PROCEDURAL ISSUES IN IRS PARTNERSHIP AUDITS AND TAX LITIGATION

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1 PROCEDURAL ISSUES IN IRS PARTNERSHIP AUDITS AND TAX LITIGATION Mary A. McNulty 1 This presentation will explore various procedural issues in partnership audits and tax litigation, including the rights and duties of the tax matters partner, the unique rules governing partnership refund claims, partner-level and partnership-level statutes of limitations, and tips and traps in navigating the complex TEFRA partnership rules. I. TEFRA OVERVIEW A. Purpose of TEFRA. Partners, not partnerships, pay federal income taxes. The partnership s aggregate income and loss items for the year are determined for the partnership as an entity and are reported on Form 1065, U.S. Return of Partnership Income. The partnership agreement determines a partner s allocable share of the partnership s items of income, gains, deductions, losses, and credits and such share is reported to a partner on Schedule K-1, Partner s Share of Income, Deductions, Credits. Although the amounts reported to each partner may vary, the starting point in determining whether the amount reported by a partner on its tax return is correct is the computation of the total amount at the partnership level. Before 1982, however, audits were conducted only at the partner level. Therefore, if the Internal Revenue Service (the IRS or Service )) wanted to audit a partnership item, such as its cost of goods sold, it could do so only by auditing each partner individually. This process caused a significant duplication of effort and administrative difficulties. Congress addressed this problem in the Tax Equity and Fiscal Responsibility Act of 1982 ( TEFRA ), Pub. L Sections of TEFRA enacted Sections 6046A (relating to foreign partnerships) and and amended Section 6031 of the Internal Revenue Code (the Code ) to address the tax treatment of partnership items. Congress subsequently added Section 6233, which extends TEFRA treatment to non-partnership entities that file partnership returns, and Section 6234, which allows a declaratory judgment for certain non-partnership items relating to oversheltered returns. Although the TEFRA provisions addressed a real and serious administrative problem, they also created a complex process with many new problems and traps for the unwary. 1 Thompson & Knight LLP, Dallas, TX, mary.mcnulty@tklaw.com. The author gratefully acknowledges the assistance of Robert P. Probasco, also a partner at Thompson & Knight, and Brandon Bloom and Lee Meyercord, associates at Thompson & Knight. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

2 B. TEFRA Defined Terms. 1. Partnership. Any partnership required to file a return under I.R.C. 6031(a). I.R.C. 6231(a)(1)(A). a. I.R.C. 6031(a) references I.R.C. 761(a), which defines the term partnership to include a syndicate, group, pool, joint venture or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. b. I.R.C. 6231(a)(1)(B) provides a small partnership exception for any partnership having 10 or fewer partners each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner. These are commonly referred to as non-tefra partnerships. A small partnership can elect to have the TEFRA provisions apply. i. A husband and wife are treated as a single partner. I.R.C. 6231(a)(1)(B). ii. iii. A disregarded entity is counted as a partner. See Rev. Rul , C.B Since 1997, this rule has applied regardless of whether the LLC or partnership has special allocations or a corporate partner or member. c. A savings provision protects the IRS from making an incorrect determination as to whether the TEFRA procedures apply. If the IRS makes a reasonable determination, based on the partnership return for a particular tax year, that the TEFRA procedures either apply or do not apply, that determination will be given effect with respect to the partnership and its partners for that tax year, even if the IRS determination was erroneous. I.R.C. 6231(g). 2. Partner. Any actual partner in the partnership and any other person whose income tax liability under subtitle A is determined in whole or in part by taking into account directly or indirectly partnership items of the partnership. I.R.C. 6231(a)(2). Thus, the term partner is not restricted to those persons with a direct interest in the partnership or those persons who receive a Schedule K-1. This part of the definition is clarified by other definitions of two different types of partners: Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

3 a. Pass-thru partner: a partnership, estate, trust, S corporation, nominee, or other similar person through whom other persons hold an interest in the partnership with respect to which proceedings under this subchapter are conducted. I.R.C. 6231(a)(9). A disregarded entity is also a pass-thru partner. Rev. Rul , C.B b. Indirect partner: a person holding an interest in a partnership through 1 or more pass-thru partners. I.R.C. 6231(a)(10). Thus, indirect partners include S corporation shareholders, partners, LLC members, trust beneficiaries, and subtrusts. Example of Tiered Structure: Partnership A has two partners, Individual B and Partnership C. Partnership C has two partners, Individual D and S- corporation E. S-corporation E has two owners, Individual F and Individual G. Result: B, C, D, E, F, and G are all partners with respect to Partnership A and may have certain rights with respect to audits or refund claims. C and E are pass-thru partners. D, E, F, and G are indirect partners. 3. Partnership Item. Partnership items are those items required to be taken into account for the partnership s taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that, for purposes of this subtitle, such item is more appropriately determined at the partnership level than at the partner level. I.R.C. 6231(a)(3). a. This definition is important because a partnership-level proceeding generally can address only partnership items. Other items are determined at the individual partner level. b. Treas. Reg (a)(3)-1(a) sets forth specific items, including: i. a partner s share of the partnership s income, gain, loss, deduction, or credit; ii. iii. Expenditures by the partnership not deductible in computing its taxable income (for example, charitable contributions); Partnership liabilities (including determinations with respect to the amount of the liabilities, whether the liabilities are nonrecourse, and changes from the preceding taxable year); Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

4 iv. Other amounts determinable at the partnership level with respect to partnership assets, investments, transactions and operations necessary to enable the partnership or the partners to determine amounts at risk, depletion, and hot assets under Section 751; v. Guaranteed payments; vi. vii. Optional adjustments to the basis of partnership property pursuant to an election under section 754; and Items relating to the following transactions, to the extent that a determination of such items can be made from determinations that the partnership is required to make with respect to an amount, the character of an amount, or the percentage interest of a partner in the partnership, for purposes of the partnership books and records or for purposes of furnishing information to a partner: contributions to the partnership, distributions from the partnership, and transactions to which section 707(a) applies, such as disguised sales. Generally, partnership items include all those items that are reported on Form 1065 and Schedules K-1. c. Partnership items also include various accounting practices and legal and factual determinations that underlie those specific items reported on Form 1065 and Schedules K-1, such as the partnership s method of accounting, taxable year, inventory method, and elections. Treas. Reg (a)(3)-1(b). d. The critical element is that the partnership needs to make a determination with respect to a matter for the purposes stated.... Treas. Reg (a)(3)-1(c)(1). e. The partnership s statute of limitations is a partnership item. Weiner v. United States, 389 F.3d 152 (5th Cir. 2004); Kaplan v. United States, 133 F.3d 469 (7th Cir. 1998); Slovacek v. United States, 36 Fed. Cl. 250 (1996). f. The determination of whether a partnership is a valid partnership is a partnership item. Tigers Eye Trading, LLC v. Comm r, 138 T.C. No. 6 (2012). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

5 g. The determination of who is a partner is a partnership item. Alpha I LP et. al. v. United States, 109 AFTR 2d (Fed. Cir. 2012); Blonien v. Comm r, 118 T.C. No. 34 (2002). h. Whether tax-motivated interest applies to an underpayment is a partnership item because it depends on the partnership s motives in entering into the transaction. Keener v. United States, 76 Fed. Cl. 455 (2007), aff d, 551 F.3d 1358 (Fed. Cir. 2009). Section 6621(c) imposes interest at a rate of 120% of the statutory underpayment rate on any substantial underpayment attributable to taxmotivated transactions. 4. Nonpartnership Item. [A]n item which is (or is treated as) not a partnership item. I.R.C. 6231(a)(4). a. Nonpartnership items are not addressed in a partnership-level audit. For example, the amount a partner paid in purchasing a partnership interest from another partner is a nonpartnership item. The partnership does not need to know the purchase price between partners for its accounting and return preparation. b. Partnership items may become nonpartnership items, and therefore not subject to partnership-level proceedings, under certain circumstances. I.R.C. 6231(b), (c). These primarily involve situations in which it would be more efficient or effective to address the partner s tax liability separately. Examples: i. The IRS decides to treat the items as nonpartnership items. The IRS must notify the partner of this decision. ii. iii. The IRS does not allow a partnership-level refund claim filed by an individual partner rather than the TMP (see below) and the partner seeks judicial review of the refund claim. The IRS and the partner enter into a settlement agreement with respect to the items. For a settlement agreement to convert partnership items to nonpartnership items, the Tax Court and Tenth Circuit have held that the settlement agreement must reflect the intent to deal with the partners individually with respect to those partnership items. Mathia v. Comm r, 109 A.F.T.R.2d (CA-10, 2012), aff g T.C. Memo (finding the settlement agreements did not convert any partnership items to nonpartnership items for purposes of Section 6231(b)(1)(C) Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

6 because the agreements were entered into by and with the partnership alone. ). iv. The IRS makes a termination assessment or jeopardy assessment against the partner. I.R.C. 6231(c)(1), (2); Treas. Reg (c)-4. v. The partner is under criminal investigation. I.R.C. 6231(c)(1)(B); Treas. Reg (c)-5. vi. The partner is named as a debtor in a bankruptcy proceeding. I.R.C. 6231(c)(2); Treas. Reg (c)-7. If the bankrupt partner is a tier, the IRS position is that the bankruptcy does not convert the partnership items of indirect partners into nonpartnership items. CCA (June 24, 2009). 5. Affected Item. [A]ny item to the extent such item is affected by a partnership item. I.R.C. 6231(a)(5); Treas. Reg (a)(5)-1(a). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS a. These items generally cannot be addressed in a partnership-level audit. Nor can they be included in a partner-level notice of deficiency or litigation unless: (a) based on the partnership return as filed; or (b) delayed until the resolution of the partnership-level proceeding. See, e.g., Bausch & Lomb Inc. v. Comm r, T.C. Memo (finding certain items in partner s deficiency notice were affected items and therefore could not be litigated in a partner-level proceeding until the partnership-level proceeding had concluded). b. Affected items include items on the partner s return that are unrelated to the items on the partnership return but determined in part by those partnership items. For example, the partner s distributive share will affect gross income and therefore the threshold for the medical expense deduction or the limitation of itemized deductions. Treas. Reg (a)(5)-1(a). c. The partner s outside basis is an affected item to the extent it is not a partnership item. The partner s at-risk limitation and income or loss from other passive activities are not partnership items. Thus, the loss a partner claims for a partnership is determined in part by its distributive share (a partnership item) and partly by its basis, atrisk, and passive-loss limitations. The loss claimed by the partner is an affected item. Treas. Reg (a)(5)-1(b), (c), (d). d. The portion of a penalty that is treated as an affected items depends on whether the penalty is subject to a floor and the impact of the 6

7 adjustment of the partnership item on the floor amount. A floor is a threshold amount of underpayment or understatement necessary before the imposition of the penalty. Treas. Reg (a)(5)- 1(e). i. If a penalty that does not contain a floor is imposed on a partner as the result of an adjustment to a partnership item, the term affected item includes the penalty computed with reference to the portion of the underpayment that is attributable to the partnership item adjustment(s) to which the penalty applies. ii. iii. If a partner would have been subject to a penalty in the absence of an adjustment to a partnership item (that is, the partner s understatement or underpayment exceeded the floor even without an adjustment to a partnership item) the term affected item includes only the portion of the penalty computed with reference to the partnership item (or affected item) adjustments. In the case of a penalty that contains a floor, if the taxpayer s understatement or underpayment does not exceed the floor prior to an adjustment to a partnership item but does so after such adjustment, the term affected item includes the penalty computed with reference to the entire underpayment or understatement to which the penalty applies. iv. Example of Portion of Penalty that is an Affected Item: C, a partner in partnership P, understated C s income tax liability attributable to nonpartnership items by $4,000. As a result of an adjustment to partnership items, that understatement is increased to $10,000. Before the adjustment, C would not have been subject to the accuracyrelated penalty under section 6662 for a substantial understatement of income tax. The accuracy-related penalty under section 6662 computed with reference to the entire $10,000 understatement to which the accuracyrelated penalty applies is an affected item. 6. Computational Adjustment. [T]he change in tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item. All adjustments required to apply the results of a proceeding with respect to a partnership under this subchapter to an Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

8 indirect partner shall be treated as computational adjustments. I.R.C. 6231(a)(6). a. Computational adjustments are the bridge between the partnershiplevel proceeding and the partner s tax liability. A final determination that the partnership understated its income by $X, and the allocation of that amount to individual partners, still does not determine or assess additional tax liability for the partners. That is done by a subsequent computational adjustment. b. There are two categories of computational adjustments. i. Affected items that do not require partner-level determinations. Treas. Reg (a)(6)-1(a)(2). These would be changes in the partner s tax liability that can be computed mechanically from the partner s return and the results of the partnership-level proceeding. For example, if the partnership-level proceeding resulted in the allocation of additional income to the partner, the partner s tax liability might be easily recalculated by substituting the redetermined partnership items for the partner s previously reported partnership items. If no partner-level determinations are required, the computational adjustment is directly assessed. See, e.g., Bush v. United States, 110 AFTR 2d (2012-XXXX (Cl. Ct. 2012) (rejecting taxpayer s argument that computational adjustment was invalid because the IRS did not first examine the taxpayer s individual return). ii. Affected items that do require partner-level determinations. These can be assessed against the partner only through normal deficiency procedures. However, penalties can be assessed directly and are not subject to deficiency procedures. See discussion below. Treas. Reg (a)(6)-1(a)(3). c. A computational adjustment includes any interest due with respect to any underpayment or overpayment of tax attributable to adjustments to reflect properly the treatment of partnership items. Treas. Reg (a)(6)-1(b). 7. Notice Partners. The IRS is required to give, to all partners whose name and address is furnished, notice of the beginning of an administrative proceeding ( NBAP ) at the partnership level and notice of the final administrative adjustment ( FPAA ) resulting from that proceeding. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

9 I.R.C. 6223(a). These partners are referred to as notice partners. I.R.C. 6231(a)(8). a. The IRS uses the names and addresses shown on the partnership return to identify notice partners. I.R.C. 6223(c)(1). b. There are exceptions for large partnerships. The IRS need not provide notice to an individual partner if (a) the partnership has more than 100 partners, and (b) the partner has less than a 1% interest in partnership profits. However, if a group of partners with a 5% aggregate interest requests notice and designates one of the members to receive the notice, the IRS must provide notice to the designated member representative. I.R.C. 6223(b); Treas. Reg (b)-1(a). c. If the IRS has the name, address, and profits interest of an indirect partner (i.e., a partner holding his interest in the partnership through a pass-thru partner), then the IRS generally must send the NBAP and FPAA directly to the indirect partner. I.R.C. 6223(c)(3). i. It is not clear whether this notice requirement applies to indirect partners who hold their interests through a large partnership. Under Section 6223(b), the IRS is not required to provide notice to an individual partner if (a) the partnership has more than 100 partners, and (b) the partner has less than a 1% interest in partnership profits. Therefore, even if the IRS has their identifying information, indirect partners should consider forming a notice group if they want to ensure that they receive notice directly from the IRS. I.R.C. 6223(b). ii. If the indirect partner is not entitled to notice from the IRS, the pass-thru partner is required to forward any notice to the indirect partners. I.R.C. 6223(h). d. Other rights in a TEFRA proceeding (e.g. the right to petition the Tax Court) are provided to notice partners. Therefore, whether a partner constitutes a notice partner can materially impact a partner s rights, particularly an indirect partner that itself may not be a notice partner. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

10 II. THE TAX MATTERS PARTNER ( TMP ) The purpose of the Tax Matters Partner (the TMP ) is to provide the IRS with a singlepoint liaison during audits and provide a single representative for litigation. The TMP represents the partnership during audits and litigation but does not otherwise have broad authority to make all decisions relating to the partnership s tax matters, unless expressly granted by the partnership or LLC agreement. A. Who can be the TMP? The primary consideration behind the complex TMP regulations is the IRS s need to ensure that it deals with a single partner that has the authority to bind the partnership. A common mistake made in drafting partnership agreements is to designate a member or officer of a partner as the TMP, rather than the partner itself. The following partners may be the TMP: 1. A general partner in the partnership at some time during the tax year for which the designation is made or as of the time when the designation is made. I.R.C. 6231(a)(7); Treas. Reg (a)(7)-1(b)(1), (c). a. The TMP may be designated on the tax return. Treas. Reg (a)(7)-1(c). b. The TMP may also be designated after the filing of a tax return by the filing of statement with the service center where the tax return was filed by general partners, or other partners if all general partners have been disqualified, collectively holding a majority interest in the partnership. Treas. Reg (a)(7)-1(e), (f). 2. If no TMP is designated, the TMP is the general partner having the largest profits interest in the partnership at the close of the taxable year involved (or, where there is more than 1 such partner, the 1 of such partners whose name would appear first in an alphabetical listing). I.R.C. 6231(a)(7)(B); Treas. Reg (a)(7)-1(m). 3. If the partnership has not designated a TMP and it is impracticable to apply the largest-profits-interest rule, the Commissioner will select the TMP. Treas. Reg (a)(7)-1(n) through (r). 4. Special rules apply to a limited liability company treated as a partnership. Treas. Reg (a)(7)-2. a. Only a member-manager of an LLC is treated as a general partner. A member of an LLC who is not a member-manager is treated as a partner other than a general partner and thus cannot be the TMP. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

11 Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS b. A member-manager means a member of an LLC who, alone or together with others, is vested with the continuing exclusive authority to make the management decisions necessary to conduct the business for which the organization was formed. c. If there are no elected or designated member-managers of the LLC, each member will be treated as a member-manager for purposes of this section and can be designated as the TMP. 5. A disregarded entity can be designated as a TMP. A disregarded entity is a partner under state law and thus may be designated as the TMP if it has the authority to bind the partnership under state law. Rev. Rul , I.R.B If a TMP is a partnership or a limited liability company, the Service must determine who has authority under state law to sign for the TMP entity. See I.R.M (2) (Oct. 1, 2010), Persons Empowered to Sign A Consent. Practice Tip: Limited partners, non-managing members, and non-partners, such as a member of officer of a partner, are not eligible to serve as TMP. However, a partnership or LLC agreement may attempt to delegate the TMP role to an ineligible partner (although it is unclear whether the IRS would accept such a delegation) or require the TMP to follow the direction of an ineligible TMP or a Board of Managers. B. What is the Statutory and Regulatory Role of the TMP? 1. The TMP has the responsibility to keep other partners informed of the proceedings, to the extent the IRS is not required to do so. I.R.C. 6223(g). Thus, the TMP must: a. Provide notices of the beginning of an administrative proceeding or of an FPAA to partners who are not notice partners. Treas. Reg (g)-1(a). b. Provide notices to indirect partners who have been identified to the TMP at least 30 days before notice is required. Treas. Reg (g)-1(b)(2)(ii). The TMP of a pass-thru partner that is a partnership is required to provide notice to those indirect partners who hold an interest in the partnership through the pass-thru partner. Treas. Reg (h)-1. c. Provide other notices relating to closing conferences with the auditor, proposed adjustments, the requirements for filing a protest, the Appeals conference, the extension of the statute of limitations, 11

12 the filing of an AAR, the filing of a petition for judicial review, the appeal of a judicial determination, and any final judicial determination. Treas. Reg (g)-1(b). 2. Collectively, the responsibilities of the IRS, the TMP, and pass-thru partners are designed to ensure that almost all partners receive notice concerning proceedings. However, the administrative proceeding and adjustment are still valid even if partners do not receive the required notice. I.R.C. 6230(f). See also Vulcan Oil Technology Partners v. Comm r, 110 T.C. 153 (1998), aff d sub nom, 198 F.3d 259 (10th Cir. 1999); Slovacek v. United States, 40 Fed. Cl. 828 (1998). C. May the TMP Bind Other Partners? 1. The TMP may bind partners only to a limited extent. 2. The TMP can generally (see discussion of exceptions below) bind other partners to extensions of the statute of limitations. I.R.C. 6229(b)(1)(B). 3. The TMP can bind another partner to a settlement agreement only if the partner (i) is neither a notice partner nor a member of a notice group and (ii) has not denied that authority to the TMP by filing a statement with the IRS. I.R.C. 6224(c)(3). The TMP must expressly state in the agreement that it binds the other partners. Other partners are bound by a settlement agreement only if they are parties to the agreement. I.R.C. 6224(c)(1). D. What is the Contractual Role of the TMP? 1. Oftentimes, the partnership agreement will expand the authority and responsibilities of the TMP beyond what is provided in the Code and regulations. For example, the partnership agreement may provide that the TMP is responsible for causing the tax returns to be prepared and filed and is authorized to make any elections or other decisions with respect to the positions taken on such tax returns. 2. Considerations when drafting TMP provisions: a. Whether the TMP s interests are aligned with other partners -- i.e., whether the TMP has an economic stake in the outcome of a proceeding or holds only a 0% GP interest; b. Whether the TMP should have authority to make all tax elections and to file all tax returns; c. Consequences of appointing an ineligible TMP; Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

13 Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS d. Consequences of designating a tax shelter promoter as the TMP; e. Whether to impose restrictions on the TMP s ability to extend the statute of limitations, settle tax controversies, or choose litigation forums; f. Consequences of the TMP behaving badly; g. Providing deadlines for partners and partnership to provide information to each other; and h. Providing for tax distributions if the petitioning partner must make a deposit before contesting an FPAA in district court or the Court of Federal Claims. E. Is the TMP an Authorized Signatory for the Partnership Tax Return? 1. Section 6063 provides: The return of a partnership made under section 6031 shall be signed by any one of the partners. The fact that a partner s name is signed on the return shall be prima facie evidence that such partner is authorized to sign the return on behalf of the partnership. 2. The regulations reiterate that [r]eturns, statements, and other documents required to be made by partnerships under the provisions of subtitle A or F of the Code, or the regulations thereunder, with respect to any tax imposed by subtitle A of the Code shall be signed by any one of the partners. Treas. Reg (a). 3. IRS guidance, although not always consistent, provides for more restrictive requirements than the Code and regulations: a. The signature line on Form 1065 and the instructions thereto require the signature of a general partner or limited liability company member-manager. b. IRS Pub. 541, Partnerships, provides that the partnership return must be signed by a general partner. If an LLC is treated as a tax partnership, it must file Form 1065 and one of its members must sign. Although the Form 1065 instructions require a membermanager of an LLC to sign the return, nothing in IRS Pub. 541 precludes nonmanaging members from signing the return. c. IRS Pub. 3402, Taxation of Limited Liability Companies is more restrictive. The IRS expressly states, Only a member manager of an LLC can sign the partnership tax return. IRS Pub defines a member-manager as any owner of an interest in the LLC 13

14 who, alone or together with others, has the continuing authority to make the management decisions necessary to conduct the business for which the LLC was formed. If there are no elected or designated member-managers, each owner of the LLC is treated as a member-manager. 4. Potential collateral TEFRA consequences dependent on whether a validly signed return was filed: a. The statute of limitations remains open under Section b. Under Section 6221, the valid filing of a partnership return effectively prevents the IRS from adjusting a partnership item on a partner s return except through a partnership-level audit. c. Section 6222 requires that a partner s return must be consistent with the filed partnership return. d. The partnership return alerts the IRS about the partners who must receive notice in a unified audit. I.R.C. 6223(c)(1). e. The filing of a validly executed partnership return starts the period within which a partner may file an administrative adjustment request. I.R.C. 6227(a). f. The filing of a validly signed partnership return establishes (with certain exceptions) that an entity will be subject to TEFRA, even if it is determined that the entity is not a partnership or that no partnership in fact existed. I.R.C F. How Long does a TMP s Authority Survive? 1. A TMP s designation as TMP for a taxable year remains in effect until (a) the TMP dies, is incapacitated, resigns, or liquidates; (b) the partnership items of the TMP become nonpartnership items; or (c) a designation of a successor TMP or revocation of the TMP s designation is made pursuant to applicable regulations. Treas. Reg (a)(7)-1(l). 2. Accordingly, a TMP s designation for a pre-closing tax year survives the disposition of the TMP s partnership interest. As a matter of tax policy, this is the right result because the TMP should be a person whose tax liability may be impacted by IRS administrative or judicial proceedings. 3. The designation of the TMP for one year does not automatically carryover to the next year. A TMP designation is made on a year by year basis and is Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

15 made through the designation on the partnership s tax return. Treas. Reg (a)(7)-1(a), (c). III. STATUTES OF LIMITATIONS Different, but related, periods of limitation apply at the partner and partnership level. These statutes of limitation have been the subject of much recent litigation. A. Partner-Level Statute of Limitations. 1. The partner-level statute of limitations for assessments is generally 3 years after the return was filed (whether or not such return filed on or after the date prescribed). I.R.C. 6501(a). 2. The statute of limitations can be extended by agreement. I.R.C. 6501(c)(4). This extension agreement will extend the period of limitations for assessing tax attributable to partnership items only if the extension agreement specifically so states. I.R.C. 6229(b)(3). a. The IRS amended Form 872, Consent to Extend the Time to Assess Tax, in October 2009 to specifically provide that it extends the period of limitations for assessing tax attributable to any partnership items. b. Before the change to this form, the IRS would request Form 872-I, Consent to Extend the Time to Assess Tax As Well as Tax Attributable to Items of a Partnership, which would extends the period for assessing items from all partnerships appearing on the taxpayer s return. It also extended the assessment period for non-partnership items. 3. The statute of limitations is based on a six-year period rather than a threeyear period for a substantial omission of gross income from the return. Generally, 25% of the gross income reported on the return is considered a substantial omission. I.R.C. 6501(e). a. The IRS contends that an overstatement of basis, resulting in an understatement of income, qualifies as a substantial omission of gross income. This is an expansive reading of the six-year statute and was used frequently in recent years in Son-of-BOSS cases. b. The Supreme Court, interpreting the 1939 Code, held that an overstatement of basis is not an omission of gross income. Colony, Inc. v. Comm r, 357 U.S. 28 (1958). In several recent cases, the Tax Court concluded that Colony required the same interpretation of the current Code. See, e.g., Intermountain Ins. Serv. of Vail, Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

16 LLC v. Comm r, 98 T.C.M. (CCH) 144 (2009); Bakersfield Energy Partners, LP v. Comm r, 128 T.C. 207 (2007), aff d, 568 F.3d 767 (9th Cir. 2009). (As discussed below, Intermountain was subsequently reversed.) c. Some district courts disagreed with the Tax Court and held for the government. See, e.g., Burks v. United States, 2008 U.S. Dist. LEXIS (N.D. Tex June 13, 2008); Home Concrete & Supply, LLC v. United States, 599 F. Supp. 2d 678 (E.D.N.C. 2008). (As discussed below, both of these decisions were later overturned.) Initially, however, the Ninth and Federal Circuits agreed with the Tax Court and held for the taxpayer. Bakersfield Energy Partners, LP v. Comm r, 568 F.3d 767 (9th Cir. 2009); Salman Ranch, Ltd. v. United States, 573 F.3d 1362 (Fed. Cir. 2009). d. The IRS and Treasury Department issued temporary regulations in 2009, 74 Fed. Reg. 49,321 (Sept. 28, 2009), and final regulations in 2010, 75 Fed. Reg. 78,897 (Dec. 17, 2010), to establish that an overstatement of basis was an omission of gross income. Treas. Reg (e)-1, (c)(2)-1. Since the regulations were issued: i. Two circuits have held for taxpayers, declining to follow the final regulations. Home Concrete & Supply, LLC v. United States, 634 F.3d 249 (4th Cir. 2011), rev g 599 F. Supp. 2d 678 (E.D.N.C. 2008); Burks v. United States, 633 F.3d 347 (5th Cir. 2011), rev g 2008 U.S. Dist. LEXIS (N.D. Tex June 13, 2008). ii. iii. iv. Four circuits have held for the government. Grapevine Imps., Ltd. v. United States, 636 F.3d 1368 (Fed. Cir. 2011) (reversing its position in the Salman Ranch case); Beard v. Comm r, 633 F.3d 616 (7th Cir. 2011); Salman Ranch, Ltd. v. Comm r, 2011 U.S. App. LEXIS (10th Cir. 2011); Intermountain Ins. Serv. of Vail, LLC v. Comm r, 2011 U.S. App. LEXIS (D.C. Cir. 2011). The Ninth Circuit has not yet revisited the issue, after ruling for the taxpayer, since the regulations were issued. The Second Circuit is currently considering the issue on appeal of Wilmington Partners, LP v. Comm r, 2010 U.S. Tax Ct. LEXIS 56 (2010). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

17 e. The Supreme Court recently resolved this split among the Circuit Courts in Home Concrete & Supply, LLC v. United States, and held that an overstatement of basis was not a substantial omission from gross income. 109 A.F.T.R.2d (2012). The Supreme Court rejected the IRS s argument that Treas. Reg (e)-1 interpreted the statute to include overstatement of basis as an omission from gross income because the Court s decision in Colony had already interpreted the statute. 4. The statute of limitations for assessments is open indefinitely if the taxpayer fails to file a return, files a false or fraudulent return with the intent to evade tax, or engages in a willful attempt in any manner to defeat or evade tax. I.R.C. 6501(c)(1) (3). 5. There are also various other exceptions. See generally I.R.C The running of the statute of limitations is suspended after the issuance of a notice of deficiency, for the period during which the Secretary is prohibited from making an assessment, and for 60 days thereafter. I.R.C. 6503(a)(1). After the IRS issues a notice of deficiency, the taxpayer has 90 days (or 150 days if the taxpayer is outside the United States) to file a Tax Court petition to redetermine the deficiency. The IRS cannot assess a deficiency until the expiration of the 90-day (or 150-day) period. If the taxpayer files a Tax Court petition, the IRS cannot assess a deficiency until the Tax Court decision has become final. I.R.C. 6213(a). B. Partnership-Level Statute of Limitations. 1. I.R.C. 6229(a): Except as otherwise provided in this section, the period for assessing any tax imposed by subtitle A with respect to any person which is attributable to any partnership item (or affected item) for a partnership taxable year shall not expire before the date which is 3 years after the later of (1) the date on which the partnership return for such taxable year was filed, or (2) the last day for filing such return for such year (determined without regard to extensions). (emphasis added) 2. The application of I.R.C. 6229(a) has been challenged repeatedly in recent years, but it is now well-settled law that it is not an exclusive statute of limitations. The IRS argued that it merely extends the I.R.C partner-level statute of limitations, based on the shall not expire before language. The Tax Court, the Court of Federal Claims, and several Circuit Courts of Appeal have endorsed the IRS interpretation. See, e.g., Rhone- Poulenc Surfactants & Specialties, L.P. v. Comm r, 114 T.C. 533 (2000); Curr-Spec Partners, L.P. v. Comm r, 579 F.3d 391 (5th Cir. 2009), cert. den., 130 S. Ct (2010); AD Global Fund, LLC v. United States, 481 Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

18 F.3d 1351 (Fed. Cir. 2007); Andantech LLC v. Comm r, 331 F.3d 972 (D.C. Cir. 2003); Schumacher Trading Partners II v. United States, 72 Fed. Cl. 95 (2006); Grapevine Imports, Ltd. v. United States, 71 Fed. Cl. 324 (2006); Russian Recovery Fund, Ltd. v. United States, 108 A.F.T.R.2d (Fed. Cl. 2011). Thus, an assessment of tax attributable to a partnership item is timely as long as either the partner-level or partnershiplevel period of limitations remains open. 3. The partnership-level statute of limitations can also be extended by agreement. I.R.C. 6229(b)(1). a. Any partner can enter into an agreement with the IRS that extends the statute of limitations for partnership items only with respect to that partner. Form 872, discussed above, is used for this purpose. b. The TMP (or any other person authorized by the partnership in writing to do so) can enter into an agreement with the IRS that extends the statute of limitations for partnership items with respect to all partners. Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Partnership Items, is used for this purpose. c. Because the TMP owes a fiduciary duty to other partners, an extension may not bind the other partners if the TMP has a severe conflict of interest known to the IRS. See In re: Martinez, 564 F.3d 719 (5th Cir. 2009). However, this is a high standard, and most challenges by other partners to an extension signed by the TMP have been unsuccessful. 4. The statute of limitations is a six-year period, rather than a three-year period, for a substantial omission of gross income from the partnership s return. I.R.C. 6229(c)(2). 5. If any partner, with the intent to evade tax, signs or participates directly or indirectly in the preparation of a partnership return that includes a false or fraudulent item: (a) the statute of limitations is open indefinitely for that partner with respect to tax attributable to partnership items for that return; and (b) the statute of limitations is based on a six-year period, rather than a three-year period, for all other partners. I.R.C. 6229(c)(1). In Transpac Drilling Venture v. United States, 83 F.3d 1410 (Fed. Cir. 1996), the general partner signed the return knowing that it contained false losses and management fees that would reduce the limited partners taxes. The six-year statute of limitations applied to the limited partners, even without evidence that they intended to evade taxes. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

19 6. The statute of limitations is open indefinitely if no return is filed. I.R.C. 6229(c)(3). 7. The running of the statute of limitations is suspended after the issuance of an FPAA for the period during which a petition for judicial review can be filed under I.R.C (and if a petition is filed, until the decision of the court is final) and for one year thereafter. I.R.C. 6229(d). 8. If a partnership item is converted to a nonpartnership item, the period for assessing tax shall not expire earlier than one year after the date the item became a nonpartnership item. I.R.C. 6229(f)(1). 9. If a partner is not properly identified on the partnership return and the TMP receives a timely notice of FPAA before the statute expires or the partner files inconsistently with the partnership return and does not file a notice of inconsistent treatment, the statute of limitations will not expire for such partner until one year after the partner s name, address, and identification number are provided to the IRS. I.R.C. 6229(e); Gaughf Properties L.P. v. Comm r, 139 T.C. No. 7 (2012) (the statute of limitations remained open for indirect partners who did not file a notice of inconsistent treatment and whose identifying information was not furnished to the IRS); Costello v. United States, 765 F. Supp (C.D. Ca. 1991) (the statute of limitations on assessing an indirect partner s share remained open because the indirect partner was not identified). IV. PARTNERSHIP REFUND CLAIMS: AARs An Administrative Adjustment Request ( AAR ) is the equivalent of a refund claim for partnerships but is subject to very different procedural requirements. An AAR is generally filed by the TMP to pursue a tax benefit not taken on the return. An AAR is generally filed by a partner when it disagrees with the tax position taken on a return or when it wants to protect its rights to judicial review when the TMP has also filed an AAR. A. Applicable Periods of Limitation 1. Partner Level Period of Limitations for Filing Refund Claim a. A claim for credit or refund shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later. I.R.C. 6511(a). b. If the statute of limitations for assessment is extended under I.R.C. 6501(c)(4), the period for filing a refund claim shall not expire Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

20 prior to six months after the expiration of the assessment period. I.R.C. 6511(c)(1). 2. Partnership-Level Period of Limitations for Filing an AAR a. General Rule: A partner may file a request for an administrative adjustment of partnership items for any partnership taxable year at any time which is (1) within 3 years after the later of (A) the date on which the partnership return for such year is filed, or (B) the last day for filing the partnership return for such year (determined without regard to extensions).... I.R.C. 6227(a)(1). b. If the statute of limitations for assessment of partnership items is extended under I.R.C. 6229(b), the period for filing an AAR is extended for the period during which an assessment may be made and for 6 months thereafter. I.R.C. 6227(b). Practice Tip: A partner may wish extend its period of limitations on assessments with respect to partnership items under section 6229(b)(1) to extend the period of limitations for filing an AAR. A longer time period may be needed to preserve claims that result from correlative adjustments to a related party. Such an extension agreement should be carefully considered, however, as it will provide the IRS with more time to audit the partnership and identify adjustments that may more than offset any potential refund claims. c. The statute of limitations for filing an AAR does not work like the statute of limitations for assessments related to partnership items. As discussed above, there are alternative periods of limitations for assessment. Thus, the government can make an assessment while either the partner-level or partnership-level periods of limitation are open. By contrast, it appears that only a single partnershiplevel period of limitations applies to the filing of an AAR. I.R.C i. The IRS has never addressed the interaction of the partnerlevel and the partnership-level limitations periods in the context of AARs. ii. Although symmetry suggests that the same statute extension theory that applies to assessments should apply to refunds, section 6227 does not include the same shall not expire before language that courts relied on when Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

21 interpreting the interaction of sections 6501 and See discussion above. iii. The only court to date that has considered the issue is McFerrin v. United States, 492 F. Supp. 2d 695 (S.D. Tex. 2007). The court did not directly address the issue but held that the partnership s amended return was untimely because it was filed more than three years after the partnership s return was filed (but less than three years after the partner s return was filed). This holding implies that I.R.C is a stand-alone statute of limitations and is not merely an alternative to the partner-level period of limitations set forth in section 6511 of the Code. 3. Partnership-Level Statute of Limitations for Allowing a Refund. a. Unlike non-tefra procedures, the TEFRA provisions include a separate statute of limitations that is relevant to refunds. b. I.R.C. 6230(d)(1) limits when the IRS may allow partners credits or refunds of overpayments attributable to partnership items. Generally, no such credits or refunds shall be allowed or made to any partner after the expiration of the period of limitation prescribed in section 6229 with respect to such partner for assessment of any tax attributable to such item. (Exceptions to the general rule are included in I.R.C. 6230(c), (d)(2), and (d)(3).) c. This provision covers the situation in which the IRS may allow a refund without an AAR. For example, the IRS may allow a refund as the result of a computational adjustment, an audit, or resolution of an FPAA. See I.R.C. 6230(d)(5) (overpayments attributable to partnership items or affected items to the extent practicable... shall be allowed or made without any requirement that the partner file a claim therefore. ). d. This provision likely does not impact the period of limitations for timely filing an AAR. See McFerrin v. United States, 492 F. Supp. 2d 265 (S.D. Tex. 2007). But the IRS may have the discretion to make a refund. FSA Practice Tip: Given the minimal guidance and lack of binding precedent in this area, a taxpayer should not intentionally rely on the statute extension theory for filing an AAR. Instead, an AAR should be filed within 3 years from the filing of the partnership return or Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

22 within the extended time period as agreed upon by the partnership and the IRS. 4. An AAR cannot be filed after the IRS mails an FPAA to the TMP for that tax year. I.R.C. 6227(a)(2). a. The TMP or another partner may file a petition for readjustment of the FPAA, as discussed more below. b. The court has the jurisdiction to determine all partnership items, I.R.C. 6226(f), so the taxpayer can litigate items totally unrelated to the FPAA. Treas. Reg (f)-1(a) ( Thus, the review is not limited to the items adjusted in the notice. ). c. This procedure is more cumbersome than an administrative resolution of the issue but generally can achieve the same results as by filing an AAR. The drawbacks are as follows: i. It comes with quicker deadlines. The petition to redetermine an FPAA must be filed within days after the FPAA is issued. An AAR can be filed within three years after the partnership return was filed, and the taxpayer then has a longer period of time to file a petition for judicial review when the AAR is not allowed. ii. It is the only alternative once the FPAA is issued. If the partners do not challenge the FPAA, they can no longer seek a favorable adjustment through an AAR. B. Who Can File an AAR? Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS Practice Tip: The partners should review the partnership return carefully for potential favorable adjustments as soon as a partnership administrative proceeding begins and consider filing an AAR. If the AAR is not filed and the auditor is not willing to incorporate a taxpayer s adjustments into the FPAA, the partners need to be prepared to include those items in a petition for a redetermination of the FPAA, even if they would otherwise concede all of the adjustments in the FPAA. If the AAR is filed and no FPAA is issued, the partnership will be able to seek judicial review. 1. The TMP can file an AAR on behalf of the partnership. I.R.C. 6227(c). a. The IRS recently published Form 1065X, Amended Return or Administrative Adjustment Request (published Jan. 12, 2012). 22