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Ninth Circuit Reverses Tax Court: Partners Cannot Selectively Opt Out of TEFRA Proceedings. (Parker Tax Publishing December 3, 2014)

The Ninth Circuit Court of Appeals has reversed the Tax Court, holding that a partner with both direct and indirect partnership interests cannot make separate elections to opt out of TEFRA proceeding with respect to each type of interest. JT USA v. Comm'r, 2014 PTC 570 (9th Cir. 11/14/14).

In the 1970s, off-road motorcycle enthusiast John Gregory and his wife, Rita, founded a business that became very successful at selling accessories to enthusiasts of motocross and paintball. In 2000, the Gregorys decided to sell the assets of their company (JT USA, LP) to a large paintball equipment manufacturer for $32 million. Faced with the problem of having to pay tax on a very large capital gain, their solution was to use an alleged Son-of-BOSS transaction to create losses large enough to offset their gain. To effectuate the tax shelter, the Gregorys implemented a complex ownership structure in which they held both direct and indirect interests in JT USA.

The IRS challenged the transaction that produced the losses, sending a letter to the Gregorys shortly before the statute of limitations expired. The Gregorys responded by opting out of the TEFRA proceedings in their capacity as indirect partners, and opting into the proceeding in their capacity as direct partners. The Tax Court held that Code Sec. 6223(e)(3)(B) allowed the Gregorys to make separate elections as direct and indirect partners, and thus their elections to opt out as indirect partners were valid. The IRS appealed.

OBSERVATION: The Tax Equity and Fiscal Responsibility Act of 1982(TEFRA) created the unified partnership audit and litigation procedures contained in Code Secs. 6221 through 6234. TEFRA procedures streamline partnership audits by allowing the IRS to deal primarily with a tax management partner to coordinate administration and settlement. In certain situations, a partner may elect out of these proceedings and thus not be bound by the results.

The issue before the Ninth Circuit was whether the Tax Court's interpretation that Code Sec. 6223(e)(3)(B) allowed partners holding both direct and indirect interests to make separate elections with respect to each type of interest was correct.

Code Sec. 6223 details requirements for giving notice to partners of partnership administrative proceedings. Under Code Sec. 6223(e)(3)(B), if the IRS fails to provide notice to a partner and proceedings are ongoing, the partner is a party to the proceedings unless the partner elects to have the partnership items of the partner treated as nonpartnership items (i.e., the partner opts out).

The Ninth Circuit held the Tax Court erred in concluding that the Gregorys could opt out of the proceedings with respect to their indirect partnership interests, and remanded the case for the court to determine the validity of the IRS's adjustments to partnership items. The appeals court found that the Tax Court and the Gregorys had overcomplicated their interpretation of Code Sec. 6223(e)(3)(B), and that a plain-meaning interpretation was appropriate. The court noted that the statute says the partner, not an indirect partner or any other subset of the term "partner," and allows the partner to have the partnership items of that partner to be treated as nonpartnership items, not some of that partner's items to be treated as such. The use of the definitive article "the" convinced the court that the language of Code Sec. 6223(e)(3)(B) is clear and unambiguous, and means that unless a partner elects to have all of his or her partnership items treated as nonpartnership items, the partner cannot elect out of the TEFRA proceeding.

The court also looked to the legislative history of Code Sec. 6223(e)(3)(B) and its regulations to further support its interpretation of the statute. H.R. Conf. Rep. No. 97-760 (1982) states that the partner will be a party to TEFRA proceedings unless he or she elects to have all partnership items treated as nonpartnership items. Reg. Sec. 301.6223(e)-2T(c)(1) tracks the language of the conference report, stating that an opt-out election applies to all partnership items for the year. Additionally, the court observed that the Tax Court's ruling would permit duplicative proceedings and the potential for inconsistent treatment of partners in the same partnership, which would be contrary to TEFRA's goal of streamlining partnership proceedings.

For a discussion of TEFRA audit procedures, see ¶28,505. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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