UTAM Ltd., et al, (CA DC 06/21/2011) 107 AFTR 2d ¶2011-967
The Court of Appeals for the District of Columbia has reversed the Tax Court and upheld IRS regs providing that a basis overstatement is an omission of income for purposes of the six-year limitations period, based on the reasoning of its same-day decision in Intermountain Insurance Service of Vail, LLC, (CA DC 06/21/2011) 107 AFTR 2d ¶2011-964 (discussed at ¶1). The Court also concluded that IRS's mailing of a final partnership administrative adjustment (FPAA) to the tax matters partner (TMP) suspended the limitation period for an individual partner under Code Sec. 6501.
Background on TEFRA audit rules. Under the TEFRA partnership audit rules, the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) generally is determined at the partnership level. (Code Sec. 6221)
If IRS decides to adjust any “partnership items,” it must notify the individual partners through an FPAA. (Code Sec. 6226) Various Code provisions define the limitations on assessments made with respect to FPAA adjustments, and the tolling of those periods (see, e.g., Code Sec. 6229, Code Sec. 6501 and discussion below). For 90 days after issuing an FPAA, the TMP has the exclusive right to file a petition for readjustment of the partnership items in the Tax Court, the Court of Federal Claims, or a U.S. District Court. (Code Sec. 6226(a)) After that period expires, other partners have 60 days to file a petition for readjustment. (Code Sec. 6226(b)(1))
Background on limitation periods. Code Sec. 6501(a) generally provides that a valid assessment of income tax liability may not be made more than three years after the later of the date the tax return was filed or the due date of the tax return. However, under Code Sec. 6501(e), a six-year period of limitations applies when a taxpayer omits from gross income an amount that's greater than 25% of the amount of gross income stated in the return. Subject to exceptions and special rules, the period for assessing tax attributable to a partnership item (or affected item), for a partnership tax year won't expire before the date that is three years after the later of: (1) the date the partnership return was filed, or (2) the last day for filing the return for that year (without regard to extensions). (Code Sec. 6229(a)) The period is six years where the partnership omits from its gross income an amount which is more than 25% of the amount of gross income stated in its return. (Code Sec. 6229(c))
Facts. David Morgan formed an insurance business then merged this business into UTA Management, a solely owned S corporation. In’99, Morgan caused UTA Management's assets to be contributed to UTAM, a newly formed limited partnership. UTA Management owned a 99% partnership interest in UTAM, with the remaining 1% held by a separate S corporation owned by Morgan and his family. Morgan later agreed to sell the partnership interests of UTA Management and DDM to an unrelated insurance company.
Before the sale, Morgan entered into a series of Son of BOSS tax shelter transactions to inflate UTA Management's outside basis in UTAM. In the end, Morgan raised UTA Management's outside basis in the partnership by nearly $38 million. UTAM later closed the sale by buying Treasury notes for slightly more than $38 million, resulting in an overall loss to UTAM from the transaction.
The sale of UTAM closed on Oct. 19,’99. The tax consequences of the sale were reflected on UTA Management's’99 return, filed on Aug. 15, 2000. As a result of the tax shelter transactions, UTA Management claimed an overall loss of approximately $13 million. Morgan filed his’99 individual return on Oct. 16, 2000, claiming the flow-through loss from the sale.
On Oct. 13, 2006, IRS mailed an FPAA to UTAM's TMP pertaining to UTAM's’99 tax year in which it adjusted UTAM's outside partnership basis to zero on the ground that the transactions lacked economic substance. IRS also found that UTAM was itself a sham, existing solely for tax avoidance purposes.
UTAM's TMP filed a timely petition for readjustment of partnership items with the Tax Court. UTAM argued, among other things, that IRS's adjustments were barred by the general three-year limitation period for tax assessments in Code Sec. 6501(a).
Tax Court's decision. The Tax Court held that IRS's FPAA was untimely issued outside Code Sec. 6501’s three-year assessment period, and that an overstatement of basis didn't constitute an income omission and thus couldn't trigger Code Sec. 6501(e)(1)(A)’s extended six-year period.
Tax Court reversed on appeal. The Court of Appeals for the District of Columbia Circuit reversed the Tax Court, finding that Code Sec. 6501(e)(1)(A)’s six-year period can be triggered by an overstatement resulting from an overstatement of basis. In so holding, the Court validated IRS regs to that effect and widened an existing split in the Circuits. (see ¶1)
The Court also addressed another argument raised by UTAM that was not considered by the Tax Court—namely, whether IRS's mailing of an FPAA tolls an individual partner's limitation period under Code Sec. 6501.
Although this issue wasn't considered by the Tax Court in its underlying UTAM opinion, the Tax Court had clearly stated its position in Rhone-Poulenc, (2000) 114 TC 533. In that case, the Tax Court held that Code Sec. 6229(d) does suspend the running of an individual partner's Code Sec. 6501 limitations period if that period is open on the date that IRS mailed the FPAA. Since Morgan's Code Sec. 6501 period was open when IRS mailed the FPAA, the Circuit Court decided that a remand on this issue would be futile, and it agreed with the Tax Court's position on the issue.
Referencing its earlier opinion in Andantech, LLC v. Commissioner, (CA DC 2003) 91 AFTR 2d 2003-2623, the Circuit Court stated that the “period for assessing any tax” specified in Code Sec. 6229(a) referred to a partner's generally applicable assessment period since partnerships aren't taxed. Since Morgan's period was six years, the FPAA was issued while his period was still running.
The Court stated that Code Sec. 6229(a) doesn't provide the maximum period for assessments—rather, it sets forth a minimum period for IRS to take action, and if UTAM's argument were accepted, the minimum period would effectively be converted to a limitations period. Thus, the Court concluded that the assessment period which is suspended under Code Sec. 6229(d) is the partner's open assessment period under Code Sec. 6501.
References: For earliest termination date for assessment period for partnership items, see FTC 2d/FIN ¶T-4018; United States Tax Reporter ¶62,294; TaxDesk ¶838,003; TG ¶70431.