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Reliance on Tax Attorney's Oral Advice Negates Penalty on Tax Understatement.
(Parker Tax Publishing September 18, 2014)

While a partnership's basis in notes contributed by two partners was really zero because the partners' bases were zero, the partnership and its partners were not liable for an accuracy related penalty imposed by the IRS because they relied on the oral advice of their tax attorney in the preparation of the tax returns. VisionMonitor Software, LLC v Comm'r, T.C. Memo. 2014-182 (9/3/14).

Torgeir Mantor and his partner, Alan Smith, started VisionMonitor Software, LLC in 2002. Vision Monitor lost money for the first several years and in order to keep the company afloat, a corporate third partner, AMC, offered to contribute nearly a million dollars if Torgeri and Alan also contributed additional capital. Lacking the liquidity to contribute cash, Torgeri and Alan consulted their longtime attorney, Rick Sympson, to discuss the tax implications of contributing promissory notes to the partnership. Rick performed some cursory research and orally advised Torgeri and Alan that the notes were appropriate capital contributions and would create partnership basis. Although Rick did not issue a written legal opinion and did not review any company documents, Torgeri and Alan agreed to contribute promissory notes to VisionMonitor in 2007 and 2008.

Torgeri and Alan contributed notes for $50,000 and $95,000 in 2007 and notes for $25,000 and $43,000 in 2008. Satisfied with these contributions, AMC provided VisionMonitor an additional $900,000 in exchange for $450,000 in equity and $450,000 in convertible debt. There were numerous inconsistencies and errors in the execution of the notes and all four notes were unsecured and Torgeri and Alan assumed no partnership debt in any of the notes. Additionally, Torgeri and Alan could not make interest payments and instead had VisionMonitor report unpaid accrued interest on the unpaid promissory notes. The IRS audited VisionMonitor's returns for 2007 and 2008 and assessed additional taxes based on the fact that the promissory notes did not provide additional basis against which Torgeri and Alan could deduct partnership losses.

Under Code Sec. 723, the basis of property contributed to a partnership by a partner is the partner's adjusted basis in that property at the time of the contribution, increased by any gain recognized. With respect to personal promissory notes contributed by a partner, under Reg. Sec. 1.704-1(b)(2)(iv)(d)(2), the contribution of the note does not by itself increase a partner's outside basis as he has zero basis in the note; instead, outside basis will only increase when there is a taxable disposition of the note by the partnership or when the partner makes payments on the note. The Tax Court has long held that the contribution of a partner's own note to his partnership is not the equivalent of a cash contribution and will not increase basis in a partnership interest.

Under Code Sec. 6662, a 20 percent penalty is applied to any substantial understatement of tax, and there is a substantial understatement of tax if the amount of the understatement exceeds 10 percent of the tax required to be reported, or $5,000. Under Code Sec. 6664(c), a taxpayer can avoid an assessed penalty if there was a reasonable cause for the underpayment and the taxpayer acted in good faith. Where a taxpayer relies on professional advice, three factors can negate the penalty for understatement: (1) the adviser was a competent professional with sufficient expertise, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment.

The primary issue before the court was whether or not Torgeri and Alan had basis in their contributed notes and subsequently whether VisionMonitor had basis in the notes. VisionMonitor argued that the contribution of the promissory notes increased Torgeri's and Alan's outside basis in amounts equivalent to the notes' face value, which would let them claim greater passthrough losses from those years on their individual returns.

The IRS argued that the partnership's basis in the notes was zero because Torgeri and Alan's basis in the notes were each zero. The IRS additionally assessed a partnership level penalty under Code Secs. 6221 and 6662, claiming a 20-percent accuracy-related penalty was applicable as VisionMonitor's position that the contributed notes had basis was negligent and an intentional disregard of the rules and regulations. VisionMonitor argued that as it relied on professional advice, the penalty was not applicable and cited the Tax Court's decision in Gefen v. Comm'r, 87 T.C. 1471 (1986), for the proposition that it had basis in the partners' notes.

The Tax Court agreed with the IRS and held that Torgeri and Alan's basis in the promissory notes contributed in 2007 and 2008 was zero and, accordingly, VisionMonitor's basis in the notes was also zero. In reaching this decision, the court relied on a line of prior cases in which they held there was no basis in a partner's own promissory notes. Specifically, the court cited its decisions in Dakotah Hills Offices Ltd. P'ship v. Comm'r, T.C. Memo. 1998-134, Gemini Twin Fund III v. Comm'r, T.C. Memo. 1991-315, and Oden v. Comm'r, T.C. Memo. 1981-184. In those cases the Tax Court held that without any payments on a promissory note, a partner's outside basis is not increased, and as such, the partnership's basis is not increased, by the contribution of a note by a partner.

The court noted that the case VisionMonitor relied on was significantly different than the current situation. In Gefen, a partner executed a limited guaranty as a condition of her acquisition of an interest in a limited partnership. Under its terms, she assumed personal liability to the partnership's existing creditor for her pro rata share of the partnership's recourse debt to that creditor. She also agreed that the partnership could call on her to contribute to the partnership an amount equal to the partnership's outstanding debt. The Tax Court held that she was entitled to increase her basis in the limited partnership by the specific amount of the partnership's recourse debt that she personally assumed under the terms of the guaranty. In the instant case, the court noted, Torgeri and Alan assumed no debt and were unable to even pay accrued interest on the notes, let alone the principal. The court remarked that the notes were only a contractual obligation to the partnership, and as such there was no basis in the notes.

The court next turned to the applicability of the penalty for substantial understatement of tax. The court noted that while a determination of tax underpayment cannot happen at the partnership level (as only partners pay tax, not partnerships), it could determine the applicability of the penalty because penalties relating to the adjustment of a partnership item must be litigated at the partnership level., Because the determination of basis in a contributed note is a partnership item, the court found that the substantial-underpayment penalty was applicable. VisionMonitor's only defense was that they had relied on Rick Sympson's advice. The court found that all three factors for reliance on professional advice were met Rick was experienced and competent, Torgeri and Alan provided necessary information, and they actually relied on Rick's advice in good faith and as such no accuracy related penalty was applicable. The court thus held that while Torgeri and Alan had no basis in their promissory notes, which resulted in a substantial understatement of tax, they reasonably relied on professional advice and no penalty applied.

For a discussion of the reliance on professional advice to avoid the assessment of an accuracy-related penalty, see Parker Tax ¶262,127. (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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