January 18, 2011
As can be seen by the sheer number of our posts that deal with it, the unified partnership audit procedures of the Tax Equity and Fiscal Responsibility Act (“TEFRA”) can cause confusion. In fact, they can be downright bewildering. It is particularly easy to get lost if one walks into the TEFRA wilderness without keeping one eye fixed at all times on the overarching purpose of TEFRA. The case of Bush v. United States, et. al., Fed Cir. Nos. 2009-5008 and 5009, is a textbook example of what happens when you lose sight of that landmark. An apparently innocuous TEFRA proceeding resulted in a startling panel opinion authored by Judge Dyk and joined by Judge Linn that has baffled TEFRA practitioners. (Judge Prost concurred in the result on a theory that comports with the common understanding of TEFRA.) Bush v. United States, et. al., 599 F.3d 1352 (Fed. Cir. 2010). Instead of ending the case, that opinion has triggered a flurry of activity that should eventually lead to an en banc decision by the full court. Thus far, the panel decision has generated two sets of petitions for rehearing and responses, a vacated panel opinion, an order from the en banc court identifying four sets of questions to be addressed in new briefs, and at least one new amicus brief. And the en banc briefing process is just getting started. In order to keep from drawing the reader too far into the wilds ourselves, we describe the issue and the law first and then explain what happened to get us to where we are.
The facts in Bush are relatively simple. The taxpayers had TEFRA partnerships. Those TEFRA partnerships were audited, and a TEFRA partnership proceeding was brought. That proceeding was settled by the taxpayers. The Internal Revenue Service sent notices of computational adjustment to the taxpayers to reflect the adjustments agreed in the settlement; no notices of deficiency were sent. The taxpayers paid the amounts reflected in the notices of computational adjustment. Later, the taxpayers filed claims for refund with respect to the amounts they paid pursuant to the settlement and eventually sued in the Court of Federal Claims seeking to recover those amounts.
Now for the law. The purpose of TEFRA is to determine the tax treatment of “any partnership item” at “the partnership level.” Section 6221. This ensures “consistent . . . treatment” among partners and between the partners and the partnership. Section 6222. Consistency and unity is so important that the Service is empowered to issue “computational adjustments” to make the partners’ individual returns consistent with the partnership return. Section 6222(c)(2). Section 6226 provides the sole mechanism to judicially challenge the Service’s proposed adjustment of a “partnership item” – namely, filing a petition in court in response to the notice of final partnership adjustment issued by the Service. The notice of deficiency process, found in subchapter B of Chapter 63 of the Code, is specifically integrated with the TEFRA process outlined above (which is found in subchapter C of Chapter 63 of the Code), by section 6230. As relevant here, section 6230(a) contains the rules for when the IRS is required to issue a notice of deficiency under subchapter B with respect to various items, and section 6230(c) contains rules that allow a taxpayer to challenge a computational adjustment.
Section 6230 leaves a relatively narrow gap within which the standard notice of deficiency process is to operate in TEFRA partner-level proceedings. Setting aside a very specific (and irrelevant for our purposes) innocent spouse rule, section 6230(a)(2) provides that a notice of deficiency must be issued with respect to “affected items which require partner level determinations” and “items which [although they had been partnership items] have become nonpartnership items.” For all other “computational adjustments” related to: (i) partnership items; or (ii) affected items that do not require partner level determinations “subchapter B of this chapter shall not apply.” Section 6230(a)(1). This limitation on the notice of deficiency requirement, however, does not leave the partner facing a computational adjustment without recourse. Section 6230(c) allows the partner to file a claim for refund in several cases including, among others: (i) to apply a partnership settlement; or (ii) to seek a credit or refund of an overpayment attributable to the application of such a settlement. Section 6230(c)(1)(A)(ii) and (B). Critically, under either of these refund claim provisions, substantive review of the “treatment of partnership items” resolved in the settlement is verboten. Section 6230(c)(4). This is necessarily the case because the whole unifying purpose of TEFRA would be undermined if a later proceeding could affect the treatment of items properly agreed in a settlement by the parties at the partnership level.
Readers that are still awake will see that there are really only two nuts to crack in order to resolve Bush. First, were the items subject to the settlement either partnership items or affected items that do not require partner level determinations (which would mean that there was no notice of deficiency requirement)? Second, assuming they were, did the questions raised in the claim attempt to substantively re-review the determination of those items (which, again, is a statutory no-no)? As to the first question, the item at issue in Bush was the section 465 “at-risk” amount (basically, the amount that the taxpayer has placed at risk in the venture and thus as to which deductions are allowed). At-risk amounts are affected items to the extent they are not partnership items. Treas. Reg. §301-6231(a)(5)-1(c). The settlement agreement set out that the taxpayers’ at-risk amounts were equal to their capital contributions to the partnership and actually specified the dollar amount. Thus, it is arguable that the affected item in Bush is actually a partnership item. See Treas. Reg. §301-6231(a)(3)-1(a)(4)(i) (considering capital contributions generally as partnership items). Regardless, it is certainly not an “affected item which require[s] partner level determinations” because it was finally resolved in the settlement agreement and the partner’s specific situation doesn’t affect it at all. Therefore, no notice of deficiency was required under section 6230. Having made it this far, even a blind squirrel in the dark TEFRA forest can find and crack the second nut; if the settlement agreement resolved the item, and if that item doesn’t require a partner-level determination, then a claim challenging the substantive application of that item is barred by section 6230(c)(4).
The foregoing analysis is consistent with Federal Circuit precedent. Olson v. United States, 172 F.3d 1311, 1318 (Fed. Cir. 1999) (no notice of deficiency required where the computational notices involved “nothing more than reviewing the taxpayers’ returns for the years in question, striking out the [items] that had been improperly claimed, and re-summing the remaining figures”). It is also essentially the analytical methodology applied by the Court of Federal Claims in denying the taxpayers’ refund claim. See Bush v. United States, 78 Fed. Cl. 76 (Fed. Cl. 2007). But someplace between here and there, the Federal Circuit majority got turned around over the definition of a computational adjustment vis-à-vis section 6230(a)(1). It affirmed the trial court, but only after a convoluted analysis that began with the conclusion that the Service had erred in failing to issue a notice of deficiency to the taxpayers as a prerequisite to assessing the amounts agreed to in the settlement.
Section 6231(a)(6) defines a computational adjustment as “the change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.” Perhaps this language, like much in TEFRA, could be clearer, but it is hard to imagine that Congress intended to give it the construction adopted by the Federal Circuit majority. The majority read the statute as associating the term “change,” at the beginning of the subsection, with the term “partnership item,” at the end of the subsection; meaning that there always has to be a “change” in a “partnership item” in order for any adjustment to be “computational.” However, based on the language itself, the statute is better read as including all situations involving a change in tax liability driven by any “treatment of a partnership item,” and not just those involving a “change” in that treatment. The word “change” directly modifies only tax liability and the use of the word “treatment” (as opposed to “change”) to define the connection to a partnership item appears to be an intentional distinction. Furthermore, any computational adjustment “affect items,” and “affected item” is defined as an item “to the extent such item is affected [not necessarily “changed”] by a partnership item.” If the partner’s tax liability changed (which it did), and that change “properly reflect[ed] the treatment” of a partnership item (and didn’t require any partner-level determinations), it is a computational adjustment. This reading also harmonizes sections 6230 and 6231 and is consistent with the broader purpose of TEFRA in unifying partnership proceedings and making partners’ returns consistent with partnership returns. See generally section 6222 (which contemplates changes to partner returns by “computational adjustment” to make them consistent with partnership returns); see also Judge Prost’s concurrence, 599 F.3d at 1366.
But the majority disagreed. And having made it this far into the woods, it turned around only to find that all of its breadcrumbs had been eaten. Worse, it could see the right answer (the taxpayer loses), but couldn’t easily get there from its entanglement in the thicket of TEFRA. Creatively, the majority got to the desired destination by stepping out of the TEFRA forest to stand on the federal harmless error statute, 28 U.S.C. §2111 (a provision, it is fair to say, that is not regularly seen in tax cases). The Federal Circuit applied section 2111 to find that the Service’s failure to issue a notice of deficiency was harmless because the taxpayer had other methods to challenge the underlying issue including both their original proceeding and a hypothetical collection due process hearing. See section 6330. If you are not badly in need of a GPS at this point, you are doing very well.
The parties filed dueling petitions for rehearing. The taxpayers did their best to take advantage of the panel opinion’s vulnerabilities (vulnerabilities that were created by the majority getting so tangled up in TEFRA it had to reach out of the tax code to solve the problem). Positing that a valid assessment was a prerequisite for the Government to retain timely made payments, the taxpayer argued that section 6213 must be mechanically followed in order to legitimately assess taxes, and therefore the alternative methods suggested by the Federal Circuit would be ineffective and could not render the error harmless. For its part, the Government tried to reorient the court to the correct reading of “computational adjustment” and pointed to Lewis v. Reynolds, 284 U.S. 281 (1932), which might allow the taxpayers a refund (due to some of the payments apparently being made after the assessment statute had closed) in spite of the court’s harmless error analysis. (As an aside, on the valid assessment point, Judge Allegra’s recent opinion in Principal Life Ins. Co. v. United States, 2010 U.S. Claims LEXIS 856 (Fed. Cl. 2010), drawing from Lewis, nicely slays the chimera that is the “requirement” of “valid assessment” for non-time-barred years)
Thankfully, the Court vacated the panel opinion and granted rehearing en banc limited to the following four issues:
a) Under I.R.C. § 6213, were taxpayers in this case entitled to a pre-assessment deficiency notice? Were the assessments the results of a “computational adjustment” under § 6230 as the term “computational adjustment” is defined in § 6231(a)(6)?
b) If the IRS were required to issue a deficiency notice, does § 6213 require that a refund be made to the taxpayers for amounts not collected “by levy or through a proceeding in court”?
c) Are taxpayers entitled to a refund under any other section of the Internal Revenue Code? For example, what effect, if any, does an assessment without notice under § 6213 have on stopping the running of the statute of limitations?
d) Does the harmless error statute, 28 U.S.C. § 2111, apply to the government’s failure to issue a deficiency notice under I.R.C. § 6213? If so, should it apply to the taxpayers in this case?
The parties are in the process of briefing these issues. We are hopeful that the Court has found its compass and is diligently working its way out of the trees. Harmless error has nothing to do with the resolution of this case and neither do the technicalities of assessment. The taxpayers agreed to the treatment of various items in a partnership proceeding. There was no need for a partner-level determination in order to compute an adjustment with respect to those items. Therefore, no notice of deficiency was required. If the taxpayers had a complaint about how those calculations were performed that did not involve a substantive challenge to the agreed at-risk amount, they would have a claim. They don’t, so they lose.