August 12, 2010
The last post in this series discussed differences in procedural posture that cause differences in the application of penalties. Court splits in how the various and sundry penalty provisions in the Code are applied is an even more confusing area. The two principal confusions are in the areas of TEFRA and valuation misstatements. We will deal with TEFRA in this post.
Partnerships are not taxpaying entities. They flow income, losses, deductions, and credits through to their partners who pay the tax. Nevertheless, since Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324, 648-71 (TEFRA), some partnerships have been subject to audit (and litigation of those audit adjustments in court) directly at the partnership level. Because individual partners still have tax issues that are not related to the partnership, tax items have to be divided between those that are handled in the partnership proceeding (so-called “partnership items”) and those that are handled at the level of the partners (so-called “non-partnership items”). (There is a third category of items that are affected by partnership items, appropriately named “affected items,” which we don’t need to address for purposes of this discussion.) As one can imagine, dividing the partnership tax world up into these two sorts of items is not always the easiest thing to do where you have items that are factually affected both by actions taken by the partnership and by actions taken by the partners.
In an apparent attempt to clarify this treatment in a small way, in 1997 Congress decreed that penalties that relate to partnership items are determined at the partnership level (i.e., the penalties themselves are partnership items). Seesection 6221. The difficulty implementing this provision is that, although partnerships are subject to audit, they are often owned and run by people and those people are often the partners. When one takes this fact into account in the context of the various penalty defense provisions, such as section 6664, which protects against penalties if a taxpayer has “reasonable cause and good faith,” you have a dilemma. Namely, if penalties are determined at the partnership (and not partner) level, whose conduct can you look at to determine if the partnership (and not the partners) had reasonable cause and good faith?
Regulations require that if an individual partner invokes section 6664 as a personal defense, that invocation has to be done in a partner level proceeding (generally, a refund action after the TEFRA proceeding is completed). Treas. Reg. § 301.6221-1(d). The IRS position as to how this applies in practice appears to be that the only conduct that is relevant for purposes of applying section 6664 in a TEFRA proceeding is what the partnership did through its own non-partner employees or, perhaps (it is unclear), the “tax matters partner” who manages the tax affairs of the partnership. From the IRS perspective, if a partner asserts conduct for purposes of section 6664, that assertion has to be parsed to see if the partner intended his or her conduct to be attributed to the partnership or, rather, asserted it on their own behalf. See Pet. for Rehearing at 8-10, Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009) (Docket No. 07-40861) (the petition was denied, it is included here to show the IRS position). Exactly how one is to conduct this hair-splitting (some might say hare-brained) analysis is hard to fathom. The best evidence of whether a partner’s conduct was on his or her behalf, or the partnership’s, will be the partner’s own statement. Presumably, any well-advised partner will say that he or she intended the conduct on behalf of the partnership if the desire is to raise the defense on behalf of the partnership, and only badly advised partners won’t. Surely, this is not a sustainable test.
Courts are split. The Fifth Circuit in Klamath rejected the IRS theory and looked to the actions of partners to impute reasonable cause and good faith to the partnership. 568 F.3d at 548. The Court of Federal Claims had at least two competing views. Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 703 (2008) generally went the same way as Klamath, looking to the managing partners’ actions. But in what has to be the most thorough analysis of the issue, Judge Allegra in Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 520 (2009) ruled for the Government giving deference to: (i) the regulatory edict that actions of the partners are only to be considered in the later refund proceeding and not in the TEFRA proceeding; and (ii) the language of section 6664 and regulations thereunder, which focuses on “taxpayers” and distinguishes partnerships from taxpayers. Based on the docket, Clearmeadow is not being appealed.
Regardless of your persuasion, at least Clearmeadow seemed to have debunked the idea that it could somehow matter (and, even more strangely, somehow be determined by the judge) whether the partner intended the conduct on his or her own behalf or on behalf of the partnership. Id. at 521. Relying on the discretion of a litigant to determine jurisdiction does seem off-base. Yet that is exactly what the Federal Circuit did on appeal in Stobie Creek, affirming on the basis that the Court had jurisdiction because the partnership “claim[ed] it had reasonable cause based on the actions of its managing partner.” Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1381 (Fed. Cir. 2010). Given that the Court went on to find that there was no reasonable cause, a cynic might say that the Court was anxious to give itself jurisdiction so it could reject the penalty defense definitively and prevent the taxpayer from taking another bite at the apple in a later refund proceeding, perhaps in district court. In any event, Stobie Creek has reignited the debate about whether a self-serving statement about intent controls jurisdiction and doesn’t seem to resolve the questions of: (i) when a partner is acting on his or her own behalf versus the partnership’s or (ii) whether the rules apply differently to managing versus non-managing partners. The state of the law in this area of penalty application is indeed still schizophrenic.
The next post in the penalties series will skip past valuation allowances (where there is also a circuit split we will come back to) and deal with reasonable reliance on tax advisers (for which we will surely get some hate mail).