Theoretically, The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) is simple:
- The partnership is audited, and partnership items are subject to adjustment at the partnership level. I.R.C. § 6221.
- Assessments are made at the conclusion of the partnership proceeding. I.R.C. § 6225(a).
- Adjustment to partnership items are typically implemented at the partner level through “computational adjustments” that usually do not require a notice of deficiency. I.R.C. § 6230(a)(1).
Actually, however, TEFRA quickly becomes complicated when applied to a particular fact pattern.
On November 24, 2015, a case in the Court of Federal Claims demonstrated that the theoretically simple process of making “computational adjustments” is anything but simple. In this instance, TEFRA’s complexity redounded to the partners’ benefit, generating a refund. Mandich v. United States, No. 02-1222T, 2015 U.S. Claims LEXIS 1572 (Nov. 24, 2015).
Mandich arose from a TEFRA proceeding that began in 1991. Id., 2015 U.S. Claims LEXIS 1572 at *4. Mr. and Mrs. Mandich elected to opt out of the partnership proceeding and settled their issues with the IRS through a closing agreement in 1999. Id. at *5. As part of a long-running audit of several years of the taxpayers’ returns, in 2000, the IRS employed the closing agreement to disallow a variety of credits claimed from prior tax years that could have been used to offset taxes it was assessing for tax years 1984 and 1990-1995. Id. at *32. These adjustments became an issue in the refund action because the IRS did not issue a notice of deficiency; instead it relied on TEFRA’s exception to the deficiency notice requirement, which applies (subject to certain exceptions) “to the assessment or collection of any computational adjustment.” I.R.C. § 6230(a)(1).
TEFRA 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.” I.R.C. § 6231(a)(6). TEFRA’s exception to the deficiency notice requirement also applies to “affected items,” which it defines as “any item to the extent such item is affected by a partnership item.” I.R.C. § 6231(a)(5).
But there’s a catch: a notice of deficiency is still required if adjustment to an affected item would require “partner level determinations.” I.R.C. § 6230(a)(2). Consequently, if an individual factual determination must be made in analyzing the tax liability associated with the affected item, a notice of deficiency must be issued. See Olson v. United States, 172 F.3d 1311, 1318 (Fed. Cir. 1999); see also Bush v. United States, 655 F.3d 1323, 1330-31 (Fed. Cir. 2011).
A portion of the taxpayers’ refund claim fell squarely within these rules. Certain of the credits disallowed by the IRS had been the subject of prior Tax Court litigation involving various partnerships; the government argued that the prior litigation had resolved all individual factual issues and that it was simply making computational adjustments in applying prior Tax Court orders to adjust affected items under the closing agreement. Mandich, 2015 U.S. Claims LEXIS 1572 at *38.
While acknowledging that the government’s argument was sound in theory, id. at *41, the court concluded that the record did not support the government’s argument in this particular case. The government had relied heavily on a prior examination report without taking account of the fact that the final Tax Court disposition was not consistent with the examination report. Id. at *38-*41. There were various instances in which the Tax Court disposition furnished the taxpayers with credits that the examiner had disallowed: the overall deficiency dropped from $37,957 in tax to $9,811. Id. at *39.
Unsatisfied that the record would permit it to trace the disallowance of the relevant credits under the closing agreement back to a specific prior disallowance by the Tax Court, the court concluded that individual factual determinations were necessary: “on the present record we would have to make partner-level factual determinations in order to untangle the mess of credits and previous legal proceedings to arrive at the conclusion that all pre-1983 carryover credits were previously disallowed.” Id. at *40. Consequently, the Court of Federal Claims concluded that the disallowance of these credits was not a computational adjustment and that a deficiency notice should have been issued. Since the time to issue a deficiency notice had long since passed, the taxpayers prevailed on this portion of their refund claim.
While the court’s reasoning is sound, this is a somewhat unusual result, as typically the taxpayer runs afoul of TEFRA’s complexity, not the government.