this section shall have jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the notice of final partnership administrative adjustment relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item.” (3) Finally, Section 6230(c)(4), which relates to partner-level refund suits following completion of the partnership-level proceeding, was amended to read: “For purposes of any claim or suit under this subsection, the treatment of partnership items on the partnership return, under the settlement, under the final partnership administrative adjustment, or under the decision of the court (whichever is appropriate) shall be conclusive. In addition, the determination under the final partnership administrative adjustment or under the decision of the court (whichever is appropriate) concerning the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item shall also be conclusive. Notwithstanding 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.” Treasury Regulations to implement this new structure were promulgated on a temporary basis in early 1999, and the Regulations were finalized in late 2001. Reg. 301.6221 1 now provides: “(c) Penalties determined at partnership level. Any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item shall be determined at the partnership level. Partner-level defenses to such items can only be asserted through refund actions following assessment and payment. Assessment of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item shall be made based on partnership-level determinations. Partnership-level determinations include all the legal and factual determinations that underlie the determination of any penalty, addition to tax, or additional amount, other than partner-level defenses specified in paragraph (d) of this section. “(d) Partner-level defenses. Partner-level defenses to any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item may not be asserted in the partnership-level proceeding, but may be asserted through separate refund actions following assessment and payment. See section 6230(c)(4). Partner-level defenses are limited to those that are personal to the partner or are dependent upon the partner’s separate return and cannot be determined at the partnership level. Examples of these determinations are whether any applicable threshold underpayment of tax has been met with respect to the partner or whether the partner has met the criteria of section 6664(b) (penalties applicable only where return is filed), or section 6664(c)(1) (reasonable cause exception) subject to partnership-level determinations as to the applicability of section 6664(c)(2) [relating to special rules for certain valuation overstatements].” In promulgating these Regulations, Treasury intended that the majority of the defenses to the application of a penalty be determined at the partnership level. Thus, in Santa Monica Pictures, LLC, TC Memo 2005-104, RIA TC Memo 2005-104, the Tax Court evaluated actions taken, and professional advice received, by a partner in the course of preparation by that partner of a partnership’s tax returns. The court found the partner’s actions on behalf of the partnership to have been inadequate and held that the partnership had thus not demonstrated that there was reasonable cause for any underpayment caused by its erroneous reporting. Accordingly, the partnership failed to establish a partnership-level “reasonable cause and good faith” defense under Section 6664(c) to the assertion of accuracy-related penalties against the partners in the partnership. The fact that the individual whose actions were being evaluated happened to be a partner did not cause the determination to be a partner-level determination, where the individual’s actions were taken on behalf of the partnership and related to preparation of the partnership return. Nevertheless, the Regulations recognize that whether certain defenses apply to a particular partner, particularly the “reasonable cause and good faith” defense, can in many cases be determined only by reference to the actions and state of mind of the partner against whom the penalty is asserted. The section 6664(c) defense would be available as a “partner-level” defense to a partner who could demonstrate that, however improperly the partnership may have acted in preparing its return, the partner acted properly – in the partner’s individual capacity, rather than in the partner’s capacity as an agent or representative of the partnership – in incorporating the partner’s distributive share of the partnership’s reported income or loss onto the partner’s individual return. Example: An individual limited partner in a partnership receives a Schedule K-1, indicating that certain losses were allocated to the partner. The individual, feeling perhaps justifiably uncomfortable with the level of care that was employed in preparation of the partnership’s return, asks a competent tax professional to investigate the matter thoroughly before the individual claims the losses on the individual’s personal return. The professional appropriately researches the factual and legal issues and advises the taxpayer in writing that the loss deductions are proper. On audit, the Internal Revenue Service disallows the losses and asserts a penalty under Section 6662 against all partners in the partnership. If the court that is adjudicating the partnership proceeding determines that the partnership did not employ due care in the preparation of its return, a penalty may be assessed against and collected from even this individual with respect to any underpayment attributable to the claiming of the losses. The court adjudicating the partnership proceeding will not permit the individual to raise the defenses arising from the additional partner-level actions that were taken to attempt to ensure compliance with the law. The individual’s only remedy will be to pay the asserted penalty and to commence a refund suit. In summary, the “plain meaning” of the statutory and regulatory regime following TRA ’97 is to permit partnership-level, but not partner-level, defenses to application of a penalty to be asserted in a partnership administrative and judicial proceeding, and, if a partnership files a petition with the Tax Court, the Court of Federal Claims, or a U.S. district court with respect to an FPAA, to prohibit penalties from being assessed or collected until the partnership-level litigation is concluded. Once partnership-level litigation is concluded, however, penalties may be assessed and collected immediately, with no opportunity to raise partner-level defenses prior to payment. Not surprisingly, several recent cases have reflected challenges by partners to this understanding of the rules. Recent Cases: Do the Words Mean What They Say? Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850, 472 F. Supp. 2d 885 (DC Tex., 2007), involved a marketed transaction – described by the court as a “tax shelter” – known as “Bond Linked Issue Premium Structure,” or “BLIPS,” which was effected by the partnership, Klamath. One important aspect of the tax structure of the transaction involved a purported borrowing by one of the partners in Klamath, Cary Patterson, liability for which was subsequently assumed by Klamath. The tax benefits claimed by Patterson had arisen from his sale, during 2000, 2001, and 2002 – when he was no longer a partner in Klamath – of property distributed to him during 2000 by Klamath in liquidation of his interest in Klamath. Patterson had claimed that the property had an extremely high basis in his hands, with the effect that he had recognized large losses on its sale. Both before and after his withdrawal from Klamath, Patterson had consulted with tax counsel (described by the court as “qualified tax attorneys”) regarding the allowability and proper reporting of the losses to be claimed on the sale of the property distributed to him by Klamath. Tax counsel provided a “detailed” and “comprehensive” written opinion to Patterson, apparently concluding that the losses would be allowable. The losses were challenged by an FPAA issued by the Service to Klamath with respect to 2000, the year of the distribution. The court evaluated the “economic substance” of the transaction, held that the borrowing by Patterson lacked economic substance, and concluded that Patterson’s basis in the property distributed to him by Klamath was much lower than he had claimed and that his losses should accordingly be disallowed. The court then turned to the applicability of the accuracy-related penalty of Section 6662 that had been asserted by the Service on the grounds, inter alia, of substantial understatement of income tax. Under the Code as in effect during the years in issue in Klamath, a penalty for substantial understatement of income tax would not be imposed with respect to an item if “there is or was substantial authority” for the taxpayer’s treatment of that item; in the case of certain “tax shelter items,” this “substantial authority” exception was unavailable unless, in addition to there being substantial authority, the “taxpayer reasonably believed that the tax treatment of such item by the taxpayer was more likely than not the proper treatment.” The court concluded that the written opinion received by Patterson “provide[d] ‘substantial authority’“ for Patterson’s computation of basis, and that Patterson reasonably believed that his treatment of the borrowing transaction was more likely than not the proper treatment. To your author, the court’s analysis of the “substantial authority” issue – which turned on evaluation of a written opinion that had been solicited and received by Patterson at a time when he was no longer a partner in Klamath and that thus indisputably could not have been taken into account by Klamath in preparing its return or determining its own tax filing positions – clearly implicated “partner-level defenses,” and one would have expected the Government to object to the court’s analysis on that ground. Nevertheless, no such objection to this portion of the court’s analysis was apparently made by the government. The court having concluded that the “substantial authority (and reasonable belief that more likely than not)” exception to application of the Section 6662 accuracy-related penalty applied, there does not seem to have been a reason for the court to go on and consider whether the Section 6664(c) “reasonable cause and good faith” exception to application of that penalty also applied – but the court did so anyway. In the course of its discussion, the court raised some important questions about the effect of the amendments made by TRA ’97. Patterson asserted that the Section 6662 penalty should not apply to him, on the grounds that he, individually, met the requirements for the “reasonable cause and good faith” exception. Patterson further asserted that, although the 1997 amendment to Section 6230(c)(4) permitted the bringing of a refund suit to assert partner-level defenses to a penalty, he could also raise such defenses in the partnership proceeding, particularly when the substantive adjustment giving rise to the underpayment for which he was to be penalized arose from a determination that a loan transaction – to which he, rather than the partnership, was the original party – lacked economic substance. The government contended that the “reasonable cause and good faith” exception was a partner-level defense and that, under the 1997 amendments, partner-level defenses were not permitted to be raised in a partnership proceeding. The court concluded that it could consider Patterson’s “reasonable cause and good faith” defense. The court’s opinion, however, suggests that the court did not accept Patterson’s assertion that a refund suit was not the exclusive remedy available for the assertion of partner-level defenses, as such. Rather, the court’s preferred articulation appears to be that, in some cases, the question of whether or not an individual partner satisfies the “reasonable cause and good faith” exception is itself a partnership-level defense. The district court noted that in Santa Monica Pictures the Tax Court had looked to the actions of a particular partner in determining whether or not the partnership satisfied the “reasonable cause and good faith” requirements, and analogized that to the situation it faced in Klamath, in which it was required, in order to evaluate the substantive tax issues before it, to look at the economic substance of a transaction (the borrowing) in which Patterson individually had participated. Thus, in this particular case, Patterson’s individual “reasonable cause and good faith” was not an item that, in the words of Reg. 301.6221 1(d) (quoted above), is “personal to the partner or dependent on the partner’s separate return” or an item that “cannot be determined at the partnership level.” Jade Trading, LLC, 100 AFTR 2d 2007-7123, 80 Fed. Cl. 11 (Fed. Cl. Ct., 2007), stands in sharp contrast to Klamath, although the background of the two cases is very similar. Like Klamath, Jade involved a marketed transaction, at the end of which individuals sold, at what was purportedly a large loss, property that had been distributed to them in liquidation of their interests in a partnership. Like the court in Klamath, the Court of Federal Claims in Jade concluded that the transaction lacked “economic substance” and disallowed the claimed loss. As it did in Klamath, the IRS in its FPAA in Jade asserted accuracy-related penalties against the individual taxpayers. As the individual taxpayer did in Klamath, the individual taxpayers in Jade tried to get the court reviewing the FPAA to consider their own “reasonable cause and good faith” as grounds not to uphold the assertion of the penalty. And there the court in Jade turns away from Klamath. The taxpayers in Jade made two arguments in favor of being able to raise their own “reasonable cause and good faith” in Jade’s partnership proceeding. First, they challenged the validity of Reg. 301.6221-1(d) (set out above), which explicitly articulates the rule that partner-level defenses may not be raised in a partnership proceeding is invalid, partly on the grounds that it would deprive the individual partners of the “reasonable cause and good faith” defense explicitly granted to them by Section 6664. The Court of Federal Claims rejected this argument, noting that, while the Regulation made it more burdensome for the individuals to assert their defense, they could still do so by means of a refund suit. Second, the individual taxpayers in Jade cited Klamath for the proposition that, even under the Regulation, “partners may raise a partner-level reasonable cause defense at a partnership-level proceeding.” The court in Jade distinguished Klamath on the basis that the individual taxpayers in Jade, unlike Patterson in Klamath, had had no role in the management of the partnership or in the preparation of its tax filings. Accordingly, the individual partners were not permitted to raise issues relating to their individual “reasonable cause and good faith” in the partnership proceeding. If the decision of the Court of Federal Claims in Jade is upheld (or if there is no appeal from that decision), the individual partners will have to pay the asserted penalties and sue for a refund, if they wish to raise their “partner-level” defense. Stobie Creek Most recently, the Court of Federal Claims was presented with an opportunity to revisit this issue in Stobie Creek Investments, LLC, 101 aftr 2D 2008-1151 (Fed. Cl. Ct., 2008), but declined to change its views. Partners in Stobie, the partnership before the court, sought an order confirming that, at the trial of the partnership proceeding, their individual “reasonable cause and good faith” defenses would be adjudicated. The government opposed the partners’ motion, but conceded that any issues relating to partnership-level “reasonable cause and good faith” were properly before the court. The partners’ primary argument was based on the words of the legislative history of the TRA ’97, quoted above: “The bill provides that the partnership level proceeding is to include a determination of the applicability of penalties at the partnership level. However, the provision allows partners to raise any partner-level defenses in a refund forum.” Based on this language, the partners argued that a refund suit was merely one allowable alternative for raising partner-level defenses, and that they should be permitted to take advantage of what they viewed as another allowable alternative, i.e., raising them in the partnership proceeding itself. The Court of Federal Claims rejected this reading and concluded that the applicable statutory and regulatory provisions made a refund suit the exclusive means of raising a partner-level defense. There are a few additional points of note in Stobie. First, the court did indicate that it would consider actions taken by the managing partner, presumably in his capacity as such, in determining the applicability of penalties. This seems entirely consistent with existing authority, such as Santa Monica Pictures. Second, the court rejected other arguments made by the individual partners to permit the consideration of partner-level defenses, one of which was based on a “creative” reading of the Rules of the Court of Federal Claims and the other of which was grounded in an attempt to amend their complaint to join a partner-level claim for refund of penalties, brought under the general jurisdictional statute of the Court, with the partnership-level proceeding commenced by the FPAA. Like the individual partners in Jade, it appears likely that the partners in Stobie will have to pay any asserted penalties before they can commence refund actions in which they can raise partner-level defenses, such as individual “reasonable cause and good faith.” CONCLUSION In the two most recent partnership proceedings to consider the issue, taxpayers have been unsuccessful in persuading the Court of Federal Claims to consider partner-level defenses to an asserted accuracy-related penalty. Accordingly, if an opportunity to raise such defenses prior to paying a penalty is of significant concern, one should certainly consider selecting a forum in which the issue is at least arguably still open – that is, a forum other than the Court of Federal Claims – in which to litigate a partnership proceeding in which penalties have been asserted. In fact, the validity of Regs. 301.6221 1(c) and (d) is at issue in several partnership proceedings now pending in the Tax Court, as mentioned in 7050, Ltd., TCM 2008-112. In that very recent decision, a partnership proceeding, the Tax Court denied (without prejudice to renew) the Service’s motion for summary judgment that penalties should be imposed on the partners because the issue of the validity of the Regulations, which would bar the partners from raising partner-level defenses in the partnership proceeding, had not been briefed by the parties and was the subject of pending cases. Nevertheless, the facts in even the most “favorable” case, Klamath, were such that the ability to raise, even in the most friendly forum, partner-level defenses in the partnership proceeding may have to be viewed as an exception, rather than a general rule. The words of the Code, Treasury Regulations, and legislative history may be so clear that no court will ordinarily allow the raising of such defenses in a partnership proceeding, but the advocate’s job will be to convince the court, as frequently as possible, that special factors are present to justify permitting a taxpayer to raise partner-level defenses in a partnership proceeding, prior to payment of the asserted penalties.