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How Pigs Get Slaughtered:

PARTNERSHIP AUDIT PROCEEDINGS UNWIND ABUSIVE TAX SHELTERS

JENNIFER L. VILLIER, JD, WEALTHCOUSEL LEGAL EDUCATION FACULTY

VOLUME 9 NUMBER 3 / Q3 2015

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Partnership taxation is the default federal tax classi-fication for multi-member LLCs. Most LLCs are taxed as partnerships because of the flexibility and pass-through taxation available to partnerships, which is not characteristic of the corporate form. As a result of the flexibility afforded partnership tax structures, they run the risk of abuse in the form of federally pro-hibited tax shelters. A number of recent cases, includ-ing a U.S. Supreme Court case that is the focus of this article, remind us that tax shelter litigation is still very much a part of many court dockets today.1 In review-ing partnership tax filings, the Internal Revenue Ser-vice (“IRS”) may identify red flags that trigger an au-dit, such as when an abusive tax shelter arrangement or sham partnership structure is suspected.

This article (i) provides a brief overview of federal partnership tax audit proceedings under the Tax Eq-uity and Fiscal Responsibility Act of 1982 (“TEFRA”),2 (ii) discusses U.S. v. Woods, a 2013 U.S. Supreme Court case involving a federal partnership audit where an abusive tax shelter was in place, and (iii) concludes that attorneys should be aware of the characteristics of abusive tax shelters and refrain from assisting in their formation or operation.

FEDERAL PARTNERSHIP TAX AUDIT PROCEEDINGS

Although a partnership3 is not a tax-paying entity, it must file a Form 1065 information return to report its income, gains, losses, deductions, and credits. Those tax items pass through the partnership, appear on each partner’s Schedule K-1, and are reported on each partner’s individual tax return. Prior to the enactment of TEFRA, there were no unified audit proceedings for partnerships. Instead, if the IRS identified an er-ror on the partnership’s information return, then it would have to bring a separate deficiency proceed-ing against each partner, which resulted in duplica-tive, sometimes inconsistent, proceedings. Pursuant to TEFRA, many partnerships are subject to unified federal tax audit proceedings, which are designed to facilitate partnership tax audits by determining ad-justments at the partnership level rather than requir-ing the IRS to audit each individual partner. Any part-nership subject to the comprehensive unified audit proceedings is required to have a tax matters partner.

The tax matters partner must be a “general partner,” and must either be (i) designated as tax matters part-ner by the partnership or, if no designation has been made, (ii) the partner with the largest profits interest.4

The unified federal tax audit proceedings generally consist of two stages: a partnership-level proceeding followed by partner-level proceedings. A partnership-level proceeding involves the partnership as a whole and is typically held after the IRS has identified an is-sue with the partnership’s information return. In a part-nership-level proceeding, “partnership items” may be adjusted. Once the partnership-level proceeding has taken place, the IRS issues a Notice of Final Partnership Administrative Adjustment (“FPAA”), which is subject to judicial review in the Tax Court, the Court of Federal Claims, or federal district court.5 The reviewing court has jurisdiction over all partnership items, including al-location of partnership items among the partners and determination of the applicability of penalties or ad-ditional tax relating to an adjustment of a partnership item.6 Following judicial review, the IRS’s partnership item adjustments become final, and the IRS may initi-ate partner-level proceedings to make related adjust-ments to each individual partner’s tax liability.7

A “small partnership” is exempt from the unified audit rules. A partnership is considered to be a “small part-nership” if it has ten or fewer partners, each of which is an individual (other than a non-resident alien), a C corporation, or the estate of a deceased partner. Any partnership having a disregarded entity as a partner cannot be a “small partnership,” regardless of its total number of partners. A husband and wife are treated as one partner for purposes of determining whether a partnership is a “small partnership.” Although exempt from the unified audit rules, a “small partnership” can elect to be subject to them.

U.S. V. WOODS8

In a series of recent cases, the unified partnership au-dit proceedings were utilized in situations involving abusive tax shelters. Two of those cases, Tigers Eye Trading9 and Petaluma,10 were resolved based upon the U.S. Supreme Court’s holding in U.S. v. Woods, and all three have remarkably similar fact patterns.11

The taxpayers in Woods were involved in an offset-ting-option tax shelter, a structure intended to create

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large paper losses that a taxpayer could use to reduce taxable income. By giving the taxpayer an artificially high basis in a partnership interest, the tax shelter en-abled the taxpayer to claim a substantial tax loss upon disposition of the partnership interest. The taxpayers in Woods, Gary Woods (the tax matters partner) and Billy Joe McCombs, participated in the tax shelter by engaging in the following series of transactions:

They created two general partnerships, one intended to produce ordinary losses (Tesoro Drive Partners) and the other intended to produce capital losses (SA Tesoro Investment Partners).

Acting through their respective wholly owned LLCs, each purchased five 30-day currency-option spreads and contributed them to the newly formed partner-ships, along with $900,000 in cash. The option spreads consisted of a long option (entitling them to a sum of money if a currency exchange rate exceeded a certain amount on a given date) and a short option (requiring them to pay the bank a sum of money if the exchange rate for the currency on the given date exceeded a cer-tain amount). The noteworthy feature of the long and short options was that the trigger amounts for each were so close that it was likely that both options would be triggered (or not triggered) on the specified date.

Using the cash, the partnerships purchased Canadian dollars for the partnership created to produce ordi-nary losses, and Sun Microsystems stock for the part-nership created to produce capital losses.

The partnerships terminated the five option spreads and received a lump-sum payment from the bank.

Near the tax-year end, the taxpayers each transferred their partnership interests to two S corporations (one S corporation received both partners’ interests in Tes-oro Drive Partners and the other received both part-ners’ interests in SA Tesoro Investment Partners).

The partnerships, each now having a single partner (the S corporation), were liquidated by operation of law and their assets were deemed distributed to the S corporations.

The S corporations sold the assets for a gain of $2,000 on the Canadian dollars and $57,000 on the stock.

Rather than reporting the gains, the S corporations reported an ordinary loss of $13 million on the sale of the Canadian dollars and a capital loss of $32 million on the sale of the stock. The losses were allocated be-

tween the taxpayers as the S corporations’ co-owners.

The taxpayers were able to claim such enormous losses because their outside tax basis was greatly inflated.12 The taxpayers had contributed $3.2 million in option spreads and cash to acquire their partnership interests, but, because they omitted the “short” option in their basis computation on the theory that it was “too con-tingent,” their total outside basis was over $48 million. Under Code §732(b), the basis of property distributed to a partner in a liquidating distribution is equal to the adjusted basis of the partner’s interest in the partner-ship (reduced by any cash distributed with the prop-erty). Therefore, the taxpayers’ inflated outside basis figures were carried over to the S corporations’ basis in the Canadian dollars and the stock, resulting in the taxpayers’ huge losses when the assets were sold.

The partnerships’ information returns triggered an audit, after which the IRS issued each partnership an FPAA. The IRS determined that the partnerships (i) had been formed and used solely for purposes of tax avoid-ance, (ii) had no business purpose other than tax avoid-ance, (iii) lacked economic substance, and (iv) were shams.13 Furthermore, the IRS subjected the taxpayers to a 40% penalty for gross valuation misstatements as a result of inflating the tax basis of their interests in a partnership that, for tax purposes, did not exist.

Woods sought judicial review of the FPAAs. The District Court held that the partnerships were properly disre-garded as shams but that the valuation misstatement penalty did not apply. As to the latter determination, the IRS appealed. While the appeal was pending, the Fifth Circuit held in a similar case that the valuation misstate-ment penalty does not apply when the partnership is disregarded as a sham.14 The U.S. Supreme Court grant-ed certiorari to resolve a Circuit split on this issue.

Under Code §6226(f), a court in a partnership-level proceeding has jurisdiction to determine the applica-bility of a penalty that “relates to” an adjustment to a partnership item. Thus, the issue was whether the val-uation misstatement penalty “relates to” the determi-nation that the taxpayers’ partnerships were shams. In resolving the dispute, the Court examined the struc-ture of TEFRA and concluded that, while penalties must be imposed at the partner level, their applicabil-ity may be determined at the partnership level. In oth-er words, a penalty can “relate to” a partnership-item adjustment even if the penalty cannot be imposed

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without additional, partner-level determinations.15

Next, the Court considered the applicability of the valuation misstatement penalty. Generally, a 20% penalty applies to any underpayment of tax attribut-able to any substantial valuation misstatement. The penalty increases to 40%, however, when a taxpayer’s adjusted basis exceeds the correct amount by at least 400%.16 The Woods Court determined that because “the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim an out-side basis greater than zero.”17 Since the partners used an outside basis greater than zero to claim losses that caused the partners to underpay their taxes, the re-sulting underpayment is “attributable” to the inflated adjusted basis amount. Thus, the Court held that (i) the District Court had jurisdiction in the partnership-level proceeding to determine the applicability of the valuation misstatement penalty, and (ii) the penalty is applicable to tax underpayments resulting from the partners’ participation in the tax shelter.

TAKEAWAYS

While the case law made no mention of the attorneys’ roles or liability in any of the three fact patterns (other than to point out that the tax shelter in Woods was de-veloped by the “now-defunct” law firm Jenkens & Gil-christ, P.C.), it goes without saying that, as professionals, we should steer clear of any involvement with abusive tax shelters.18 Model Rule of Professional Conduct Rule 1.16 instructs that attorneys should avoid counseling clients on matters involving illegal conduct or transac-tions. Attorneys representing clients in connection with abusive tax shelters risk stiff penalties as well as expen-sive and time-consuming malpractice litigation.

When Jenkens & Gilchrist closed its doors following its role in the marketing and promotion of fraudulent tax shelters, the IRS announced, “this should be a lesson to all tax professionals that they must not aid or abet tax evasion by clients or promote potentially abusive or illegal tax shelters, or ignore their responsibilities to register or disclose tax shelters.”19 Thus, attorneys rep-resenting partnership clients should consider whether a client’s proposed or existing structure has economic substance, and counsel clients regarding the lengthy audit proceedings and potential for penalties should the IRS suspect the partnership is merely a sham

formed with the purpose of evading federal taxes.

ENDNOTES

1 See U.S. v. Woods, 134 S.Ct. 557(2013); Logan Trust & Tigers Eye Trading, LLC v. Comm’r, No. 12-1148 (D.C. Cir. 2015); Petaluma FX Partners, LLC v. Comm’r, No. 12-1364 (D.C. Cir. 2015); Basr Partner-ship v. U.S., No. 2014-5037 (Fed. Cir. 2015)

2 26 U.S.C. §§6221, et seq.

3 Note that all references in this article to a “partnership” include any LLC taxed as a partnership, and all references to a “partner” include a member of an LLC that is taxed as a partnership.

4 When preparing an LLC operating agreement in Business Docx, you will be prompted to select a tax matters member. You have the option to either name a specific member in the Operating Agree-ment, or indicate that the manager will appoint a tax matters mem-ber at a later time.

5 26 U.S.C. §6226(a)

6 Id. §6226(f)

7 Id. §§6230(a)(1)-(2), (c), 6231(a)(6)

8 134 S.Ct. 557 (2013)

9 Logan Trust & Tigers Eye Trading, LLC v. Comm’r, No. 12-1148 (D.C. Cir. 2015)

10 Petaluma FX Partners, LLC v. Comm’r, No. 12-1364 (D.C. Cir. 2015)

11 Both Tigers Eye Trading and Petaluma involved taxpayers hold-ing interests in LLCs taxed as partnerships. Each such partner-ship was created to establish a Son of BOSS tax shelter pursuant to which each taxpayer artificially inflated his basis resulting in substantial “losses” that the taxpayers were able to use to offset against income and gains on their personal tax returns. The scheme artificially reduced their taxable income, as discovered by the IRS upon audit. Both cases were held in abeyance pending the Supreme Court’s decision in Woods, as the issue in all three cases was the same: whether courts in partnership-level proceedings have ju-risdiction to determine the applicability of accuracy-related pen-alties related to the partners’ underpayment of income tax. Both cases were ultimately decided on June 26, 2015, consistent with the Woods’ holding.

12 Tax basis is generally the cost of an asset and it is used to deter-mine the owner’s gain or loss for tax purposes upon sale.

13 Id. at 562

14 See Bemont Invs., LLC v. U.S., 679 F.3d 339, 347-48 (2012)

15 Id. at 564

16 Id. at 565; Code §6662(h)

17 Woods, at 565-66

18 For another recent case involving a partnership tax shelter and describing the attorneys’ role in marketing the scheme, please see Basr Partnership v. U.S., No. 2014-5037 (Fed. Cir. 2015).

19 See I.R.S. News Release IR-2007-71 (Mar. 29, 2007); Soled, Jay A. “Tax Shelter Malpractice Cases and their Implications for Tax Compliance,” American University Law Review 58, no. 2 (December 2008).