As you may or may not know, a partnership is a pass through entity whereby items of income, gain, loss, deduction or credit are passed through to the individual partners and reported on their 1040 individual income tax returns. The article below has been drafted by a Denver tax attorney at The McGuire Law firm to discuss a recent Tax Court decision that displays not only the Court’s jurisdiction, but how a determination at the partnership level can impact a partner’s individual income taxes.
The United State Tax Court has determined that is has jurisdiction over affected items deficiency proceedings incurred from prior proceedings at the partnership level. The Court found that gain or loss through the disposition of a partnership interest was an affected item requiring determinations at the partner level where gain or loss would be affected by a partner level determination or determinations.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership audit rules would generally hold that the tax treatment of any partnership item and the application of penalty or additions of tax via a deficiency notice, or additional amounts due to the adjustment of a partnership item would be determined at the partnership level- See IRC Section 6221. Furthermore, under IRC Section 6224, a partner whose tax liability may be affected via the partnership litigation of partnership items can participate in the proceedings, and under IRC Section 6229(d) the IRS can assess additional tax to an individual partner within one year of the final conclusion or determination of the partnership items.
Prior to discussing the facts further, it may help to define and discuss some of the related terms. A partnership item under IRC Section 6231 is an item (any item) that must be taken into account for the partnership’s tax year under the IRC to the extent the IRS regulations provide the item is most appropriately determined at the partnership level as opposed to the partner level. Non-partnership items, which are also under IRC 6231 is an item that is not a partnership item.
The United States Tax Court has limited jurisdiction and can only exercise such jurisdiction allowed by statute. If a taxpayer files a petition to the Tax Court, the Court does have jurisdiction to determine or re-determine the amount of the deficiency. Generally, the deficiency procedure does not need to be followed to determine affected items coming from a TEFRA proceeding analyzing a partnership level matter, but an exception exists for affected items that require partner level determinations- see IRC Section 6230(a)(2)(A)(i).
A partnership can make an election to adjust the basis of partnership assets on the sale, transfer or distribution of a partnership interest by filing a statement of election with the partnership income tax return (generally Form 1065 US Partnership Income Tax Return) for the tax year of which the transfer or distribution of the interest occurs- See IRC Section 754.
The facts of the case at hand are as follows. Mr. Greenwald was a limited partner in Regency Plaza Associates, and Regency petitioned the bankruptcy court for relief under Chapter 11 in 1996. Regency terminated operations in 1997, and the IRS filed substitute returns for Regency in 1996 and 1997. Regency was subject to TEFRA’s unified partnership audit and litigation procedure and in October 2007, the IRS issued a notice of final partnership administrative adjustment to tax years 1996 and 1997. As a result, two of the partners apart from the tax partner filed petitions in tax court and Mr. Greenwald filed notices of election to participate in both cases and motions to have himself appointed the tax matters partner. The Court granted these motions and the case was consolidated.
After the TEFRA proceeding, the IRS issued a notice of computational adjustment to Mr. Greenwald regarding the 1996 and 1997 Regency tax returns. Additionally, the IRS issued a notice of deficiency to Mr. Greenwald for his 1997 individual income tax period adjusting his long term capital gains and other corresponding adjustments based upon the partnership adjustments. Mr. Greenwald filed petitions to the notices of deficiency and argued to dismiss the cases for lack of jurisdiction because the outside basis issue was a partnership item and should been determined at the partnership level, and that the notices were invalid. The Tax Court determined that the gain or loss through the transfer or distribution of a partnership interest was an affected item that required partner level determinations if the amount of gain or loss could be impacted by a partner level determination.
The Internal Revenue Service took the position that the Tax Court had jurisdiction because outside basis was an affected item that required partner level determinations, and the taxpayers argued that outside basis was a partnership item and therefore such issue need to have been raised during the prior partnership level proceedings. The Court agreed with the neither the IRS nor the taxpayer, deciding that it had jurisdiction to “re-determine” the amount of a deficiency attributable to affected items because there were partner level determinations that were required.
The Tax Court decided that re-determining the amounts of deficiencies resulting from partnership level adjustment would make it necessary to review the partner’s specific facts. For example, what if a partner incurred litigation or legal costs which could be added to their basis? Such costs could be added to their basis, but would not necessarily be taken into account through an IRC Section 754 election, or another partnership level determination. Moreover, determining that a partner did not incur such a cost or expense that could impact basis was a partner level determination as well. Thus, the Tax Court had subject matter jurisdiction over the consolidated cases.
The tax implications of certain partnership decisions can be complicated. If you have any questions regarding your partnership, you can speak with a Denver tax attorney or business attorney by calling The McGuire Law Firm.