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, [email protected]. 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

23 The TMP must file the Form 1065X with the service center where the partnership s return was originally filed. The TMP submits amended Schedules K-1 for each partner. If the partnership files Form 1065X, the partners do not need to file anything else, even in the case of multi-tiered entities. b. The TMP can request substituted return treatment. I.R.C. 6227(c)(1). Such treatment allows the IRS to treat any changes as corrections of mathematical or clerical errors on the partnership return. i. Assessments of individual partners tax liabilities can be made without a partnership-level proceeding. I.R.C. 6230(b)(1). ii. However, each partner has 60 days after receiving the notice of correction to request that the IRS not make such correction with respect to that partner. I.R.C. 6230(b)(2). Thus, a TMP cannot unilaterally force a deficiency on other partners, who may disagree with the AAR, without allowing them an opportunity to contest the adjustments. c. If the IRS does not treat the AAR as a substituted return, it can conduct a partnership-level audit, allow credits or refunds from the AAR to all partners (except with respect to partners for whom the item has become a nonpartnership item), or simply do nothing. I.R.C. 6227(c)(2). Practice Tip: A request to treat an AAR as a substituted return should be approached with caution. The IRS generally will not treat an AAR as a substituted return unless the AAR results in additional tax to some partners and no refunds to any partner. Further, requesting substituted return treatment may harm relations with other partners, even though they have an opportunity to contest the adjustment. Example of TMP with Authority to File AAR: A (60%), B (20%) and C (20%) are members of ABC LLC. A, a member-manager, is the TMP and is granted broad authority under the LLC agreement to file all tax returns and make all decisions on behalf of ABC LLC regarding federal income tax matters. On July 1, 2011, A sells its ABC interest to D and assigns all of A s rights attributable thereto to D in connection with the sale. ABC terminated for tax purposes upon the sale under Section 708. D causes the final tax return of ABC to be filed after the closing of the sale. A disagrees with certain tax elections made by D on the final ABC tax return Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

24 and wishes to file an AAR for the final ABC tax year. Can A file the AAR on behalf of ABC? 2. Any partner can file an AAR on its own behalf. I.R.C. 6226(d). a. The partner other than a TMP files an AAR in duplicate: i. The partner files its own amended return (e.g., Form 1040X or 1120X) with Form 8082 attached. ii. The partner files a copy of Form 8082 with the service center where the partnership s return is filed. b. A partner other than the TMP may not request substitute return treatment. c. The partner can file an AAR even if the TMP has already filed an AAR for the same tax year. FSA 587 (Feb. 2, 1993); CCA (Nov. 5, 2008). Normally, the IRS will disallow the individual partner s AAR, but merely filing the AAR may help preserve the partner s rights. See discussion below. d. The IRS can conduct a partnership-level audit, notify the partner that all of its partnership items for that partnership tax year will be treated as nonpartnership items (allowing him to proceed under non-tefra procedures), or process the request as a claim for refund with respect to nonpartnership items. I.R.C. 6227(d). e. An indirect partner is a partner for purposes of this provision and therefore can file an AAR. The indirect partner must show how the source partnership items flow through the tier pass-thru partner before getting to its Form 1040 in order for us to process the request the burden is on him to show how he is entitled to a refund. The claim can be denied if he does not do so. CCA (June 9, 2011). C. Judicial Review of AAR 1. By TMP. If the IRS does not allow in full an AAR filed by the TMP, the TMP can file a petition for judicial review. I.R.C. 6228(a)(1). a. The TMP can file the petition with the Tax Court, District Court, or the Court of Federal Claims. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

25 b. The petition must be filed at least six months, but no later than two years, after filing the AAR. I.R.C. 6228(a)(2)(A). The two-year period can be extended by agreement. I.R.C. 6228(a)(2)(D). Practice Tip: Non-TEFRA refund suits must be filed no later than two years after the refund claim is disallowed. A petition for judicial review of an AAR must be filed no later than two years after the AAR is filed. The statute of limitations does not remain open indefinitely if the IRS does not formally disallow the AAR, as it does with a non-tefra refund claim. In advice, the office of Chief Counsel recognized that taxpayers may be unaware that the rule is different and suggested that the IRS inform the taxpayer as a courtesy. However, there is no standard policy. As a result, unfamiliarity with the statutes of limitation could result in forfeiting the partner s claim. c. A petition for judicial review of an AAR cannot be filed after the IRS mails either a notice of the beginning of an administrative proceeding (NBAP), I.R.C. 6228(a)(2)(B), or an FPAA, I.R.C. 6228(a)(3). i. If the IRS issues an FPAA, the partners can seek a redetermination concerning the refund items in a petition for readjustment. See discussion below. ii. What happens if the IRS mails a notice of the beginning of an administrative proceeding (NBAP), thus prohibiting a petition for judicial review of an AAR, but never issues an FPAA? If no FPAA is mailed before the expiration of the statute of limitations for assessment of tax attributable to partnership items: Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS (1) The prohibition against filing a petition for judicial review of an AAR after the issuance of a notice of the beginning of an administrative proceeding is lifted; and (2) The period for filing the petition for judicial review does not expire before the date six months after the statute of limitations for assessment expired. I.R.C. 6228(a)(2)(C). (3) But this savings clause does not apply if the notice of the beginning of an administrative proceeding (BNAP) is issued after the statute of limitations for 25

26 filing an AAR has expired. In Atlantic Richfield Co. v. Treasury, 79 A.F.T.R.2d (RIA) (D.D.C. 1996), the statute of limitations for filing an AAR expired before the IRS began auditing the partnership. The IRS identified taxpayer-favorable adjustments totaling $800 million but declined to issue an FPAA. The taxpayer sought an order compelling the IRS to issue a no change FPAA to permit it to file a petition for readjustment to claim the additional deductions and tax credits. The court denied the motion for a temporary restraining order. This is a great example of the problem with the asymmetrical statute of limitations for assessments and refunds. Practice Tip: Do not assume that that the period of limitations for filing an AAR remains open so long as the period of limitations for assessments remains open. d. As with petitions for readjustment of an FPAA, the other partners are allowed to participate in the action, as long as they have an interest in the outcome. I.R.C. 6228(a)(4). e. If the IRS does not allow an AAR filed by the TMP and the TMP does not file a petition for judicial review, no other partner may file a petition for an adjustment to the related partnership items. See I.R.C. 6228(a)(1) (authorizing only the TMP to file a petition for review after filing an AAR on behalf of the partnership). See Rigas v. United States, 110 AFTR 2d (5th Cir. 2012) (affirming the district court s dismissal of a partner s refund suit because the partner s refund claim did not substantially comply with the requirements for an AAR). 2. By Other Partners. If a partner files an AAR on its own behalf, which the IRS does not allow in full, and the TMP does not file an AAR and a petition for judicial review under section 6228(a)(1), the partner can file a regular refund suit under I.R.C I.R.C. 6228(b)(2)(A). a. The partnership items are then treated as nonpartnership items with respect to that partner. I.R.C. 6228(b)(2)(A)(ii). Thus, the partner s suit is a regular refund suit, rather than a petition under the TEFRA procedures. b. The period for filing such an action is at least six months, and not later than two years, after the AAR was filed. I.R.C. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

27 6228(b)(2)(B)(i). This two-year period can be extended by agreement. I.R.C. 6228(b)(2)(B)(ii). c. As with petitions by the TMP, this action cannot be filed after the IRS mails a notice of the beginning of a partnership proceeding for that tax year. I.R.C. 6228(b)(2)(C). i. If the IRS issues an FPAA, the AAR items can be addressed as part of that process. ii. If the IRS does not issue an FPAA, the prohibition against filing a petition for judicial review of the AAR, after the IRS mails notice of the beginning of a partnership proceeding, is lifted and the period for filing the petition does not expire before the date six months after the expiration of the statute of limitations for assessment. I.R.C. 6228(b)(2)(D). V. AUDIT PROCESS Practice Tip: If the TMP files an AAR but chooses not to file a petition for judicial review, the other partners have no recourse. (This differs from the situation with respect to an FPAA, where any partner can file a petition for readjustment if the TMP does not.) The TMP has fiduciary obligations to the other partners and in most cases will protect their rights by filing for judicial review. However, if the partner files its own AAR, it will be able to file a refund suit if the TMP does not act. Each partner should consider whether to file their own AAR to protect their rights. A. Filing Partner Returns: Consistency Requirement 1. The partnership files a Form 1065, including Schedules K-1 for each partner s distributive share of all of the items of income, deductions, gain, and loss. The partnership is required to send each partner a copy of the Schedule K-1 filed with the IRS. Unless notice is given, the partner is required to prepare its return consistently with the Schedule K-1. I.R.C. 6222(a). 2. Alternatively, if the partner believes the Schedule K-1 is incorrect, the partner can prepare its return using the amounts it believes are correct and include with its return Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request. I.R.C. 6222(b). If the partner does not file Form 8082 with its return, the IRS may immediately assess, without following deficiency procedures, any additional tax liability that results from a computational adjustment to its tax liability to conform to the partnership return. I.R.C. 6222(c). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

28 3. Partners are generally reluctant to file a Notice of Inconsistent Treatment because of concerns that its filing will trigger an audit. Trap: If a Notice of Inconsistent Treatment is not filed and a partner takes an inconsistent position with the partnership return, the IRS can immediately assess without following deficiency procedures. B. Notice Requirements. 1. NBAP and FPAA The IRS, not the TMP, is required to give, to all notice partners (defined above) notice of the beginning of the audit at the partnership level (NBAP) and notice of any FPAA resulting from the conclusion of that proceeding. I.R.C. 6223(a). a. The NBAP must be given by the IRS to all notice partners at least 120 days before the FPAA is mailed to the TMP. b. The IRS must mail the FPAA to each notice partner within 60 days of the day it was mailed to the TMP. I.R.C. 6223(d). c. If the IRS fails to give notice of the NBAP or FPAA to any notice partner, the partner has two options depending on whether the proceeding is finished: i. If the time to file a proceeding has expired and no petition was filed or the proceeding is finished, the partner may elect to treat the items as nonpartnership items (I.R.C. 6223(e); Treas. Reg (e)-2(b)); or ii. If the proceeding is not finished, then the partner will automatically become a party to the proceeding unless the partner elects instead to treat the items as nonpartnership items. I.R.C. 6223(e)(3); Treas. Reg (e)-2(c). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS d. Following the mailing of a NBAP to the TMP, the TMP must furnish to the IRS office that issued the notice the name, address, profits interest, and taxpayer identification number of each person who was a partner in the partnership at any time during that taxable year, if that information was not provided on the partnership return filed for that year. Treas. Reg (e) Other Notices. The TMP is required to advise notice partners of the following items: a. Closing conference with the examining agent; 28

29 b. Proposed adjustments, rights of appeal, and requirements for filing of a protest; c. Time and place of any Appeals conference; d. Acceptance by the Internal Revenue Service of any settlement offer; e. Consent to the extension of the period of limitations with respect to all partners; f. Filing of a request for administrative adjustment on behalf of the partnership; g. Filing by the tax matters partner or any other partner of any petition for judicial review; h. Filing of any appeal with respect to a judicial determination; and i. Final judicial redetermination. Treas. Reg (g)-1(b). Notice must be given within 30 days of taking the action or receiving the information. The notices should be sent by certified mail, return receipt requested, so that the TMP has proof of mailing, should a question later arise. Note that the TMP is required to comply with these regulatory notice requirements, even if the partnership agreement imposes less stringent notice requirements. Notice for any of these matters is not required to be given by the TMP if the partner has already received information about the matter from another person. Treas. Reg (g)-1(b). 3. Indirect Partners. Generally, the IRS s duty to give notice to an indirect partner arises only to the extent that the IRS has the indirect partner s name, address, and indirect profits interest in the partnership. See I.R.C. 6223(c)(1). The IRS can obtain this information through one of three ways: (1) the tax return of the partnership under audit; (2) a statement provided to the IRS by the indirect partner that meets the requirements of Treas. Reg (c)-1(b); or (3) from the TMP of the pass-through partner. The TMP of a pass-through partner is required to furnish to the IRS office that issued the NBAP the name, address, profits interest, and taxpayer identification number of each person who was a partner in the partnership at any time during that taxable year if that information was not provided on the partnership return filed for that year. Treas. Reg (e)-1(c). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

30 a. A pass-thru partner is required to forward any notice on to its partners within 30 days of receiving the notice. In the case of a pass-thru partner that is a partnership, the tax matters partner is responsible for complying with this forwarding requirement. I.R.C. 6223(h); Treas. Reg (h)-1(a). b. The IRS has no obligation to obtain information regarding indirect partners that is not provided to it. Walthall v. United States, 911 F. Supp (D. Alaska 1995), aff d, 131 F.3d 1289 (9th Cir. 1997). c. Thus, TEFRA places the primary burden on the TMP and the passthrough partners, and not on the IRS, to keep indirect partners informed about the partnership audit. However, the partnership proceedings and adjustments still apply to an indirect partner if the TMP or pass-thru partner fails to provide notice. I.R.C. 6230(f); Vander Heide, supra. This procedure can severely impinge on an indirect partner s rights. C. Partners Right to Participate Example of Impact of Notice Provisions on Indirect Partner: The determination of who is a partner is a partnership item that can only be challenged at the partnership level. Blonien v. Comm r, 118 T.C. 541 (2002). Thus, an alleged indirect partner who believes it is not a partner and who did not receive notice from its pass-thru partner would not have an opportunity to challenge the partner status. 1. Any partner, including an indirect partner, has the right to participate in the administrative proceeding. I.R.C. 6224(a); Treas. Reg (a)-1(a). 2. However, neither the IRS nor the TMP has statutory obligations to notify the other partners about administrative proceedings or ongoing audit activities, other than in the limited circumstances discussed above. Oftentimes, the LLC or partnership agreement will require the TMP to provide prompt notice to the other partners of audit proceedings. Otherwise, the other partners, including indirect partners, will have to inform the TMP of their desire to be informed more fully (such as by receiving copies of all correspondence with the IRS, including IDRs) and to attend meetings. 3 The IRS and the TMP will determine the time and place for all administrative proceedings. Arrangements will generally not be changed Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

31 Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS merely for the convenience of another partner. Treas. Reg (a)- 1(a). D. Summary Report and Closing Conference. 1. At the conclusion of the audit, the IRS will issue a Summary Report that includes both the information relating to the Closing Conference as well as the proposed adjustments. I.R.M (Oct. 1, 2010). 2. The Closing Conference will be scheduled 30 days or more after the issuance of the final Summary Report. I.R.M (June 1, 2004). The TMP should agree on the date and time of the closing conference with the agent within 7 days of receiving the final Summary Report. 3. The TMP should transmit the final Summary Report to all notice partners and must advise as to when and where the Closing Conference will be held. Treas. Reg (g)-1(b). The TMP should direct that, by a specified date, any partner planning on attending the Closing Conference so advise the TMP and provide the TMP with a valid power of attorney for any representatives who will attend. The specified date needs to be more than 10 days before the Closing Conference, so the TMP can timely comply with its obligation to send the POAs to the agent before the Closing Conference and notify the agent of the number of partners attending. The TMP should also state whether or not the partnership entered into a partnership-level extension of the period of limitations and, if so, include a copy. 4. Although the TMP may waive the closing conference, it will be held if any notice partner requests a closing conference. Treas. Reg (b)-1 explains how a partner may waive its rights to a closing conference or any other rights granted in the unified audit procedures of a partnership proceeding. The TMP cannot waive the rights of any notice partner. I.R.M (June 1, 2004). E. Appeals Day Letter. Although not required by statute, IRS procedure is to send a 60-day letter to the TMP providing partners with the opportunity to go to Appeals. IRM (Oct. 1, 2010). This letter will again set forth the proposed adjustments and advise as to the rights to appeal and file a protest. Therefore, the TMP must send the 60-day letter to all notice partners within 30 days of receiving it. Treas. Reg (g)-1(b). 2. Protests and Appeals Conference. Any notice partner may file a protest and request an Appeals conference. The Service will combine all of the protests received and forward them to Appeals, and there will be a 31

32 Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS consolidated Appeals conference to discuss all protests. Whether or not a notice partner files a protest, the notice partner is entitled to attend the IRS Appeals conference if it does not agree with the IRS s findings. Before the conference, the TMP must provide the IRS with the names of the partners who will be attending the conference. The TMP then must notify all partners who plan to attend of the time, date, and place of the conference. I.R.C. 6224(a); Treas. Reg (g)-1(b)(1); I.R.M (4), (2), (1). F. Administrative Settlements. 1. Any partner can settle with the IRS by signing Form 870-P, Settlement Agreement for Partnership Adjustments. I.R.C. 6224(c)(1). The case can be settled in any manner to which parties agree, so long as the settlement does not violate public policy. Miller Tabak Hirsch & Co. v. Comm r, 101 F.3d 7 (2d Cir. 1996). 2. A settlement agreement is binding in the absence of fraud, malfeasance, or misrepresentation of fact. I.R.C. 6224(c)(1), (3). 3. If the IRS enters into a settlement agreement with any partner, the IRS shall offer the same terms to any other partner who requests them. I.R.C. 6224(c)(2). The consistent settlement is not available to a partner whose partnership items have been converted into nonpartnership items. 4. Circumstances in which a partner may bind other partners to a settlement: a. The LLC or partnership agreement may authorize the TMP to enter into settlements on behalf of all partners. Typically, however, the other partners reserve the right to review and approve of settlement agreements. In such case, a TMP may not bind a notice partner to a settlement. Treas. Reg (c)-1. b. A TMP may bind non-notice partners who have not formed a 5 percent notice group to a settlement agreement as long as (1) the agreement expressly states its intent to bind such partners; and (2) the non-notice partners have not previously notified the IRS that the TMP lacked the right to enter into such a settlement. I.R.C. 6224(c)(3)(B). c. An indirect partner may be bound by a settlement agreement entered into by its pass-thru partner unless the IRS has been notified of the indirect partner s name, address and beneficial interest in the partnership. I.R.C. 6224(c)(1). See also Hays v. U.S., 79 A.F.T.R. 2d (PH) , No (5th Cir. 1997) (enforcing a settlement agreement against an indirect partner). 32

33 c. Once the case is before the Tax Court, the TMP can bind all partners if the TMP certifies that no partners object to the settlement. Tax Court Rule 248(a). 5. If there is a delay in making a computational adjustment stemming from a settlement, interest on the deficiency will be suspended. I.R.C. 6001(c). 6. If a partner enters into a partial settlement resolving some but not all of the issues, the statute of limitations for the remaining items is determined as if the agreement was not entered into. I.R.C. 6229(f). VI. JUDICIAL REVIEW A. Notice of Final Administrative Adjustment ( FPAA ). 1. If any partner does not settle the disputed issues with appeals, then Appeals will issue an FPAA. a. An FPAA is the equivalent of the statutory notice of deficiency for partnerships, but only partnership items are adjusted and no deficiency is proposed. b. The IRS may issue a no-change FPAA at the partnership level. In this situation, certain computational adjustments may still result at the partner level that give rise to assessments or refunds for individual partners. For example, these adjustments could result from a partner filing inconsistently with the partnership under Section CCA (Dec. 12, 2011). 3. The FPAA is mailed to the TMP and to all notice partners. I.R.C. 6223(a)(2). Mailing notice directly to the indirect partner of the notice partner has been found sufficient to meet I.R.C. 6223(a). Murphy v. Comm r, 129 T.C. 82 (2007). B. Where can a partner seek redetermination of the FPAA? 1. Tax Court a. As with a non-tefra notice of deficiency, the TMP can file a petition in Tax Court within 90 days after the FPAA is mailed. I.R.C. 6226(a)(1). b. If the TMP does not file a petition within 90 days, any notice partner or notice group can file a petition within 60 days after the TMP s 90-day period ends. I.R.C. 6226(b)(1). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

34 i. Since the TMP is also a notice partner, the TMP can file a petition for readjustment, in its capacity as a partner other than the TMP, within 150 day after the FPAA is mailed. Barbados #6, Ltd. v. Comm r, 85 T.C. 900 (1985). ii. iii. If a notice partner prematurely files a petition for readjustment during the 90-day period and if no petition for readjustment is filed by the TMP or by any notice partner during the 60-day period, the premature petition will be deemed filed at the end of the 60-day period. I.R.C. 6226(b)(5). The 150-day filing period is jurisdictional and is not subject to equitable tolling. A.I.M. Controls, L.L.C. Comm r, 109 A.F.T.R.2d (5th Cir. 2012) (affirming the Tax Court s finding that the partner s petition was time-barred because the 150-day period was not tolled during the time a district court suit had been pending). c. For the Tax Court to have jurisdiction over the petition, the FPAA must be valid. i. The Tax Court will not have jurisdiction over a FPAA issued to an indirect partner when the source partnership proceedings have not concluded. Rawls Trading LP et al. v. Comm r, 138 T.C. 12 (2012). ii. The Tax Court lacks jurisdiction over an erroneously issued FPAA. Thompson v. Comm r, 137 T.C. 17 (2011) (finding the court lacked jurisdiction over an erroneously issued statutory notice of deficiency when it was only required to make a computational adjustment). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS d. If multiple petitions are filed within the day period, the first action brought in Tax Court shall go forward. If multiple petitions are filed, but none in Tax Court, the first action brought shall go forward. The other actions are dismissed. I.R.C. 6226(b)(2), (3), (4). 2. District Court or U.S. Court of Federal Claims a. Either the TMP or a notice partner can also file suit in U.S. District Court or the U.S. Court of Federal Claims. I.R.C. 6226(a)(2), (3). Suit in district court must be brought in the district court for the district in which the partnership s principal place of business is located. I.R.C. 6226(a). If the partnership has dissolved, 34

35 practitioners recommend that suit be filed in the Court of Federal Claims and not in a district court, unless the government has waived venue objections. See Transcapital Leasing Associates v. United States, 398 F.3d 1317 (Fed. Cir. 2005). b. There is a further jurisdictional requirement for such suits. A readjustment petition can be filed only if the partner filing the petition deposits with the IRS the amount by which the partner s tax liability would increase if the partner s return were made consistent with the partnership return as adjusted by the FPAA. I.R.C. 6226(e). The deposit is based on only the potential increased tax liability and not interest and penalties. Thus, if the TMP files the petition in district court or the Court of Federal Claims, the TMP must deposit the amount by which its tax liability would increase if the FPAA were applied. A deposit requirement does not apply to suits filed in Tax Court. c. This requirement is similar to the full payment rule of Flora v. United States, 362 U.S. 145 (1960), for non-tefra refund suits, with two notable differences. i. The petition for readjustment must still be filed within 90 days after the FPAA is mailed to the TMP. The deposit is not considered a payment that then allows the taxpayer to wait up to two years to file a refund claim. ii. iii. The deposit generally only covers the potential increased tax liability for that partner rather than all partners. Treas. Reg (e)-1(a)(1). However, the Service s position, adopted by two decisions of the Court of Federal Claims, is that the deposit must cover tax increases for all affected years, not only the tax year that is the subject of the suit. Kislev Partners, L.P. v. United States, 84 Fed. Cl. 385 (2008); Russian Recovery Fund, Ltd. v. United States, 90 Fed. Cl. 698 (2008). A later decision of the Court of Federal Claims reached a contrary result. Prestop Holdings, LLC v. United States, 96 Fed. Cl. 244 (2010). A pass-thru partner is required to deposit an amount based on the potential tax liability of all indirect partners who own interests through the pass-thru partner. Treas. Reg (e)-1(a)(1). The IRS has interpreted Treas. Reg (e)-1(a)(1) as requiring the deposit amount to include the total impact on the tax liability of indirect partners, even if some of the changes to the indirect Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

36 partner s tax liability stem from an interest in a separate pass-thru intermediary and not the pass-thru partner filing the petition. The Court of Federal Claims agreed with this interpretation. Russian Recovery Fund v. U.S., 90 Fed. Cl. 698 (2009). iv. Incorrectly calculated deposits will not deprive a court of jurisdiction, so long as the TMP made a good faith attempt to satisfy the deposit requirement and any shortfall in the amount required to be deposited is timely corrected. I.R.C. 6226(e)(1). Courts liberally interpret the good faith requirement. See Gail Vento LLC v. United States, 108 AFTR 2d (D.V.I. Nov. 8, 2011), for a survey of relevant cases. d. A deposit is not a payment of tax. Therefore, the IRS still may assess and collect deficiencies based on non-partnership items, even if the deposit exceeds those deficiencies. Treas. Reg (e)-1(c). More significantly, the IRS may assess and collect deficiencies based on partnership items while the case is pending in the Court of Federal Claims or the district court. The prohibition against assessment and collection of tax based upon adjustments to partnership items expires 150 days after the mailing of the FPAA, unless a proceeding is begun in Tax Court. I.R.C. 6225(a). e. Jury trials are not available for TEFRA suits because jurisdiction is based on 28 U.S.C and 28 U.S.C. 1346(e). 3. An indirect partner may not have the right to file a petition on its own behalf because, as discussed above, an indirect partner may not constitute a notice partner. Therefore, an indirect partner s right to file a petition will depend on its ability to convince the pass-thru partner to file a petition for readjustment. Practice Tip: As noted above, the TMP can file a petition even after the 90- day deadline is missed, by filing a petition in its capacity as a notice partner. This allows more time to prepare, although there is a risk that another notice partner will file first and take priority. 4. Under non-tefra procedures, a taxpayer can choose to not respond to a notice of deficiency, allow the IRS to assess additional tax liability, pay the assessed amount, and then file a refund claim and litigate in District Court or the Court of Federal Claims. That same opportunity is not available under TEFRA procedures and thus presents a trap for the Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

37 unwary. If the partners do not contest the FPAA, any determinations as to partnership items are final. C. Right to Participate in the Action. 1. Any person who was a partner at any time during that tax year is allowed to participate in the action, as long as the partner has an interest in the outcome. Thus, if the partnership items at issue have been converted to nonpartnership items with respect to that partner, or the limitations period for assessment against that partner of any tax attributable to the partnership items has expired, the partner can no longer participate. I.R.C. 6226(c), (d). 2. To participate, the partner files a notice of election to participate with the court. 3. Suit covers only partnership items, not non-partnership items, but may cover items other than those raised in the FPAA. I.RC. 6226(f). Thus, the review is not limited to the items adjusted in the notice. In addition, the court has jurisdiction in the partnership-level proceeding to determine any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item. See, e.g., 106 Ltd. v. Commissioner, 684 F.3d 84 (D.C. Cir. 2012) (court considered whether the partnership had a reasonable cause defense to penalties under Section 6664(c)(1)). However, the court does not have jurisdiction in the partnership-level proceeding to consider any partner-level defenses to any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item. Treas. Reg (f)-1(a). D. Final Determination 1. The court s determination in the proceeding concludes the partnership proceedings for all partners (subject to appeal). I.R.C. 6226(f). 2. The right to appeal the court s determination is limited to the TMP, notice partners, or a 5 percent notice group. Therefore, a non-notice indirect partner s right to appeal may depend on its ability to convince the passthru partner to appeal. I.R.C. 6226(g). Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

38 E. Adjustment to Partners Tax Liabilities 1. The IRS cannot assess the partner until 150 days after the FPAA was mailed or, if a petition for redetermination was filed, until the court s decision has become final. I.R.C. 6225(a). 2. The IRS generally does not have to issue a partner-level notice of deficiency and provide another opportunity to challenge the assessment. I.R.C. 6230(a)(1). a. The IRS mails a notice of computational adjustment to each partner. b. The partner has six months after the mailing of that notice to file a claim that the IRS erroneously calculated the computational adjustment. I.R.C. 6230(c)(1)(A), (2)(A). i. The partner can bring a non-tefra refund suit (see I.R.C. 7422) if the claim is not allowed. I.R.C. 6230(c)(3). ii. The claim or refund suit cannot challenge any substantive issues. Those must be challenged in a partnership-level petition to redetermine the FPAA. 3. For affected items requiring partner-level determinations or items that have become nonpartnership items, the IRS must provide a notice of deficiency and opportunity to file a petition for redetermination, rather than assess the additional tax liability immediately. I.R.C. 6230(a)(2). 4. The IRS does not have to provide a notice of deficiency with respect to penalties, even though those may require partner-level determinations. I.R.C. 6230(a)(2)(A)(i). Instead, the IRS can simply assess the penalty amount. The partner must pay the assessed amount and then timely file a claim for refund that the IRS erroneously imposed the penalty. I.R.C. 6230(c)(1)(C); Treas. Reg (c). The claim for refund must be filed within 6 months after the day on which the Secretary mails the notice of computational adjustment to the partner. I.R.C. 6230(c)(2). The challenge to the penalty is limited to partnerlevel defenses. Treas. Reg (c), (d). See e.g., Jade Trading LLC, et. al. v. U.S., 109 A.F.T.R. 2d (C.A. Fed. Cir. 2012) (affirming the Court of Federal Claims decision that it lacked jurisdiction to determine whether accuracy-related penalties applied in a unified partnership-level proceeding because the penalties turned on the individual partners outside tax basis, which is not a partnership item); Petaluma FX Partners, LLC, v. Comm r, 135 TC 581 (2010) (Tax Court lacked jurisdiction to determine the valuation misstatement penalty under section Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

39 6662(b)(3) because it applies to an overstatement of the partner s outside basis, which is not a partnership item); Domulewicz v. Comm r, 129 TC 11 (2007) (Commissioner may assess a partnership-item penalty before the deficiency to which the penalty relates is adjudicated; the partner must pay the assessed penalty and raise his partner-level defenses in a refund proceeding). But see Tigers Eye Trading LLC v. Comm r, 138 T.C. No. 6 (2012) (Section 6662(a) penalty related to the zeroing out of partnership items that results from a determination that the partnership must be disregarded for Federal income tax purposes is a partnership item and therefore may be determined at the partnership-level). Practice Tip: When evaluating a case, a taxpayer should take into account the procedural requirements for contesting a penalty. Certain matters may be raised at the partnership level. However, most penalty issues will be determined at the partner level, following assessment, payment, and the filing of a claim for refund. This procedure can be costly and time-consuming to a partner. Therefore, if the primary issue in a case is the penalty and the defenses to that penalty are at the partner level, a taxpayer may wish to accept the partnership level adjustments and spend its resources defending the penalty. Mary A. McNulty, Thompson & Knight LLP, October 1, DALLAS

40 Dallas Bar Association Tax Section October 1, 2012 Procedural Issues in IRS Partnership Audits and Tax Litigation Mary A. McNulty Thompson & Knight LLP

41 2 1982

42 Procedural Issues in Partnership Audits and Litigation TEFRA Overview The Tax Matters Partner Statutes of Limitations Partnership Refund Claims (AARs) Audit Process Judicial Review Tips and Traps 3

43 TEFRA Overview Purpose of TEFRA TEFRA Defined Terms 4

44 TEFRA Overview As with any effort to simplify the Code, the TEFRA provisions created a complex process with new problems and traps for the unwary. The Tax Court describes these rules as "distressingly complex and confusing. 5

45 Purpose of TEFRA Pre-TEFRA Audits were only conducted at the partner level; if the IRS wanted to audit a partnership item, the IRS had to audit each partner individually. Created duplication of effort and administrative difficulties. Also led to inconsistencies in how partners were treated. TEFRA was designed to address these problems by allowing an audit of partnership items to be conducted at the partnership level. The TEFRA provisions are incorporated in Sections of the Code. 6

46 TEFRA Defined Terms Partnership Partner Partnership Items Nonpartnership Item Affected Item Computational Adjustment Notice Partners 7

47 TEFRA Defined Terms Partnership The TEFRA rules apply to audits of all partnerships, unless the partnership has 10 or fewer partners; and all partners are individuals, C corporations, or an estate of a deceased partner. TRAP: A disregarded entity is counted as a partner and causes the partnership to be a TEFRA partnership. Rev. Rul , C.B I.R.C. 6231(a)(1). 8

48 TEFRA Defined Terms Partner A partner is 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). 9

49 TEFRA Defined Terms Partner The definition of a partner includes: Pass-thru partners 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 Indirect partners: a person holding an interest in a partnership through 1 or more passthru partners. I.R.C. 6231(a)(10). Thus, indirect partners include S corporation shareholders, partners, LLC members, trust beneficiaries, and subtrusts. 10

50 TEFRA Defined Terms Partners Tiered Entity Example D C Partnership F G E S Corporation B B, C, D, E, F and G are all partners for TEFRA purposes D, E, F and G are all indirect partners C and E are pass-thru partners A Partnership 11

51 TEFRA Defined Terms Partnership Items 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 TEFRA partnership audit can address only partnership items. Nonpartnership items are determined at the individual partner level. 12

52 TEFRA Defined Terms Partnership Items Partnership items include all items reported on IRS Form 1065 and Schedules K-1, such as: A partner s distributive share of the partnership s income, gain, loss, deduction, or credit; Partnership liabilities; and Guaranteed payments. Treas. Reg (a)(3)-1(a). 13

53 TEFRA Defined Terms Partnership Items Partnership items also include: The partnership s statute of limitations. Slovacek v. United States, 36 Fed. Cl. 250 (1996); Weiner v. United States, 389 F.3d 152 (5th Cir. 2004); Kaplan v. United States, 133 F.3d 469 (7th Cir. 1998). The determination of who is a partner of the partnership. Blonien v. Comm r, 118 T.C. No. 34 (2002) 14

54 TEFRA Defined Terms Nonpartnership Items A nonpartnership item is an item that is not a partnership item. I.R.C. 6231(a)(4). Nonpartnership items are addressed at the partner level, often after the partnership-level proceeding ends. Example: A purchases a partnership interest in Partnership X for $5,000. The amount A paid for the partnership interest is a nonpartnership item and would not be audited at the partnership level. 15

55 TEFRA Defined Terms Affected Items An affected item is any item to the extent such item is affected by a partnership item. I.R.C. 6231(a)(5); Treas. Reg (a)(5)-1(a). Affected items include items on a partner s return that are computed in part based on partnership items. Examples: Miscellaneous itemized deductions the amount allowed is based on adjusted gross income, which is affected by a partner s distributive share of partnership items. Treas. Reg (a)(5)-1(a). Partner s outside basis the amount of a partner s outside basis is affected by a partner s distributive share of partnership items. Treas. Reg (a)(5)-1(b). 16

56 TEFRA Defined Terms Computational Adjustment A computational adjustment is the change in tax liability that properly reflects the correct treatment of a partnership item. I.R.C. 6231(a)(6). Computational adjustments are the bridge between the partnership-level proceeding and the partner s tax liability. They are the tax assessments or abatements. 17

57 TEFRA Defined Terms Computational Adjustment There are two categories of computational adjustments: Affected items that do not require partner-level determinations. The adjustments are mechanical. When no partner-level determinations are required, the computational adjustment is directly assessed. Treas. Reg (a)(6)-1(a)(2). Example: Partnership A underreported its income by $100. Corporation B has a 50% interest in Partnership A, and B s income increases by $50. B is in the 35% tax bracket, and a computational adjustment is made that increases B s tax liability by $ This amount plus interest is assessed. Affected items that do require partner-level determinations. These can be assessed against the partner only through normal deficiency procedures. Treas. Reg (a)(6)-1(a)(3). Exception: Penalties require partner-level determination but fall outside of the normal deficiency procedures and can be directly assessed. 18

58 TEFRA Defined Terms Notice Partners Certain rights are provided to notice partners. I.R.C. 6231(a)(8). A notice partner includes: Any partner in a partnership with 100 or fewer partners. A partner in a partnership with more than 100 partners who holds at least a 1% interest in the partnership. Partners who hold a 5% aggregate interest and form a notice group. Indirect partners for whom the IRS has their name, address, and profits interest. Tip: Most partners will be notice partners. I.R.C. 6223(a), (b), (c); Treas. Reg (b)-1(a). If an 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). 19

59 TEFRA Defined Terms Notice Partners - Tiered Entity Example F G IRS audits Partnership A. IRS must give notice to partners B and C. D C Partnership E S Corporation A Partnership B IRS must also give notice to the indirect partners, D, E, F and G, if it has the necessary contact information to do so. The passthrough partners, C and E, are required to give notice to their partners if the IRS is not required to do so. C notifies D and E. 20 E notifies F and G.

60 The Tax Matters Partner ( TMP ) Overview Who can be the TMP and for how long? What is the Role of the TMP? How long does the TMP s authority survive? 21

61 TMP Who Can be the TMP? The TMP must be a partner with the authority to bind the partnership. General partnership: any partner Limited partnership: a general partner LLC: a member-manager or, if none, any member Trap: Limited partners, non-managing members, and nonpartners may not be the TMP. But a disregarded entity can be the TMP, if it has the authority to bind the partnership under state law. I.R.C. 6231(a)(7); Treas. Reg (a)(7)-1, - 2; Rev. Rul , I.R.B

62 TMP Who Can Be the TMP? If ABC is a limited partnership and A is a general partner, A can be the TMP. If ABC is an LLC and A is a managing member, A can be the TMP. If ABC is an LLC and there are no managing members, A can be the TMP. If ABC is an LLC, A is an entity and a managing member, A can be the TMP. An officer of A cannot be the TMP. A B C ABC Partnership 23

63 TMP What is the Role of the TMP? The TMP is the IRS s single-point liaison during audits and the single representative for litigation. The TMP plays a notice role and keeps other partners informed of the audit proceedings. I.R.C. 6223(g). The TMP may file suit on behalf of the partnership. I.R.C. 6226(a). The TMP may file a partnership-level refund claim on behalf of the partnership. I.R.C. 6227(c). The TMP may extend the statute of limitations on behalf of the partnership. I.R.C. 6229(b)(1)(B). Tip and Trap: The TMP s role is limited unless expanded contractually by the partnership or LLC agreement. 24

64 TMP How Long does its Authority Survive? A TMP s designation as TMP for a specific taxable year remains in effect until: He dies, is incapacitated, resigns, or liquidates; The partnership items of the TMP become nonpartnership items; or A designation of a successor TMP or revocation of the TMP s designation is made pursuant to applicable regulations. 25 Treas. Reg (a)(7)-1(l). Thus, a TMP s designation for a specific taxable year typically survives the disposition of the TMP s partnership interest. H th d i ti f th TMP f

65 26 Statutes of Limitation

66 Statutes of Limitation Overview Partner-Level Partnership-Level 27

67 Statutes of Limitation Partner-Level Tax at the partner-level shall be assessed within 3 years after the return was filed. I.R.C. 6501(a). The statute of limitations can be extended by agreement. I.R.C. 6501(c)(4). IRS Form 872 extends the period of limitations for assessing tax attributable to partnership items, because it now expressly so states. I.R.C. 6229(b)(3). 28

68 Statutes of Limitation Partner-Level The partner-level limitations period becomes six years when there is a substantial omission of gross income. I.R.C. 6501(e). Does an overstatement of basis result in an omission of income? This was a common issue in recent tax shelter cases and was resolved recently by the U.S. Supreme Court favorably to taxpayers in Home Concrete & Supply, LLC v. United States, 109 A.F.T.R.2d (2012). The Supreme Court held that an overstatement of basis was not a substantial omission from gross income. This result was changed by Treasury regulations that were finalized in They provide that an overstatement of basis is an omission of gross income. Treas. Reg (e)-1, (c)(2)-1. 29

69 Statutes of Limitation Partnership-Level 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). I.R.C. 6229(a). It is now settled that this provision may not shorten but may extend the partner-level period of limitations. 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), AD Global Fund, LLC v. United States, 481 F.3d 1351 (Fed. Cir. 2007). Tip: An assessment of tax attributable to a partnership item is timely as long as either the partner-level or partnership-level period of limitations remains open. 30

70 Statutes of Limitation Partnership-Level The partnership-level statute of limitations can also be extended by agreement. By the TMP for all partners. By any partner for that partner. I.R.C. 6229(b)(1). 31

71 Partnership Refund Claims -- AARs An Administrative Adjustment Request ( AAR ) is the equivalent of a refund claim for partnerships but is subject to different procedural requirements. 32

72 AARs Overview Statutes of Limitations Who can file Judicial Review 33

73 AARs Statutes of Limitation General Rule for Refund Claims: A claim for refund must be filed within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever is later. I.R.C. 6511(a). This period may be extended by agreement. I.R.C. 6511(c)(1). Special Rules for AARs: A partner must file an AAR within 3 years after the partnership return is filed. I.R.C. 6227(a)(1). If the limitations period for the assessment of partnership items is extended by agreement, the limitations period for filing an AAR is also extended for the same period plus 6 months. I.R.C. 6227(b). A partner may extend the limitations period for the assessment of partnership items and thereby extend the limitations period for the filing of an AAR. I.R.C. 6227(b), 6229(b)(1). Trap: The time when the tax is paid has no impact on when an AAR may be filed. 34

74 AARs Statutes of Limitation Trap: The time for filing an AAR is governed by when the partnership return is filed, not when the partner s return is filed. McFerrin v. United States, 492 F. Supp. 2d 695 (S.D. Tex. 2007) (an AAR was untimely when 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). Example: 4/15/11: Partnership s 2010 return filed 10/15/11: Partner s 2010 return filed 9/30/14: The partner files an AAR within 3 years of when his return was filed but more than 3 years from when the partnership s return was filed. The AAR is untimely filed. 35

75 AARs Who Can File? TMP can file an AAR on behalf of the partnership. I.R.C. 6227(c). 36

76 AARs Who Can File? If Form 1065X is filed, the partners do not need to file anything else, even in the case of multi-tiered entities. The TMP can request substitute return treatment. I.R.C. 6227(c)(1). That allows the IRS to treat any changes as corrections of mathematical or clerical errors and to make assessments without a partnership-level proceeding. I.R.C. 6230(b)(1). If not treated as a substitute return, the IRS can conduct a partnership-level audit, allow credits or refunds from the AAR to all partners, or simply do nothing. I.R.C. 6227(c)(2). 37

77 AARs Who Can File? Any partner can file an AAR (its own amended return, e.g., 1120X, with Form 8082 attached) on its own behalf. I.R.C. 6226(d). The partner can file an AAR even if the TMP has already filed an AAR for the same tax year. FSA 587 (Feb. 2, 1993); CCA (Nov. 5, 2008). The partner may not request substitute return treatment. I.R.C. 6227(c). Tip: A partner should seriously consider filing its own AAR to protect its right to seek judicial review. 38

78 AARs Judicial Review If the IRS does not allow in full an AAR filed by the TMP, the TMP can file a petition for judicial review. I.R.C. 6228(a)(1). Suit can be filed in the Tax Court, a district court, or the Court of Federal Claims. The petition must be filed at least six months, but no later than two years, after filing the AAR. I.R.C. 6228(a)(2)(A). Trap: The two-year period for filing suit is based on when the AAR was filed, not when it is disallowed. 39

79 AARs Judicial Review The other partners are allowed to participate in the suit filed by the TMP, as long as they have an interest in the outcome. I.R.C. 6228(a)(4). Trap: If only the TMP files an AAR and the TMP does not file suit, no other partner may file suit. The partner must have filed its own AAR to seek judicial review. I.R.C. 6228(a)(1). 40

80 AARs Judicial Review If a partner files an AAR on its own behalf and the TMP does not file an AAR or a suit, the partner can file a regular refund suit. I.R.C. 6228(b)(2)(A). The partner s suit is a regular refund suit, rather than a petition under the TEFRA procedures. I.R.C. 6228(b)(2)(A)(ii). The period for filing suit is at least six months, and not later than two years, after the AAR was filed. I.R.C. 6228(b)(2)(B)(i). 41

81 Audit Process

82 SB/SE: Audit Process Overview Audits partnerships with $10 million or less in assets. Conducted about 5150 partnership audits in LB&I: Audits partnerships with more than $10 million in assets. Conducted about 150 partnership audits in 2011, which was an increase of 20% over According to a recent Treasury report, the IRS is most likely to recommend adjustments to partnerships in the real estate and construction industries with two partners and a reported loss. 43

83 Audit Process Overview Notice Requirements Partners Right to Participate Summary Report and Closing Conference Appeals Administrative Settlements 44

84 Audit Process Notice Requirements The IRS must give notice to all notice partners of the beginning and end of a partnership audit sort of. Notice of the Beginning of the Audit at the Partnership level (NBAP) at least 120 days before the FPAA is mailed to the TMP. Notice of the Final Administrative Adjustment (FPAA) resulting from the partnership audit within 60 days of when the FPAA was mailed to the TMP. I.R.C. 6223(a). 45

85 Audit Process Notice Requirements The TMP provides other notices to other partners. These notice requirements mostly arise at the conclusion of the audit. Closing conference with the examining agent; Proposed adjustments, rights of appeal, and requirements for filing of a protest; Time and place of any Appeals conference; Acceptance by the IRS of any settlement offer; Consent to extend the period of limitations for all partners; Filing of an AAR on behalf of the partnership; Filing by the TMP or any other partner of any petition for judicial review; Filing of any appeal with respect to a judicial determination; and Final judicial redetermination. Treas. Reg (g)-1(b). 46

86 Audit Process Notice Requirements Notice must be given by the TMP to the other partners within 30 days of taking the action or receiving the information. Treas. Reg (g)- 1(b)(3). The notices should be sent by certified mail, return receipt requested, so that the TMP has proof of mailing, should a question later arise. The TMP is required to comply with these regulatory notice requirements, even if the partnership agreement imposes less stringent notice requirements. 47

87 Audit Process Partners Right to Participate Any partner, including an indirect partner, has the right to participate in the administrative proceeding. I.R.C. 6224(a); Treas. Reg (a)-1(a). The IRS and the TMP will determine the time and place for all administrative proceedings. Arrangements will generally not be changed merely for the convenience of another partner. Treas. Reg (a)-1(a). Fast-track settlement is not available for a TEFRA partnership proceeding. Ann

88 Audit Process Summary Report and Closing Conference When the audit ends, the IRS will issue a Summary Report that includes both the information relating to the Closing Conference and the proposed adjustments. I.R.M (Oct. 1, 2010). The Closing Conference will be scheduled 30 days or more after the issuance of the final Summary Report. I.R.M (June 1, 2004). The TMP must transmit the final Summary Report to the other partners and advise them as to when and where the Closing Conference will be held. Treas. Reg (g)-1(b). Although the TMP may waive the Closing Conference, it will be held if another partner requests it. The TMP cannot waive the other partners right to the closing conference. Treas. Reg (b)-1; I.R.M (June 1, 2004). 49

89 Audit Process IRS Appeals 60-Day Letter. Standard IRS procedure is to send a 60-day letter to the TMP providing partners with the opportunity to go to Appeals. IRM (Oct. 1, 2010). The TMP must send the 60-day letter to all notice partners within 30 days of receiving it. Treas. Reg (g)- 1(b). The 60-day letter will again set forth the proposed adjustments and advise as to the rights to appeal and file a protest. 50

90 Audit Process Appeals Protests and Appeals Conference. Any notice partner may file a protest and request an Appeals conference. The Service will combine all of the protests received and forward them to Appeals, and there will be a consolidated Appeals conference to discuss all protests. Any notice partner is entitled to attend the IRS Appeals conference if it does not agree with the IRS s findings. I.R.C. 6224(a); Treas. Reg (g)-1(b)(1); I.R.M (4), (2), (1). 51

91 Audit Process Administrative Settlements Any partner can settle with the IRS by signing Form 870-P, Settlement Agreement for Partnership Adjustments. I.R.C. 6224(c)(1). If the IRS enters into a settlement agreement with any partner, the IRS must offer the same terms to any other partner who requests them. I.R.C. 6224(c)(2). The TMP may not bind other partners to a settlement agreement, except for certain non-notice partners. I.R.C. 6224(c)(3)(B). 52

92 Judicial Review Overview Notice of Final Administrative Adjustment FPAA Choice of Forum Right to Participate in the Action Final Determination Adjustment to Partners Tax Liabilities 53

93 Judicial Review FPAA If any partner does not settle the disputed issues with Appeals, then Appeals will issue an FPAA (Notice of Final Administrative Adjustment). An FPAA is the equivalent of a statutory notice of deficiency for partnerships, but only partnership items are adjusted and no deficiency is proposed. The FPAA is mailed to the TMP and to all notice partners. I.R.C. 6223(a)(2). 54

94 Judicial Review Choice of Forum The TMP may file a petition in Tax Court within 90 days after the FPAA is mailed. I.R.C. 6226(a)(1). If the TMP does not file suit, any notice partner may file a petition within the next 60 days. I.R.C. 6226(b)(1). Either the TMP or a notice partner may also file suit in U.S. District Court or the U.S. Court of Federal Claims. I.R.C. 6226(a)(2), (3). If multiple petitions are filed within the day period, the first action brought in Tax Court shall go forward. If multiple petitions are filed, but none in Tax Court, the first action brought shall go forward. The other actions are dismissed. Trap: These are the only time periods for filing suit. Unlike in a nonpartnership proceeding, the partners may not wait to pay the tax and then file a refund suit. 55

95 Judicial Review Choice of Forum There are deposit requirement for suits filed in Court of Federal Claims or district court, but not in the Tax Court. I.R.C. 6226(e). The deposit is made by the partner filing the petition. The deposit equals the amount by which the partner s tax liability would increase if the partner s return were made consistent with the partnership return as adjusted by the FPAA. A pass-thru partner is required to deposit an amount based on the potential tax liability of all indirect partners who own interests through the pass-thru partner. Treas. Reg (e)-1(a)(1). Other partners who participate in the suit are not required to make a deposit. 56

96 Judicial Review Final Determination The court has jurisdiction to determine any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item. I.RC. 6226(f). The court s determination in the proceeding concludes the partnership proceedings for all partners, subject to appeal. I.R.C. 6226(f). The right to appeal is limited to the TMP and notice partners. I.R.C. 6226(g). 57

97 Judicial Review Adjustment to Partners Tax Liabilities Once the court s decision has become final, the IRS can assess the partners. I.R.C. 6225(a). The IRS does not have to issue a partner-level notice of deficiency and provide another opportunity to challenge the assessment. I.R.C. 6230(a)(1). The IRS simply mails a notice of computational adjustment to each partner. 58

98 Judicial Review Penalties The IRS can simply assess the penalty amount, without providing a notice of deficiency. Treas. Reg (a)(6)- 1(a)(3). To contest the penalty, the partner must pay the penalty and then file a refund claim. I.R.C. 6230(c)(1)(C); Treas. Reg (c). The refund claim must be filed within 6 months from when the notice of computational adjustment was mailed to the partner. I.R.C. 6230(c)(2). The challenge to the penalty is limited to partner-level defenses. Treas. Reg (c), (d). Tip: If the primary issue in a case is the penalty and the defenses to that penalty are at the partner level, you should consider accepting the partnership level adjustments. Then, you can spend your resources defending the penalty. 59

99 Top Tips Most partners will be notice partners. The TMP s role may be expanded contractually by the partnership or LLC agreement. An assessment of tax attributable to a partnership item is timely as long as either the partner-level or partnership-level period of limitations remains open. A partner should seriously consider filing its own AAR to protect its right to seek judicial review. If the primary issue in a case is the penalty and the defenses to that penalty are at the partner level, you should consider accepting the partnership level adjustments. Then, you can spend your resources defending the penalty. 60

100 Top Traps A disregarded entity is counted as a partner and causes the partnership to be a TEFRA partnership. The TMP may not be an officer of the GP entity. The time for filing an AAR is governed by when the partnership return is filed, not when the partner s return is filed or when the tax is paid. The two-year period for filing suit is based on when the AAR was filed, not when it is disallowed. Suit must be filed within days of receiving an FPAA. Unlike in a non-partnership proceeding, the partners may not wait to pay the tax and then file a refund suit. 61