The Court of Federal Claims denied a taxpayer’s claim that the terms of his partner’s closing agreements with the government allowed him to use previously disallowed passive losses to offset nonpassive income.
Lyman Bush was a limited partner in two partnerships, Lone Wolf McQuade and Cinema 84, which were among several created and marketed by Robert M.and A. Frederick Greenberg to acquire and exploit certain cinematic film rights. (See also Greenberg Brothers Partnership No. 12 et al. v. Commissioner, TC Memo 1998-198, and earlier proceedings in the instant case, 100 AFTR2d 2007-5655. The instant case and another ( Shelton v. U.S., 102 AFTR2d 2008-6287) were selected for representative resolution of lawsuits brought by approximately 30 partners.)
The IRS disallowed certain deductions of the partnerships for tax years 1983 through 1989. In 1999, the disputes were settled, and Form 906 closing agreements were signed. The agreements established Bush’s capital contribution, his amount at risk and the amount available to offset partnership losses under section 465 at-risk rules. Later that year, Bush filed for refunds for some tax years by using the allowed amount of suspended passive losses to offset nonpassive income. The IRS rejected these deductions, and both sides sued for summary judgment.
Both sides agreed that absent a closing agreement, the losses in dispute would be limited by the section 469 passive loss rules. The taxpayer argued that the closing agreement, which stated, “suspended losses may be used to offset the taxpayer’s pro rata share of any income earned by the partnership and/or other income in accordance with the operation of IRC § 465,” permitted the losses to be deducted without imposing the section 469 limits.
Normally, the ability of a partner who does not materially participate in the partnership’s trade or business activity is limited in deducting partnership losses to (1) the partner’s outside basis (section 704(d)), (2) the partner’s at-risk basis (section 465) and (3) the passive income the partner reports that tax year under section 469. These limits are applied sequentially. Unused losses are carried forward and are deductible in future years as provided in the appropriate section. The taxpayer’s basic argument was that the closing agreement, by stating the section 465 losses were deductible against other income, changed the general rules by nullifying section 469 for these losses.
Closing agreements are binding on both parties and cannot be modified or set aside except in cases of fraud, malfeasance or misrepresentation of material fact. In other words, taxpayers are bound by closing agreements as they would be by any signed contract unless they can prove the agreement should not be enforced under a rule similar to the Danielson rule (19 AFTR2d 1356 (3rd Cir. 1967)) that applies to general contacts. However, a closing agreement is binding only as to the matters agreed upon.
The Court of Federal Claims reviewed prior cases in which the taxpayer and the government disagreed as to the scope of the closing agreement. From these cases, the court concluded that closing agreements do not apply to tax rules not mentioned in the agreement. If the parties want a section or rule to not apply, the closing agreement must explicitly state so. The closing agreement at issue clarified and limited section 465. It did not mention section 469. Since section 469 is applied after section 465, the closing agreement did not affect the application of the passive loss rules. Thus, the taxpayer was not entitled to the loss deductions claimed.
Closing agreements will be enforced as written. All affected provisions must be explicitly mentioned. Any rule omitted from the agreement will be applied as it normally is without regard to the signed agreement. Failure to specifically address an issue or item in the agreement will be interpreted as a decision by the taxpayer and the government to tax the issue or item under all relevant code provisions.
On Oct. 28, the plaintiff gave notice of appeal to the Federal Circuit.
n Lyman F. Bush v. U.S., 102 AFTR2d 2008-6300
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.