In a Son-of-BOSS appeal, the Ninth Circuit Court of Appeals rejected a taxpayer’s two procedural arguments and upheld the Tax Court’s jurisdiction to redetermine the tax shelter participant’s deficiency.
The petitioner, Michael Napoliello, entered into two pairs of offsetting long and short foreign currency option contracts held by an LLC of which he was the sole member. After exchanging his interest in the LLC for one in a partnership, Napoliello withdrew from the partnership and received publicly traded securities and $392,492 cash. He sold the securities for $358,296 and reported $60,942,026 in losses from the sale on his 2000 individual tax return. The loss was calculated by allocating his claimed outside basis in the partnership, in which he included the premiums paid for the long options but not the offsetting premiums received for the short options.
The IRS determined that the partnership was a sham that lacked economic substance, with tax avoidance as its sole purpose. As a result, the partnership and all related transactions were disregarded, increases in basis disallowed and claimed losses not allowed. In 2004 the IRS sent the partners a notice of final partnership administrative adjustment (FPAA) to that effect for tax year 2000. None of the partners contested the FPAA.
The IRS reviewed Napoliello’s tax return for 2000 and in 2006 sent him a deficiency notice of $12,072,927, resulting primarily from the recalculated basis in the securities and addition to gross income of $59.3 million. No penalties were determined because the taxpayer had disclosed his participation in the tax shelter as part of an agreement with the IRS under Announcement 2002-2.
Napoliello filed a petition for redetermination of the deficiency with the Tax Court. Napoliello argued that the deficiency notice was invalid and the Tax Court lacked jurisdiction to redetermine the deficiency since it was attributable to outside basis, which is a partnership item. He also argued that the deficiency notice was invalid because the FPAA did not provide him with fair notice of the deficiency. The Tax Court rejected both arguments and granted the IRS’ motion for summary judgment. The Tax Court also made minor adjustments to the amount of the deficiency.
Napoliello appealed to the Ninth Circuit, where he raised two jurisdictional arguments. He once again asserted that the Tax Court did not have jurisdiction to redetermine the deficiency because the notice was invalid. Napoliello claimed that only partnership items were involved and the IRS should have made a direct computational adjustment based on the FPAA rather than issuing a deficiency notice. Second, he argued that the Tax Court’s jurisdiction was limited to items that reflect FPAA adjustments of partnership items, which do not include whether the partnership was a sham.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) established partnership audit and litigation procedures to reduce the administrative burden and promote consistency among partners in a partnership. Under TEFRA, the IRS sends an FPAA to the partnership when the IRS changes the tax treatment of partnership items (any items better determined at the partnership level) on the partnership’s return. The IRS then sends a deficiency notice to a partner if nonpartnership items are affected by partnership items and require determinations at the partner level.
The Ninth Circuit held that the deficiency notice was valid since the deficiency required a partner-level determination. The court followed the Sixth Circuit’s decision in another Son-of-BOSS case, Desmet (581 F.3d 297 (6th Cir. 2009)), maintaining that factual issues about the stock sold, such as holding period and amount sold, had to be determined at the partner level.
Napoliello’s second argument centered on the notion that the FPAA could not determine that the partnership was a sham, since that determination was not a partnership item. Consequently, he argued, the Tax Court lacked jurisdiction to redetermine affected items based on the FPAA’s sham conclusion. The Ninth Circuit rejected that argument as well, agreeing with the D.C. Circuit in Petaluma FX Partners, LLC (591 F.3d 649 (D.C. Cir. 2010)) and the Eighth Circuit in RJT Investments (491 F.3d 732 (8th Cir. 2007)) that the sham determination is a partnership item. The validity of the partnership affects all partners and should be determined at the partnership level.
By Karyn Bybee Friske, CPA, Ph.D., Schaeffer Professor of Business Ethics and professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.
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