This past week I learned a lesson about partnership tax returns from the case of Inman Partners, RCB Investments, LLC, Tax Matters Partner, v. Commissioner, T.C. Memo. 2018-114 (July 23, 2018). Partnership taxation is definitely out of my comfort zone, so I am quite grateful for the help of my colleagues on the double-super-secret-tax-profs-rule-the-world listserv that Paul Caron started back in 1995, shortly after the internet got its graphical interface. They got me straight on some terminology and sent me off reading some cool stuff. Still, readers may well spot error, and if you do, please give a correction in the comments. I am especially hesitant when I think I spot an error in a Tax Court opinion as I did here. I know full well the error could be mine.
Inman is a case where the partners, but not the partnership, had signed a Form 872 waiver for their 2000 tax year. The IRS issued a FPAA to Inman Partners. Inman petitioned the Tax Court and it’s argument was a procedural one: the FPAA was too late because it was issued more than three years after the due date of the Partnership Return. In response the IRS said “Hey, we got these here waivers!” Inman said: “those were just signed by the individual partners and were not signed by the partnership and so they cannot waive the limitation period for the FPAA against the Partnership.”
Judge Holmes held that the language in the Form 872 was strong enough to also waive the limitation on assessment for the related partnership for an earlier tax period. It might be, however, that the language worked only because of the statutory scheme then in place for partnership audits. Congress nuked that scheme in the December 2017 tax reform legislation. Does Inman give us any insights on whether the Form 872 language still works? For a quick swim through the murky waters of partnership procedure, I invite you to dive below the fold.
Partnerships and other pass-through entities present a peculiar problem for tax administration. They are separate legal entities under state law and under state law they earn income or have losses. But they are not subject to the federal income tax. Instead they pass their income or losses to their members. Tax administrators need to know both what income or losses the partnership has, and how the partnership has allocated those items to the various partners. Partnerships do that by filing a Form 1065, even though it is not a return of tax and even though---at least before 2017 and even after that for electing partnerships of a certain size---the IRS does not assess taxes directly at the partnership level.
Each Form 1065 contains a Schedule K where the partnership reports the allocations made to the partners. In addition, §6031(b) requires partnerships to attach a separate Schedule K-1 for each of its partners, detailing the amount of the partnership’s income, deductions, and credits that the partnership allocates to that specific partner. As it does with other types of information returns, the IRS puts the K-1 information into a database and matches that information with what the individual partners report on their returns.
One problem for tax administration is that members of a partnership might themselves be partnerships and so they also file the Form 1065 for their partners. And if those partners are partnerships, why then we have another round. And so it goes down the chain of ownership until the bucks stop with the ultimate owners---who may then turn out to be tax-exempt entities. But at least there is usually some ultimate non-partnership owner. Note the word "usually." According to this National Bureau of Economic Research study (helpfully sent to me by Prof. David Kamin of NYU and Prof. Reed Shuldiner of U. Penn.): “there are some circular ownership chains, and that are quantitatively important: 14.9% of income flowing to ultimate owners is associated with circular partnerships.” In other words, sometimes the bucks never stop and it’s partnerships all the way down! Oh, turtles!
A second problem is timing. Partnerships may have different taxable years than partners, although §706 tries to limit those differences. The most important rule in §706(a) is the one that requires partners to include in their own returns their distributive shares of income, gain, loss, deduction, or credits from any partnerships whose partnership tax year ended before the partner’s tax year ended. That proves an important rule in Inman.
A third problem involves coordinating the audits of partnerships and their respective partners. When the IRS audits a partnership and finds a problem, it needs to be sure that it can then propose the resulting deficiency as to the relevant partner returns within the statute of limitations on assessments in §6501. And vice versa. If the IRS audits a taxpayer and finds a problem with what came from a partnership, it needs to be sure that it still has time to fix the partnership return. To fix any partnership return it must send the partnership a document called the Final Partnership Administrative Adjustment (FPAA). Like an NOD, the FPAA is a ticket to the Tax Court. Partnerships can obtain Tax Court review of the IRS’s proposed adjustments to the partnership Form 1065. In both situations the audit problem involves making sure that the assessment limitation periods are still open for both the partners and the partnerships.
Remember that §6501(a) generally gives the IRS only three years from the due date of a return (or the actual date filed, if later) to examine a return and propose a deficiency. Section 6501(c)(4), however, permits taxpayer and the IRS to extend that time period. But §6501(a) does not apply to partnership returns, at least not before 2018. So you need to look elsewhere to find restrictions on how long the IRS had to audit partnership returns. Before 2018, you found that in §6229.
Under the old law, §6229 dealt with the audit coordination problems with the following rules:
First, §6229(d) provided that once the IRS issued a timely FPAA and the partnership filed a petition in Tax Court, the ability of the IRS to assess taxes against the partners would be extended until one year after the date on which the decision in the partnership court action became. IRC §6229(d). I cannot find that rule in the new law. The new law does creates a similar rule over in §6501(c)(12) but it just applies to assessment of employment taxes, not income taxes.
Second, §6229(b) provided that when a partnership agreed to extend the §6229(a) limitation period, that agreement could also operate to extent the §6501(a) limitation period for all the partners as well. You see that allowed the IRS to then focus on the partnership return audit and issue a timely FPAA without having to secure additional agreements from all the partners to extend the time to issue a later NOD to them. I cannot find that rule in the new law.
Third, §6229(b)(3) also said that if the IRS and individual partners signed an agreement, per §6501(c)(4), to extend the limitation period for the partners’ individual returns, that same agreement would also operate to extend the §6229(a) limitation period for the partnership, but only if the agreement “expressly provides that such agreement applies to tax attributable to partnership items.” In other words, Congress said that if an extension agreement signed by even a single partner was specific enough, it would also serve to toll the three year period to audit the related partnership return. I cannot find that rule in the new law.
It’s this third audit coordination rule that is in play in Inman.
There are three individual taxpayers involved in this case: Raymond Craig Brubaker; Todd Clendening; and Jeffrey Rupp. In 2008 they each formed single-member LLCs. They also each owned their own S Corporations. Between October and December 8, 2000, their three LLCs formed Inman Partners, then transferred the shares to the three S Corps who then liquidated the Partnership.
If you think that sounds like a lot of fuss for nothing, you are partially correct. It was a lot of fuss designed to generate a lot less than nothing: fake losses that Inman would then pass to the three partners. The entire Rube Goldberg structure was part of a tax shelter scheme of the kind that got Mr. Brubaker indicted for tax fraud (the jury acquitted him) and got some of his colleagues convicted for the same.
The IRS picked up the three partners’ tax returns for audit but needed more time to complete the audits and so asked each of the three individuals to agree to extent the §6501(a) three year limitation period to make assessments. Ultimately each of the three individuals signed various agreements to extend the period for the IRS to assess income tax against them to June 30, 2006.
However, in order to properly determine the correct tax owed by Mr. Brubaker; Mr. Clendening; and Mr. Rupp, the IRS first had to examine the Inman Partnership returns. Inman Partnership’s tax year had ended on December 8, 2000, and its return was thus due April 15, 2001 per §6072(a). The IRS, however, did not completed its work on the partnership examination until May of 2006, issuing the FPAA for Inman on May 18, 2006. That is more than three years after the due date of Inman’s Form 1065. If the FPAA was timely issued then the first coordination rule in §6229(d) would give the IRS up to a year after the Tax Court decision becomes final to assess the three individuals. If not, however, then the IRS would be SOL.
The Inman Partnership argument is simple. The Partnership never waived the limitation period. Period. So the FPAA was late and now it’s too late to make any adjustments. BWHAHAHAH (the latter sentiment was left off the briefs, I’m sure).
Against that the IRS offered the multiple Forms 872 signed by the individual partners. They had signed what was then Form 872-I. That Form no longer exists but IRM In 22.214.171.124.1 (08-28-2014) explains that the relevant language in 872-I was moved into the basic Form 872 in 2009.
So here's the question: how can those individual waivers of the §6501(a) limitation period for assessment of income taxes against the individuals work to extend the §6229(d) limitation period for adjustment of partnership returns?
The answer, it seems, lies in the language used in the forms. There were two provisions in the Forms 872-I that the IRS relied upon.
First, the three individual partners agreed that: “Without otherwise limiting the applicability of this agreement, this agreement also extends the period of limitations for assessing any tax (including additions to tax and interest) attributable to any partnership items (see section 6231(a)(3)), affected items (see section 6231(a)(5)), computational adjustments (see section 6231(a)(6)), and partnership items converted to nonpartnership items (see section 6231(b)).”
Second, they agreed that: “Income tax due on any return(s) made by or for the * * * taxpayer(s) for the period(s) ended December 31, 2000 may be assessed at any time on or before” June 30, 2006.”
You can see how the first provision triggers the third statutory audit coordination rule in §6229(b)(3) that I discuss above. It “expressly provides” that the extension applies to “tax attributable to partnership items.” Once you have that language, the statute takes care of the rest by deeming the waiver agreement as applying to “the period described in subsection (a)” which is the three year period for FPAAs.
I did not see in the opinion where the Partnership fought about this first provision. It seems the Partnership focused on attacking the second provision, and the Tax Court thought it needed to address that attack. The Partnership argued that the partnership tax returns were not covered by this second provision because the partnership tax year ended December 8, 2000 and so those tax returns were not ones made “by or for the taxpayer for the period ending December 31, 2000.” Judge Holmes rejected that argument by invoking the statutory timing rule in §706(a):
“The Forms 872-I may have extended the statute only for the individual returns with tax years that ended December 31, 2000, but sections 702(a) and 706(a) mean those individual returns had to report any income tax due to partnership items from any of their partnerships whose tax year ended in 2000 on or before December 31. The key point to understand is that the IRS forms don’t extend the statute for returns but for the assessment of income tax due on those returns. The Code required the partners to report their Inman Partners’ partnership items on their individual returns for their December 31, 2000 tax years, and the partners each consented twice to extend the statute for assessing the income tax due on those returns.”
I offer the following observations for your consideration, or amusement, as the case may be.
First, I still do not know why the Inman FPAA was timely. The first provision in the Form 872-I seems to have been sufficient because of the statutory coordination rule in §6229(b)(3). I would think that would be the end of the opinion. The fact that Judge Holmes believes it necessary to address the Inman Partnership’s argument about the second provision, however, muddies the waters for me. If the first provision is good enough, why then even consider the second provision with its “by or for” language? But if the first provision is not good enough, why isn't it? I do not see that explained in the opinion.
Second, I cannot tell from the opinion whether the first provision works without the statutory coordination rule. That is, does the language work only because it triggers the statutory coordination rule or is it good enough standing alone? That could become important because Congress has now nuked §6229(b)(3) under a new partnership audit regime that allows the IRS to actually assess something like tax liability (called an "imputed underpayment" in §6225(a)) against the Partnership (unless the Partnership is eligible to elect out and actually does elect out). I do not see where this §6229(b)(3) coordination rule still exists (although perhaps I just missed it and it’s been re-codified somewhere).
I do note that 100% of the Inman partners signed a Form 872. That would seem to me to indicate that the “partnership” had also agreed to the extension of time. But I am guessing that idea is trumped by the technical statutory scheme, which creates a Tax Matters Person (TMP) who is generally the only person who can bind the legal entity that is the partnership.
Third, if Judge Holmes’ opinion about the second provision in the Form 872 is not dicta, the rationale he uses to allow that Form, signed only by a partner, to extend the FPAA limitation period would seem to still be good, because the statutory hook he uses there---§706(a)---is unchanged. So even if the first provision in the Form 872 is no longer sufficient to allow a partner’s agreement to extend the deadline for a FPAA, this second provision should still work, even under the new law. Is that the real lesson here?
Well, I have some doubts that provision can bear the weight Judge Holmes gives it, even with the statutory help. That is, I don't see how that language allows a partner to unilaterally extend the limitation period for the IRS to audit a related partnership return. The language waives the assessment only of “income tax due on any return(s) made by or for the taxpayer(s).” But §701(a) still says that partnerships are not subject to income tax, regardless of the new concept of "imputed underpayment." The Form 1065 simply does not show an income tax due. So I don’t see how that language in From 872 even applies to audits of partnership returns, even if those returns are important to proper computation of the income tax due on the taxpayer's own return. Inman Partnership seemed to focus on the “ending December 31, 2000” part of the provision. I do not know why the Partnership did not argue about the "income tax due" language.
Bottom Line: The audit coordination problem that the IRS faces is not, I don't think, going away anytime soon. In fact, from my quick read of how Congress has changed the partnership audit procedures, it seems the problem may get worse because Congress eliminated some useful audit coordination rules, forcing the IRS to rely more on waiver provisions. The IRS is hard at work trying to make what Congress wrote workable. But one of the smartest lawyers I know who is out there practicing partnership-related tax litigation, A. Lavar Taylor, wrote me that "reading and understanding final and proposed BBA regs is comparable to reading and understanding Bleak House after it has been translated into Swahili." I suppose others might say Finnegan's Wake rather than Bleak House. Meanwhile, practitioners should be careful to watch not only the language of any Form 872, but also be careful to see how that language links up to the statutory scheme.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.