While the Bipartisan Budget Act of 2015 repealed TEFRA (or the Tax Equity and Fiscal Responsibility Act of 1982) for tax years ending after December 31, 2017, courts continue to grapple with cases governed by its partnership audit and assessment procedures. Tuesday, the Tenth Circuit issued an interesting opinion on when a good faith/reasonable cause defense to a penalty determination can be raised by an individual partner in a refund action. McNeill v. United States, No. 15-8095, 2016 U.S. App. LEXIS 16343 (10th Cir. Sept. 6, 2016).
TEFRA’s audit process works like this:
- There is a partnership-level audit that results in a final partnership administrative adjustment. I.R.C. § 6223(a)(2).
- The partnership audit determination is then subject to judicial review. Generally, a partnership’s tax matters partner initiates this process, but other partners are free to do so if the tax matters partner fails to act. I.R.C. § 6226(a), (b).
- Tax assessments against individual partners generally are deferred until the administrative and judicial partnership level proceedings are completed. I.R.C. § 6225(a).
- In issuing tax assessments to individual partners, the IRS is authorized to make computational adjustments, which are generally not subject to the normal deficiency procedures, including Tax Court review. I.R.C. § 6230(a)(1).
- Since computational adjustments are generally not subject to Tax Court review, individual partners are left to pursue refund claims to challenge any computational adjustment. I.R.C. § 6230(c)(1).
- In any refund case, the individual partners are barred from challenging what was determined at the partnership level, but they can raise “any partner level defenses that may apply or to challenge the amount of the computational adjustment.” I.R.C. § 6230(c)(4).
- But the partnership-level determination “concerning the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item shall . . . be conclusive.”
And that’s a simplified synopsis; various issues along the path from the initial partnership audit determination through the final disposition of partner-level assessments have divided courts.
Penalties pose particular problems because TEFRA indicates that their applicability should be determined “conclusively” at the partnership level, but they remain subject to partner level defenses. Id. This dichotomy led the Supreme Court to describe the partnership level determination that a penalty is applicable as “provisional.” United States v. Woods, 135 S. Ct. 557, 564 (2013). A court conducting a partnership level proceeding under TEFRA “may decide only whether adjustments properly made at the partnership level have the potential to trigger the penalty. Each partner remains free to raise, in subsequent, partner-level proceedings, any reasons why the penalty may not be imposed on him specifically.” Id.
In McNeill, the Tenth Circuit addressed the availability of a good faith/reasonable cause defense under Section 6664(c) of the Internal Revenue Code in a partner level proceeding after an administrative determination that penalties were applicable because the relevant partnership was an abusive tax avoidance scheme. 2016 U.S. App. LEXIS 16343 at *4-*6. A majority of the court concluded that the defense was available despite some fairly awkward facts.
Mr. McNeill was slated to receive an $18 million payment upon retirement from a utility company, and he sought out a mechanism to reduce his tax bill. Id. at *2. He settled upon a distressed debt arrangement through a partnership, which is known as a distressed asset debt or “DAD” shelter. The taxpayer’s advisors took the following steps:
- They created a series of partnerships; the foreign debt owners contributed their distressed debt, and Mr. McNeill contributed cash.
- McNeill held 90% of the final partnership.
- The distressed debt was liquidated, generating losses, and Mr. McNeill claimed $20 million in losses.
Id. at *3.
The arrangement attracted scrutiny from the IRS, which determined that the foreign debt holders had actually sold their assets, and that Mr. McNeill’s basis in those assets was the relatively modest amount of cash that he invested. Id. at *4. For good measure, several million dollars in penalties and interest were also included in the final partnership administrative adjustment. Id.
Mr. McNeill, who was the tax matters partner, sought judicial review, but that case was dismissed without prejudice. Id. Mr. McNeill paid the full amount of the assessment and then filed for a refund, arguing that the penalty and associated interest should be refunded because he had reasonable cause for the position on his return and acted in good faith within the meaning of section 6664(c)(1). Id. at *5-*6. To support this defense, Mr. McNeill relied upon tax opinions that he had received from both lawyers and accountants. Id. at *6.
While the district court refused to consider the taxpayer’s good faith/reasonable cause defense, the Court of Appeals was more receptive. The Tenth Circuit started its analysis with the language of TEFRA, which was the basis for the government’s successful summary judgment motion in district court. The government asserted that the language of section 6230(c)(4) made the prior administrative proceeding conclusive against the partnership and against its managing partner, Mr. McNeill. Id. at *8. In the court’s view, the surface appeal of the argument was inconsistent with the final sentence of section 6230(c)(4), which preserves partner level defenses for “any partner.” Id. (quoting I.R.C. § 6230(c)(4)). The government asserted that someone like the taxpayer, who was the central figure of the partnership, should be bound by an administrative determination on good faith that was made at the partnership level because, of necessity, it was his good faith that was at issue. Id. at *9. The Tenth Circuit rejected this argument because section 6230(c)(4) did not exclude managing partners. Id. The court also observed that the facts relevant at the partner level might very well be different, noting that the taxpayer had received a separate opinion letter that was not issued to the relevant partnership. Id. at *10. For good measure, the court observed that the TEFRA regulations explicitly indicate that the good faith/reasonable cause defense is a partner level defense. Id. at *11 (citing Treas. Reg. § 301.6221-1(d)).
The majority opinion did caution that its holding was in large measure dependent upon the peculiar procedural posture of the case; since the partnership level judicial proceeding was dismissed without prejudice, collateral estoppel was not an issue. Id. at *14-*15.
There is a dissenting opinion, which is premised on the notion that the dismissal of the partnership level judicial proceeding meant that the audit findings “rise to the level of final and correct findings of the district court itself.” Id. at *17 (Phillips, J. dissenting). That premise is difficult to square with the fact that the partnership level judicial proceeding was dismissed without prejudice.
While this is a pro-taxpayer ruling, it should be viewed with caution. The outcome probably would have been very different if there was a final judicial determination on good faith and reasonable cause.