The Tax Court had jurisdiction in a partnership-level proceeding to determine whether a taxpayer's purported partnership should be disregarded for tax purposes, whether the partners had any outside basis in their partnership interests, and whether the valuation misstatement penalty should apply. The partnership's alleged business purpose was to engage in foreign currency option trading on behalf of its partners; however, the taxpayer and his brother merely contributed pairs of offsetting long and short options and then, two months later, withdrew from the partnership, receiving cash and shares of corporate stock. The brothers increased their basis in their partnership interests to reflect their contributions of the long options, but did not reduce their basis to reflect the partnership's assumption of the short options they contributed. On the subsequent sale of the stock they had received from the partnership they claimed multimillion dollar losses. In its final partnership administrative adjustment (FPAA) for the year, the IRS determined that the partnership was not a partnership as a matter of fact, or if it was, that it had no business purpose other than tax avoidance and so was abusive, under Reg. §1.701-2, so that the partnership transactions should be treated as having been entered into by the partners directly, and neither the partners nor the partnership entered into the option or currency transactions with a profit motive. In challenging the FPAA, the taxpayer stipulated that he would not contest any items raised in the FPAA if the court determined that it had jurisdiction over them, except for the issue of whether valuation misstatement penalties applied. The IRS filed a motion for summary judgment on the grounds that the remaining issues raised in the FPAA all related to partnership issues.
The taxpayer argued that the determination of the partnership's status is either not a partnership item or not an "item" at all. However, the court had jurisdiction over the status question under Temporary Reg. §301.6233-1T(a), which provides that whether a partnership existed should be determined in a partnership-level proceeding. Furthermore, the determination that a partnership should be disregarded under a sham or economic substance doctrine is indeed a partnership item since the definition of "item" is not limited to items of income, deduction, credit, gain, loss or basis or similar accounting entry, and the status of a partnership directly affects the calculation of all of those types of items. Though the listing of partnership items inReg. §301.6231(a)(3)-(1)(a) does not explicitly include the applicability of sham or economic substance doctrines, it does include "the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain loss, deduction, etc."
The taxpayer argued that the determination of the partners' outside bases in their partnership interests was not a partnership item, and so was beyond the court's jurisdiction in this case. The IRS conceded that position was generally the rule, but argued that where it is determined that the partnership should be disregarded, there can be no outside basis in it. The Tax Court adopted this view, noting that
Reg. §301.6231(a)(3)-1(c)(2) and
(3) recognize that the determination of partners' outside basis can sometimes be a partnership item. Once it has been determined that a partnership, or a particular partner's participation in a partnership should be disregarded, the Court may determine that the outside basis is zero.
The Tax Court had jurisdiction to consider the imposition of penalties in this case. Even if the penalties were more directly related to affected items, and only indirectly related to partnership items, because they arose from the determination that the partnership should be disregarded, they were sufficiently related the vest the court with jurisdiction under Code Secs. 6221 and 6226(f). The taxpayer argued that the valuation misstatement penalty should not apply because the understatement was the result of the partnership's incorrect application of the law, not because of an erroneous valuation. Although there is a split among the Circuit Courts of Appeals on this issue, the court agreed with the majority of circuits in finding that the gross valuation misstatement penalty does apply in such a case, citing Reg. §1.6662-5(g), which provides that, when a taxpayer claims a basis in an item in which he has no basis, the gross valuation misstatement penalty will apply.
The taxpayer also argued that the penalty should not apply because it would not be possible to determine why the partners' outside bases were disallowed. However, while a deduction or credit is or may have been disallowed for reasons other than the fact that the basis was inflated, and the penalty not imposed, in this case all of the IRS's alternative arguments resulted in a determination that a misstatement of the bases had occurred. Finally, the taxpayer argued that his stipulations did not prohibit him from arguing, with respect to the penalty, that the partnership was not a sham. The Tax Court rejected this claim, construing the stipulation to have preserved only the right to argue that sham and lack of economic substance are not partnership items, not the right to have challenge the sham determination on factual grounds.
Petaluma FX Partners, LLC, 131 TC No. 9, Dec. 57,562
Other References:
Code Sec. 6221
CCH Reference - 2008FED ¶37,569.12
Code Sec. 6226
CCH Reference - 2008FED ¶37,709.70
Code Sec. 6231
CCH Reference - 2008FED ¶37,849.45
Code Sec. 6662
CCH Reference - 2008FED ¶39,654.45
Code Sec. 7442
CCH Reference - 2008FED ¶42,058.1535
Tax Research Consultant
CCH Reference - TRC PART: 60,060
CCH Reference -
TRC PART: 60,558
CCH Reference - TRC PENALTY: 3,110.05