Ninth Circuit Sustains Notice of Deficiency for Affected Items Despite No Partnership Level Proceeding (8/18/12)

In Meruelo v. Commissioner, ___ F.3d ___, 2012 U.S. App. LEXIS 17208 (9th Cir. 2012), here, the Ninth Circuit held that a notice of deficiency ("NOD") adjusting partnership affected items which is timely by reference to the individual taxpayer's statute of limitations is proper despite there having been no partnership level TEFRA audit.  The setting and resolution of the case permit me to address an issue I made earlier that, under the Allen holding (which I think is wrongly decided), fraud on the return can keep the statute of limitations for a taxpayer who does not commit the fraud.  In Allen, the fraud of the return preparer was involved, but the sweep of the holding is not limited to the return preparer but to anyone materially involved in a chain of events that support a fraudulent position reported on the taxpayer's return.  I noted particularly that fraud with respect to the abusive tax shelters that ran rampant in the late 1990s and early 2000s and led to criminal prosecution of the enablers should be a potential application of the Allen holding.  See Does the Preparer's Fraud Invoke the Unlimited Statute of Limitations? (8/5/12), here.  This type of fraudulent shelter may have been involved in Meruelo.

In Meruelo, the partnership in question (Intervest) did a foreign currency transaction, probably of a Son-of-Boss variety.  The transaction may have been fraudulent, although that issue was not resolved in Meruelo.  Rather than TEFRA audit the partnership, however, the IRS sent the taxpayers (husband and wife) a NOD disallowing the partner's losses claimed indirectly from the partnership.  (Actually the partner in the tax shelter partnership (Intervest) was a disregarded sole member LLC owned by the taxpayer; I ignore the intervening disregarded entity because, well, for tax purposes it is disregarded.)  The NOD was timely under the taxpayers' statute of limitations.

Although it is clear that, had there been a timely TEFRA audit of the partnership, the IRS could have relied upon TEFRA's statute of limitations period to make a timely assessment of partnership items and partnership affected items, there was in fact no TEFRA audit.  Now, I have just used some TEFRA jargon that I am going to have to explain in order to move.  The following is a good summary from CC-2009-011 "Protective Assessments of Affected Items in TEFRA Partnership Cases, (March 11, 2009),  here.

A partnership item is any item required to be taken into account for the partnership's taxable year that is more appropriately determined at the partnership level rather than at the partner level. I.R.C. § 6231(a)(3). These items include, but are not limited to, (1) the partnership aggregate and each partner's share of items of income, gain, loss, deduction, or credit of the partnership; (2) the amount and type of any partnership liabilities; (3) optional adjustments to the basis of partnership property pursuant to a section 754 election; and (4) the amount of contributions to the partnership. Treas. Reg. § 301.6231(a)(3)-1. At the conclusion of an audit, the IRS will issue a notice of Final Partnership Administrative Adjustment with respect to the partnership's partnership items. I.R.C. § 6223. 

Partnership items flow through and are reported in the computation of the taxable income of the partners. Adjustments to partnership items have an affect on the partners' tax return (e.g., Form 1040 or Form 1120) by causing adjustments to other line items, some of which are not related to the partnership (referred to as nonpartnership items). These nonpartnership items that are affected by the partnership adjustments are "affected items." 

There are two types of affected items: (1) those that only require a computation of the tax once the partnership proceeding is completed and (2) those that require partner-level determinations to be made once the partnership-level proceeding is completed. See Maxwell v. Commissioner, 87 T.C. 783 (1986); N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 744 (1987); Treas. Reg. 301.6231(a)(5)-1. 

A computational affected item is an item on a partner's return that can be adjusted mathematically without the need for further factual determinations at the partner level. Treas. Reg. § 301.6231(a)(6)-1(a)(1). Computational affected items include those items on a partner's return that vary if there is a change in the individual partner's adjusted gross income. For example, an adjustment to a partnership item that results in a change to a partner's adjusted gross income will have a cascading effect, resulting in a change to the threshold dollar limit for the medical expense deduction permitted under section 213. The threshold limit for the medical expense deduction is an affected item for which no partner-level determination needs to be made to determine the new amount to be reported on the partner's return. These adjustments are purely mathematical and can be directly assessed at the conclusion of the partnership proceeding by applying the partnership adjustments to each of the partners. I.R.C. § 6230(a)(1); Treas. Reg. § 301.6231(a)(6)-1. 

The second type of affected item is an adjustment that requires further determinations at the partner level before the adjustment can be made to the partner's return. For example, a partner's basis in the partnership interest is generally determined at the partner level, as are the limitation of deductions under the passive activity and at-risk rules. Because further determinations are required at the partner level, deficiency procedures apply to these affected items. I.R.C. § 6230(a)(2); Treas. Reg. § 301.6231(a)(6)-1(a)(3). The IRS has one year from the conclusion of the partnership proceeding to issue a notice of deficiency for the affected items. I.R.C. § 6229(d). Under section 6213(a), the partner has 90 days to petition the deficiency in Tax Court. Alternatively, the partner can pay the deficiency and file suit for refund under section 7422.

In Meruelo, the IRS discovered the loss at the individual taxpayer level and, since it had not instituted a TEFRA proceeding for the partnership, timely sought from the taxpayers a consent to extend the statute of limitations.  The taxpayers refused to executed the consent.  The IRS then issued the NOD just a few days before the taxpayers' individual level three year statute of limitations would have expired.  The taxpayers petitioned the Tax Court to redetermine and urged that the NOD was invalid because, they urged, the NOD made an adjustment for a partnership affected item that can only be made after a partnership level TEFRA audit.

There was no TEFRA audit, apparently, because the underlying shelter was the subject of a grand jury investigation and, generally, the IRS does not proceed civilly until such a criminal investigation is concluded.  That meant that there was some likelihood that, absent a parallel TEFRA audilt, an FPAA could not be issued even under the extended TEFRA statute of limitations for fraud (6 years).  These phenomena, the taxpayers hoped, would give them victory where they surely deserved defeat.  (OK, if the statute had closed, which was the bottom line result the taxpayers wanted, then one can make the argument that they did not deserve defeat.)

The Tax Court and the Ninth Circuit rejected the argument, each holding that the NOD was valid, thus holding the taxpayers "liable for $1,387,006 in additional income tax and $277,401 in penalties."   I won't go further into the TEFRA analysis of the holding.

The point I want to make in this blog is that, as I noted in yesterday's blog, Assessment Statute of Limitations When Contesting an Allegedly Invalid Notice of Deficiency (8/16/12), here, if the NOD were declared invalid, a taxpayer should make sure that the statute of limitations is not otherwise open.  In Meruelo, it is clear that, if the NOD were invalid and if -- note this if -- the 3-year statute of limitations applied, the taxpayers' individual statute of limitations had closed and that the special TEFRA extended statute of limitations did not apply (because there was no TEFRA audit).  So the taxpayer would just avoid the admitted liability for the tax, penalties and interest on tax and penalties.

But, the question is as discussed in my blog on the Allen case, whether fraud that evidences itself on the return would make the taxpayers' returns subject to an open-ended statute of limitations under Section 6501(c)(1).  See Does the Preparer's Fraud Invoke the Unlimited Statute of Limitations? (8/5/12), here.  If that is the case, then the IRS could have audited the TEFRA partnership at any time -- at least sufficiently to deny any flow through deductions an impose the penalties -- and visited the consequences on the taxpayers because their statutes of limitations would still be open because the special TEFRA statute of limitations does not otherwise shorten the taxpayer level statute of limitations for making adjustments for partnership items and affected items.  See Curr-Spec Partners, LP v. Commissioner, 579 F.3d 391 (5th Cir. 2009); Andantech L.L.C. v. Commissioner, 331 F.3d 972 (D.C. Cir. 2003); GD Global Fund LLC v. United States, 481 F.3d 1351 (Fed. Cir. 2007); Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner, 114 T.C. 533, 2000 WL 863142 (2000) (reviewed).