Wednesday, July 11, 2007

Tax Attorney: Sham LLC treated as a partnership
RJT Investments X,v Commissioner CA-8, 2007-2 USTC ¶50,535, July 2, 2007.


Partners and partnerships: Partnership item determinations: Sham transactions. --
The Tax Court correctly treated as a partnership item its determination that an LLC was a sham and lacked economic substance. Although the definition of partnership item in Code Sec. 6231(a)(3) includes items required to be taken into account under subtitle A, the statutory language provides room for partnership items that, even in the absence of an explicit subtitle A reference, are necessary for income tax calculation purposes. Further, other courts have applied a similarly broad reading of the partnership item definition in concluding that the TEFRA statute of limitations is a partnership item, even through the statute of limitations is not governed by subtitle A. The taxpayer did not present a compelling reason to distinguish the partnership's status as a sham from the treatment of the statute of limitations. Moreover, the treatment of sham status as a partnership item was consistent with Congress's intent in enacting TEFRA. The determination of sham status was also more appropriately determined at the partnership level. Under Reg. §301.6231(a)(3)-1(b), the determination of partnership items includes underlying legal and factual determinations including the partnership's method of accounting, its inventory method, and whether partnership activities have been engaged in with the intent to make a profit for purposes of Code Sec. 183. The status of a partnership as a sham is an underlying legal determination that falls within the definition of partnership item.

The taxpayer's argument that the LLC's sham status cannot constitute a partnership item was rejected. Although the definition of partnership item in Code Sec. 6231(a)(3) includes items required to be taken into account under subtitle A, the statutory language provides room for partnership items that, even in the absence of an explicit subtitle A reference, are necessary for income tax calculation purposes. Further, other courts have applied a similarly broad reading of the partnership item definition in concluding that the TEFRA statute of limitations is a partnership item, even through the statute of limitations is not governed by subtitle A. The taxpayer did not present a compelling reason to distinguish the partnership's status as a sham from the treatment of the statute of limitations. Moreover, the treatment of sham status as a partnership item was consistent with Congress's intent in enacting TEFRA.

The determination of sham status was also more appropriately determined at the partnership level. Under Reg. §301.6231(a)(3)-1(b), the determination of partnership items includes underlying legal and factual determinations including the partnership's method of accounting, its inventory method, and whether partnership activities have been engaged in with the intent to make a profit for purposes of Code Sec. 183. The status of a partnership as a sham is an underlying legal determination that falls within the definition of partnership item.



II.


The Internal Revenue Code defines "partnership item" as "[(A)] any item required to be taken into account for the partnership's taxable year under any provision of subtitle A[, (B)] to the extent regulations prescribed by the Secretary provide that...such item is more appropriately determined at the partnership level than at the partner level." 26 U.S.C. §6231(a)(3). 5


A. "Required to be taken into account under...subtitle A"


RJT and Thompson first contend that the "sham, etc." status cannot constitute a partnership item because no provision of subtitle A explicitly requires that a partnership make such a determination for purposes of deriving individual income tax. They assert, as a result, that the Tax Court improperly broadened the partnership item definition by effectively substituting "regarding any provision of subtitle A" for the "required to be taken into account...under any provision of subtitle A" language. We find Thompson's argument unavailing and contrary to TEFRA's language and intent.

To begin, we disagree with RJT and Thompson's premise that the legal validity of a partnership is not something "required to be taken into account" for income tax calculation purposes. When filling out individual tax returns, the very process of calculating an outside basis, reporting a sales price, and claiming a capital loss following a partnership liquidation presupposes that the partnership was valid. Even if the partnership's validity is, in some instances, assumed, the proper resolution of a partner's income tax is no less dependant on the correctness of that assumption.

Additionally RJT and Thompson misread the statutory language when they argue that the "sham, etc." status cannot be a partnership item because subtitle A does not reference it. Their interpretation effectively and improperly replaces the actual language "required... under any provision" with "required... by any provision." The word "under" is typically used to broadly describe relevance or relatedness to the overarching concept. "By," on the other hand, connotes a distinct and explicit link connecting one thing to another. 6 Accordingly, the statutory language itself provides room for partnership items that, even in the absence of an explicit subtitle A reference, are nevertheless necessary for income tax calculation purposes. Cf. Weiner v. United States, 389 F.3d 152, 155-58 (5th Cir. 2005) (finding a broad definition by relying, in part, on regulatory language).

This interpretation is supported by case law as well. 7 For example, the majority of courts faced with the question have considered the running of TEFRA's statute of limitations to be a partnership item. See, e.g., Weiner, 389 F.3d at 157 (collecting cases); Slovacek v. United States, 36 Fed. Cl. 250, 255 (Fed. Cl. 1996); see also Chimblo v. Comm'r, 177 F.3d 119, 125 (2nd Cir. 1999). This result could not be reached by what we understand to be RJT and Thompson's narrow reading of the "required to be taken into account under subtitle A" language. The statute of limitations under TEFRA is governed by subtitle F, not subtitle A. When addressing an identical argument to that presented by RJT and Thompson as it pertained to the statute of limitations, the court in Weiner observed that the absence of the statute of limitations from subtitle A does not alone defeat the conclusion that the statute of limitations is a partnership item because the partnership item definition "is broad enough to include in its parameters legal and factual determinations not specifically found in subtitle A." Weiner, 389 F.3d at 157 n.3.

RJT and Thompson have not presented a compelling reason to distinguish the partnership's status as a "sham ,etc." from our treatment of the statute of limitations. There are reasons to treat it similarly, however. Status as a "sham, etc." directly affects various components relevant for income tax reporting. It not only may render a "thumbs-up or thumbs-down" verdict on other relevant partnership item entries, see Weiner, 389 F.3d at 152 (noting how the statute of limitations affects the tax reporting process), but also, in the event of a legally incognizable partnership, it dictates whether certain income tax concepts are even applicable. The IRS notes, for example, that for individual tax reporting purposes, one cannot take into account startup investment costs for an illegitimate, legally unrecognizable partnership.

Furthermore, RJT and Thompson's interpretation runs counter to congressional intent. TEFRA was intended, in relevant part, to prevent inconsistent and inequitable income tax treatment between various partners of the same partnership resulting from conflicting determinations of partnership level items in individual partner proceedings. Randell v. United States, 64 F.3d 101, 103-04 (3rd Cir. 1995) (describing the goals of TEFRA and the problems TEFRA was intended to address); see also H.R. CONF. REP. NO. 97-760, at 599-600 (1982), reprinted in 1982 U.S.C.C.A.N. 1190, 1371-72. With that intention in mind, we can think of few examples more emblematic of a congressionally envisioned partnership item than the one before us here. The resulting tax treatment of two partners in the same partnership could vary substantially if the court in one partner's deficiency proceeding recognized the legitimate existence of the partnership and the court in the other proceeding decided to disregard the partnership as a matter of law. Accordingly, even were there some ambiguity in the act's language, we would choose the interpretation consistent with Congress's clear intention when enacting TEFRA. "Sham, etc." status, then, meets the first of TEFRA's two threshold requirements for consideration as a partnership item.


B. More appropriately determined at the partnership level


As previously stated, however, the Secretary of the Treasury must also consider a partnership item to be something more appropriately determined at the partnership level. Although RJT and Thompson do not challenge the validity of the Treasury regulation at issue, they contend that no fair reading of it allows for the conclusion that the Secretary made such an assessment with respect to "sham, etc." status. We disagree.

The Treasury regulation includes within the "partnership item" classification "the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc." 26 C.F.R. §301.6231(a)(3)-1(b) (emphasis added). Examples of such legal and factual determinations falling within the partnership item ambit include, among other things, the partnership's method of accounting, its inventory method, and even "whether partnership activities have been engaged in with the intent to make a profit for purposes of §183." Id. As an underlying legal determination with direct bearing on the items mentioned, the status of the partnership as a "sham, etc." falls squarely within this definition. The regulation does not limit its applicability to line items and technical accounting issues as RJT and Thompson suggest. Finally, just as Thompson and RJT have failed to justify treating "sham, etc." differently from our treatment of the statute of limitations with respect to the statutory language, they have also failed to present us with any reason to distinguish our treatment of "sham, etc." from the statute of limitations under the language of the regulation. In fact, RJT and Thompson even acknowledge that the statute of limitations is a valid partnership item under the regulation. Accordingly, the Tax Court correctly treated as a partnership item its determination that RJT is a "sham, etc." 8

The judgment is affirmed. 9

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