In a third appeal of partnership proceedings in Petaluma FX Partners, the D.C. Circuit reversed the Tax Court's holding that it lacked jurisdiction to apply accuracy-related penalties to the partners of a partnership involved in a tax shelter and remanded the case.
Facts: In the original Tax Court case (Petaluma I, 131 T.C. 84 (2008)), the partners in the Petaluma partnership set up what the IRS claimed was a sham partnership in a son-of-boss scheme to create artificially inflated basis in their partnership interests. The eventual sales of the partnership interests resulted in capital losses that the IRS disallowed in a final partnership administrative adjustment. The IRS also imposed accuracy-related penalties under Sec. 6662 on the partners. The Tax Court upheld the IRS's determinations, including that accuracy-related penalties would apply to the partners.
The plaintiffs appealed to the D.C. Circuit (Petaluma II, 591 F.3d 649 (D.C. Cir. 2010)), which upheld the Tax Court's jurisdiction to hold the partnership a sham but remanded the case on the issues of jurisdiction in a partnership-level TEFRA proceeding to determine the outside basis of the partners and applicability of accuracy-related penalties. On remand, the Tax Court determined that it lacked jurisdiction to apply accuracy-related penalties (Petaluma III, 135 T.C. 581 (2010)). The IRS then appealed this decision. Due to the Tax Court's contrary opinion on this issue in another case, Tigers Eye Trading, 138 T.C. 67 (2012), the D.C. Circuit again remanded the case to the Tax Court to determine whether its Tigers Eye decision affected Petaluma. The Tax Court again determined in Petaluma that it lacked jurisdiction to determine the partners' accuracy-related penalties (Petaluma IV, T.C. Memo. 2012-142).
The IRS appealed to the D.C. Circuit again. The Tigers Eye case was also appealed to the same court. The D.C. Circuit waited to determine the cases until the Woods case (134 S. Ct. 557 (2013)) was determined by the Supreme Court. The Supreme Court held in that case that courts do not have jurisdiction in partnership-level proceedings to determine an individual partner's outside basis but can determine the applicability of accuracy-related penalties.
Back before the D.C. Circuit, the plaintiffs in Petaluma continued to argue that the courts lacked jurisdiction to determine applicability of the penalties. They also challenged the validity of Temp. Regs. Sec. 301.6233-1T, which authorized judicial determinations with respect to items of an entity in a partnership-level proceeding that would be partnership items if the entity had been a partnership (i.e., was a sham partnership). The taxpayers claimed the temporary regulations' promulgation by the IRS did not conform to Administrative Procedure Act (APA) requirements of notice and comment. Temp. Regs. Sec. 301.6233-1T was finalized as Regs. Sec. 301.6233-1 in October 2001.
Holding: Following Woods, the D.C. Circuit held that the Tax Court had jurisdiction to determine accuracy-related penalties against Petaluma's partners. The court concluded that the plaintiffs' APA argument with respect to the regulation was moot because the regulation had been issued in final form. The court explained that the final regulation controls for all tax years; and for tax years beginning before Oct. 4, 2001, the final regulation effectively incorporates the rules set forth in the no-longer-operative temporary regulation. Any procedural deficiencies in the temporary regulations therefore were no longer of any consequence. In addition, the court determined that since the Supreme Court in Woods relied only on Sec. 6226 for its holding, it was not clear a regulation conferring jurisdiction was required.
- Petaluma FX Partners, LLC, No. 12-1364 (D.C. Cir. 6/26/15)
—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 Business, both of the College of Business, West Texas A&M University, Canyon, Texas.