Partner-Level Defense Rule Held Valid

The Tax Court upheld the validity of temporary regulations requiring a partner to raise partner-level defenses to penalties in separate litigation after resolution of unified partnership proceedings.

Andrew Filipowski created New Millennium Trading LLC in 1999 to generate a deductible loss through the use of foreign currency options. In 2005, the IRS determined that the partnership and the transactions were shams. It denied the deductions and assessed penalties under section 6662. Filipowski raised partner-level defenses against the penalties during the partnership-level litigation, and the IRS objected to their consideration.

Treas. Reg. § 301.6221-1T, in subsections (c) and (d), states that partner-level defenses may be raised only in separate litigation for refund following payment by the partner of the tax and penalty due. The taxpayer argued that these regulations were invalid because they denied the Tax Court the authority to hear penalty cases and because they were an invalid and unreasonable interpretation of section 6221. However, the Tax Court found that Congress amended the law in 1997 to provide that a partner, in the court’s words, “may raise partner-level defenses only in a refund action filed after the close of partnership-level proceedings.” Therefore, the regulations did not deny the Tax Court any authority granted to it by Congress, the court said.

To analyze the taxpayer’s argument against the validity of the regulations, the Tax Court had to determine which standard for review to apply. Since any appeal would be to the Court of Appeals for the District of Columbia Circuit, the court applied the Chevron standard adopted by that circuit. Under Chevron, regulations are upheld unless they directly conflict with the Code or are an unreasonable interpretation of an ambiguous Code provision. Since Code §§ 6221 and 6230, taken together, are unambiguous that partner-level defenses are to be raised by refund suits and the regulation is consistent with this rule, the regulation is valid, the court said. Following the partnership litigation, the partner must pay the tax and penalty and then sue for a refund to raise partner-level defenses. The Court of Federal Claims has decided the issue similarly in two cases, Stobie Creek and Jade Trading (respectively, 101 AFTR2d 2008-1151 and 100 AFTR2d 2007-7123; see also “Tax Matters: Levels of Certainty,” JofA, July 08, page 86).

 New Millennium Trading LLC v. Commissioner, 131 TC no. 18

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.