Levels of Certainty

Two rulings in separate cases by the Court of Federal Claims helped clarify how penalties involving partnerships are imposed and defended against at the partnership and partner levels.

Because partnerships are flow-through entities, contested partnership items were formerly litigated at the partner level. This approach, however, led to repetitive legal proceedings and occasional conflicting decisions. Congress tried to prevent these problems by requiring partnership items to be considered and litigated in a single partnership-level proceeding (IRC § 6221). This measure, however, hasn’t dispelled all confusion, especially concerning the boundaries between a unified partnership proceeding and individual partner defenses.

In Stobie Creek Investments LLC v. U.S. , the Court of Federal Claims declined to determine the applicability of partner-level defenses to the imposition of a negligence penalty in partnership-level proceedings. In Jade Trading LLC v. U.S. , the same court denied a motion by Jade’s managing member and tax matters partner, Sentinel Advisors LLC, to reconsider the court’s earlier imposition of a negligence penalty at the partnership level. (For the underlying decision in the latter case, see 100 AFTR2d 2007-5591 and “ Tax Matters: Economic Substance Prevails Against Another Son of BOSS,” JofA, March 08, page 71.) Both cases involved foreign currency option spreads that the IRS deemed tax-avoidance shams.

In Stobie Creek , the taxpayer argued in a pretrial motion that the court could save time, effort and money by considering partner-level defenses against negligence penalties at the same time it considered partnership-level defenses. Unfortunately for the taxpayer, however, the regulations are very clear. The partnership-level proceeding may consider only partnership items and partnership defenses. Partnerlevel penalty defenses must be considered in a separate partner-level refund suit. The regulations (principally Treas. Reg. § 301.6221-1) are a reasonable implementation of the Code and are not invalidated by the taxpayer’s rational arguments, the court said.

In Jade Trading, Sentinel pointed out that the disputed amounts were partners’ outside basis in their membership interests in the LLC not reported on the partnership return. Therefore, it argued, Sentinel was not negligent and its conduct irrelevant, because it neither reported the erroneous item nor claimed tax losses deriving from it. The court acknowledged that the penalty is normally assessed at the partner level based on errors in the partnership return. But as the only partner involved in marketing and implementing the transaction that enabled the claimed tax losses, Sentinel played a major role in facilitating them, the court said. Therefore, its conduct was deemed relevant and sufficient to support a partnership-level negligence penalty. The court also pointed out that the Tax Code is silent on whose negligence may be assessed at the partnership level, not restricting responsibility to partners with inaccurate returns.

Taken together, the cases demonstrate that while partner and partnership items are generally considered separately, penalties can be imposed upon a partnership for erroneous items reflected only on partners’ returns.

Stobie Creek Investments LLC v. U.S., 101 AFTR2d 2008-1151

Jade Trading LLC v. U.S., 101 AFTR2d 2008-1411

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.