Taxpayers often complain about how difficult the tax code and law are. And they are correct to do so, as the complexity generally favors the IRS. It leaves taxpayers in the position of having to wait for an IRS audit only to find that all of their efforts to comply and do their taxes correctly can be for naught. Even the most diligent taxpayers can find themselves in this position.
But this can be a two-way street. There are times when the IRS is on the receiving end of the complexity and loses tax revenue due to it. The rules for auditing partnerships are a very good example of this. The rules are so convoluted that IRS agents frequently make mistakes in how they handle these IRS audits. The recent Mathia v. Commissioner, No. 10-9004 (10th Cir. 2012) case provides a prime example of this. It considers the TEFRA rules, which have now been replaced by the unified audit regime rules that most taxpayers opt out of.
The Facts & Procedural History
The case involves individual taxpayers who filed joint tax returns for all relevant years. They owned an interest in a limited partnership. The case ended up being litigated in the U.S. Tax Court.
The IRS reached an agreement with the partnership regarding disallowed losses. The agreement required that any final settlement and entry of judgment bind all partnerships and each individual partner.
The IRS sent a “Stipulation of Settlement Agreement” to the partnership, which had to be signed by both the partnership and the IRS. The U.S. Tax Court accepted the settlement, and its decision became final in 2002.
In 2003, the IRS issued assessments for deficiencies and interest owed for 1982-84, based on the agreed-upon figures in the Stipulation.
The taxpayers paid the deficiencies but not the interest. The IRS subsequently sought to recover the unpaid interest, and the taxpayer argued at a Collection Due Process hearing that the assessments were untimely.
The U.S. Tax Court rejected the taxpayer’s argument, affirming that the assessments were timely and that the interest should not be abated. The taxpayers appealed the decision.
About TEFRA Partnerships
Partnerships are generally treated as pass-through entities for tax purposes, meaning that they do not pay federal income tax themselves. Instead, all income, deductions, and credits are allocated among the individual partners, who are then responsible for paying taxes on their share of the partnership’s income.
Before the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) was enacted in 1982, partnership proceedings were conducted at the individual partner level, which created inefficiencies for the IRS. TEFRA streamlined partnership taxation by requiring the resolution of “partnership items” – items that are appropriately determined at the partnership level – in a single, unified audit and judicial proceeding. This was intended to allow for more efficient partnership-level administrative audits and judicial proceedings.
Under TEFRA, if the IRS disagrees with any reported partnership item, it may adjust the items reported on the partnership’s Form 1065 by mailing a Final Partnership Administrative Adjustment (“FPAA”) to the tax matters partner and all notice partners. If a tax matters partner (“TMP”) does not respond to the FPAA, the IRS may proceed with the assessment of taxes against the partnership and its partners based on the proposed adjustments in the FPAA. It is more common for the TMP to respond. They do so by filing a petition in the U.S. Tax Court, a federal district court, or the Court of Federal Claims contesting the adjustments. All partners with an interest in the proceeding are treated as parties and are bound by its outcome.
Partnership vs. Nonpartnership Items
The taxpayers in this case argue that the assessments were untimely because they were made more than one year after the execution of a settlement agreement pursuant to Section 6231(b)(1)(C).
Section 6231 details the various methods by which partnership items are reclassified as nonpartnership items and resolved on the partner level. The rule at issue, in this case, reads as follows:
- In general. For purposes of this subchapter, the partnership items of a partner for a partnership taxable year shall become nonpartnership items as of the date—
- the Secretary mails to such partner a notice that such items shall be treated as nonpartnership items,
- the partner files suit under section 6228(b) after the Secretary fails to allow an administrative adjustment request with respect to any of such items,
- the Secretary enters into a settlement agreement with the partner with respect to such items, or
- such change occurs under subsection (e) of section 6223 ? or under subsection (c) of this section.
This provision recognizes individual partners may opt out of a partnership-level proceeding by entering into a settlement agreement with the IRS with respect to the determination of their individual partnership items. This is important in this case because which statute of limitations applies depends on whether partnership items were converted to nonpartnership items. The IRS only has 3 years to make an assessment. If converted to nonpartnership items, there is a shorter one year period for the IRS to make the assessment.
Which Assessment Period Applies?
The taxpayer argued that the IRS’s assessments were untimely because they were levied more than one year after the execution of a settlement agreement pursuant to I.R.C. § 6231(b)(1)(C). The court did not agree.
The court noted that the taxpayer never entered into an individual agreement with the IRS, and the IRS timely issued the assessments within one year of the U.S. Tax Court’s decision becoming final. The court also noted that the nature and character of the agreements show that the taxpayer remained a party to the partnership-level proceeding until the U.S. Tax Court’s decision became final, and there was no conversion of the taxpayer’s partnership items to nonpartnership items.
As a result, the court held that the settlement was governed by the statute of limitations set forth in Section 6229(d), which permits the IRS to make assessments up to one year after the U.S. Tax Court’s decision becomes final. The assessments were made well within Section 6229(d)’s one-year window and were timely.
The TEFRA provisions were intended to make it easier for the IRS to audit partnerships by allowing the IRS to just focus on the partnership level adjustments. It has not accomplished this goal, as TEFRA adjustments are now much more complex and fraught with danger as this case demonstrates. Those who have TEFRA partnerships should carefully consider these rules when handling and working on IRS audits. The IRS frequently makes errors here and the errors can result in no tax being due. Taxpayers should plan for this as they manage their audits.