Tread Carefully: Extension Agreements in Tiered Partnerships.

In the course of an audit, taxpayers are frequently presented with a request to extend the assessment statute of limitations to permit the audit to be concluded.

Section 6501 of the Internal Revenue Code authorizes extensions so long as they are entered into before the limitations period expires. When an extension is requested, the taxpayer is permitted to limit it to specific issues. See I.R.C. § 6501(c)(4)(B). If the scope of the extension is later disputed, courts apply contract principles to determine whether the taxpayer’s extension covered the particular issue in dispute.

A recent case from the Ninth Circuit shows that particular care must be used in looking at the language of the extension agreement in the context of tiered partnerships. Candyce Martin 1999 Irrevocable Trust v. United States, 2014 U.S. App. LEXIS 605 (9th Cir. Jan. 13, 2014).

The case involved a large number of entities, but two play a prominent role: First Ship, which was controlled by the taxpayers, and 2000-A, a lower tier partnership owned in part by First Ship. 2014 U.S. App. LEXIS 605, slip op. at *9-*10. The taxpayers then entered into a series of option contracts (the long options) and sold others (the short options) in a “Son of BOSS” transaction. Most of these assets were contributed to First Ship, which, in turn, contributed most of what it received to 2000-A. Id., slip op. at *10.

No one addressed the short options in determining their tax basis, which was calculated by all parties by reference to the purchase price of the long options alone. Id. 2000-A later terminated the options, distributed its remaining assets, and then dissolved. After 2000-A filed its partnership return, First Ship filed its own return, reporting a substantial loss on its interest in 2000-A, and taxpayers then reported their share of those losses on their own returns. Id., slip op. at *11.

The IRS and the taxpayers entered into agreements that extended the limitations period to permit an assessment “resulting from any adjustment directly or indirectly (through one or more intermediate entities) attributable to partnership flow-through items of First Ship” and related penalties and additions to tax. Id., slip op. at *11-*12.

The IRS issued a notice of Final Partnership Administrative Adjustments to both First Ship (for the 2001 tax year) and 2000-A (for the 2000 tax year). The FPAA for 2000-A labeled the partnership a sham that lacked economic substance; it also determined that the short options constituted liabilities that should have been considered in determining First Ship’s basis in 2000-A. This eliminated the bulk of First Ship’s losses, which meant the taxpayers had substantial additional tax liabilities. Id., slip op. at *12.

When several of the taxpayers challenged the 2000-A FPAA, the district court initially concluded that the extension agreement was applicable. Id., slip op. at *13. The court of appeals also concluded that the extension was applicable, rejecting the taxpayer’s argument that an agreement that specifically referenced an upper-tier partnership did not encompass adjustments made to a lower tier partnership, and distinguishing Russian River Recovery Fund Ltd. v. United States, 101 Fed. Cl. 498 (2011).

I will cover the court’s reasoning in greater detail in a subsequent post as it deserves additional treatment.

Jim Malone is a tax lawyer in Philadelphia. © 2014, Malone LLC.

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