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Wednesday, June 20, 2012
In a unified partnership proceeding involving a Son-of-BOSS transaction, the Court of Appeals for the Federal Circuit has held that the Court of Federal Claims wrongfully concluded that:
... it lacked jurisdiction to determine the identities of the partners at the partnership level; and
... the taxpayers' concessions on capital gain and loss adjustments prevented IRS from seeking to impose gross valuation misstatement penalties.
A “Son-of-BOSS” tax shelter employs a series of transactions to create artificial financial losses that are used to offset real financial gains, thereby reducing tax liability. Notice 2000-44, 2000-2 CB 355, identified Son of BOSS tax shelters as abusive transactions.
In light of the penalty holding, the Federal Circuit dismissed, as premature, the taxpayers' appeal of the Court of Federal Claim's imposition of other accuracy-related penalties.
Alpha, L.P. v. U.S. (CA FC 06/15/2012) 109 AFTR 2d ¶ 2012-888
Background. To remove the substantial administrative burden occasioned by duplicative audits and litigation, and to provide consistent treatment of partnership tax items among partners in the same partnership, Congress enacted the unified partnership audit and litigation procedures as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA, P.L. 97-248).
Under the TEFRA partnership procedures, before assessing the tax liability of the partners, IRS determines the tax treatment of partnership items in a partnership-level proceeding. (Code Sec. 6221, Code Sec. 6225)
During the ninety-day period after the mailing of the Notice of Final Partnership Administrative Adjustment (FPAA), the tax matters partner (TMP) may file a petition for judicial review. (Code Sec. 6226(a)) If the TMP does not file a petition within that ninety-day period, any notice partner or any five percent group (Code Sec. 6231(a)(11)) may, within sixty days after the close of the TMP's ninety-day period, file a petition for judicial review. (Code Sec. 6226(b))
A partnership item is any item required to be taken into account for the entity's tax year under the Code's income tax provisions to the extent IRS regs provide that the item is more appropriately determined at the partnership level than at the partner level. (Code Sec. 6231(a)(3)) Reg. § 301.6231(a)(3)-1 provides a list of such items.
A nonpartnership item is an item that is (or is treated as) not a partnership item. (Code Sec. 6231(a)(4))
An affected item is any item to the extent the item is affected by a partnership item. (Code Sec. 6231(a)(5)) Although affected items by definition aren't partnership items and thus aren't determined in the partnership-level proceeding, they depend on partnership-level determinations.
To file a readjustment petition with the Court of Federal Claims, the filing partner must deposit with IRS the amount by which the filing partner's tax liability would increase if the partnership items on his return were treated in a manner consistent with the treatment of partnership items on the partnership return, as adjusted by the FPAA. (Code Sec. 6226(e)(1) )
Code Sec. 6226(f) provides that, regardless of whether IRS raised adjustments in the FPAA, the Answer, or in any other manner, the court has jurisdiction to determine: all partnership items of the partnership for the partnership tax year to which the FPAA relates; the proper allocation of the partnership items among the partners; and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item.
Facts. This case arises from two Son-of-BOSS transactions, as well as a transaction involving charitable remainder unitrusts (CRUTs), conducted by the heirs of the late Marvin Sands, founder of Constellation Brands, Inc. The heirs owned stock in Constellation.
In the first Son-of-BOSS transaction, the heirs used several partnerships to convert approximately $66 million in taxable gain that they anticipated receiving from the sale of their stock into large capital losses. They also prearranged for their partnership interests to be held temporarily by tax-exempt CRUTs at the time of the sale so that any gain that might be recognized from the sale would escape taxation. The CRUTs were terminated shortly after they were formed, and the assets of the CRUTs, including the sale proceeds, were distributed to the heirs, purportedly tax free. In the second Son-of-BOSS transaction, the heirs sought to generate significant capital losses to offset other income, again through the use of various partnerships.
In FPAAs issued to the partnerships involved in the Son-of-BOSS transactions, IRS determined that the transactions should be disregarded and that the transfers of the partnership interests to the CRUTs were shams. It also asserted various basis and capital gain and loss adjustments, as well as several alternative penalties, including a 40% gross valuation misstatement penalty. IRS also contended that the transactions did not increase the partners' amounts at risk under Code Sec. 465.
The partnerships initially challenged IRS's adjustments to the basis, capital gain, and capital loss calculations. In an amended complaint, however, they conceded the capital gain and loss adjustments on the purported basis of Code Sec. 465. The Court of Federal Claims later agreed with the partnerships that, because the adjustments had been conceded on the basis of Code Sec. 465, the 40% gross valuation misstatement penalty was inapplicable. It also held that the identity of a partnership's partners is a non-partnership item that cannot be addressed in a partnership proceeding, As a result, it held that it could not consider whether the transfers of the partnership interests to the CRUTs were shams. It did, however, impose 20% penalties for substantial underpayment of tax and negligence.
Court had jurisdiction. The Federal Circuit held that the Court of Federal Claims erred when it dismissed IRS's determination that the transfers of the partners' interests to the CRUTs were shams. In determining whether the transfers were shams, the Court of Federal Claims was asked to determine the identity of the true partners. It erred in finding that it lacked jurisdiction to determine partner identity because it incorrectly found that the determination of the identity of the partners would not affect the allocation of the partnership items among them. The Federal Circuit determined that, on the facts of this case, partner identity could, in fact, affect allocation of the partnership items. As such, under Code Sec. 6226(f), partner identity could properly be resolved at the partnership level in this proceeding.
The Federal Circuit observed that it is possible that the distributive shares reported to the partners would change if one or more of the CRUTs were disregarded. If the court were to disregard one, two, or three of the CRUTs, for example, the distributive shares would be different than if the court were to disregard all of the CRUTs. In such a scenario, the court would be required to decide who should report the disregarded CRUT's share. Thus, while the validity of the CRUTs would not impact the partnership's aggregate income, it could affect the remaining parties' individual shares of that income.
Gross valuation misstatement penalty. The Federal Circuit said that the Court of Federal Claims erred in granting the taxpayers summary judgment when IRS sought to impose the 40% gross valuation misstatement penalty. The Federal Circuit said that the Court of Federal Claims was wrong to conclude that it was not obligated to determine whether the taxpayers' underpayments were attributable to a valuation misstatement merely because the taxpayers conceded the gain and loss adjustments in the FPAAs.
The Federal Circuit observed that Code Sec. 6662(b)(3) requires that any underpayment of tax on which a valuation misstatement penalty is based be “attributable to” the valuation misstatement. On remand, the Court of Federal Claims must determine whether the taxpayers' underpayments were attributable to a valuation misstatement. That determination is a fact-driven one, focusing on the role that any valuation misstatements played in attaining any improper tax benefits.
Appeal of other penalties premature. The taxpayers appealed the Court of Federal Claims's grant of summary judgment to IRS on the 20% penalty for negligence, substantial understatement, and failure to act reasonably and in good faith. The Federal Circuit concluded that the appeal is premature. If the Court of Federal Claims concludes on remand that the 40% gross valuation misstatement penalty applies, the taxpayers' cross appeal of the 20% penalty potentially will be moot. Even if it were to find that both penalties apply, it would be permitted to impose only the highest of those because the gross valuation misstatement penalty and accuracy-related penalty may not be stacked under Reg. § 1.6662-2(c).
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