In 17th Century warfare, armies used a primitive explosive device called a petard to help breach castles and walled cities. It was basically a bell filled with gunpowder that would be shoved in a tunnel or hole facing the wall or gate to be breached. The operator, called an enginer (pronounced “engine-ur” with emphasis on first syllable) would light the fuse and scramble back. If all did not go well, however, the enginer might be blown up (hoisted) in the resulting explosion. Thus the expression. It’s an extremely common trope in fiction starting at least as far back as Hamlet, and continuing in modern times, as this lovely time-wasting website extensively details.
In tax law taxpayers build both primitive and sophisticated devices to avoid taxation. Last week’s decision in Allen R. Davison III v. Commissioner, T.C. Memo. 2019-26 (April 3, 2019)(Judge Ashford) involves a taxpayer whose tax reduction device consisted of layering partnerships. How ironic, then, that it blew up his chances for pre-payment litigation over the merits of a tax assessment. He did not learn that unhappy lesson until both the IRS and then the Tax Court refused to let him litigate the merits of his tax liability in the CDP process. Details below the fold.
This case involves the interplay of old TEFRA procedures and CDP procedures. First the facts, then the law, then the lesson.
Mr. Davison timely filed his 2005 tax return, reported a tax overpayment and received a refund. In May 2011 the IRS assessed additional taxes based on computational adjustments resulting from its audit of two flow-through entities: Cedar Valley Bird Co., LLP and TARD Properties, LLC. Mr. Davison was not a partner in either of the entities. But he was a partner in Six-D Partnership, LLC, and Six-D was a partner in both Cedar Valley and TARD.
Mr. Davison did not pay the taxes. In January 2012 the IRS sent him a CDP notice proposing to levy on all his property or rights to property to collect the unpaid liabilities.
Mr. Davison timely requested a CDP Hearing. He thought that the levy was improper because the assessments were improper. He wanted to contest the basis on which the IRS had made the computational adjustments. Judge Ashford would not let him. To see the lesson, we need a quick review of TEFRA partnership audit procedures and CDP hearing procedures.
Law: Old TEFRA
I am not an expert on partnerships. So I will here give only the very basic outline of how I understood the law to work before Congress repealed and replaced TEFRA in 2015 for tax years that start in 2018. Bipartisan Budget Act of 2015 P.L. 114-74, 129 STAT. 584. If you catch me in error, do not hesitate to comment!
(stands for Tax Equity and Fiscal Responsibility Act) created a highly regulated statutory scheme for auditing partnerships. The purpose was to better coordinate audits of partnerships and their partners. TEFRA made the partnership entity (and its partners) responsible for litigating the merits of partnership tax positions while leaving individual partners responsible for litigating the merits of their own returns. While partnerships were not taxpayers in the sense of owing income tax, they were taxpayers in the sense of determining the tax consequences of the partnership’s business transactions during the relevant tax period.
created a three-bucket concept for determining the tax consequences of partnership activities on partners.
The first bucket was labeled “partnership items.” Those were items that needed to be determined at the partnership level rather than at the partner level, and included the legal and factual issues that went into the determining items “of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year.” See former §6231(a)(3). The regulations expanded on that.
The second bucket was called, unsurprisingly, “non-partnership items.” Those were items that did not depend on the determination of partnership items. See former §6231(a)(4).
The third bucket is what Davison concerns. It contained “affected items,” which were partially determined by what happened at the partnership level but could also turn on specific facts and circumstances individual to each partner. See former §6231(a)(5).
Affected items came in two flavors: those that required further factual development at the partner level and those that did not. An example of the former might be the passive loss rules or at-risk rules or basis adjustment rules. Those rules could affect different partners differently with respect to particular gains or losses passed through by the partnership. So the resolution of those items partly depended on facts and circumstances at the partnership level and partly at the individual partner level. This idea was codified in former 6231(a)(6) (describing a “change in the tax liability of a partner which properly reflects the treatment...of a partnership item.”).
The second flavor of affected items were “computational adjustments.” These were adjustments that flowed automatically from partnership items. For example, changes to the partnership items may have changed a partner’s AGI. If so, the resulting adjustments to individual deductions or credits that related to AGI would simply be a matter of re-computation and would not require any further factual development. Those would be computational adjustments.
imposed various notice requirements on the IRS that linked to each of these buckets.
1. Partnership Items: When the IRS opened an audit, it had to give notice to the partnership’s designated Tax Matters Person (TMP), to the other partners, and to any properly identified indirect partners. When it closed an audit, it also had to give the same parties notice of the Final Partnership Administrative Adjustment (FPAA). Those parties could then petition the Tax Court for review. They were often called the "notice partners."
Many partnerships are made up of other partnerships. When a partner in a partnership was itself a second partnership, the partners of that second partnership were called “indirect partners.” If the second partnership took the proper steps to identify the indirect partners to the IRS, then the indirect partners would also become notice partners. Otherwise, former §6223(h) required those other partnership TMPs to forward the relevant notices to their partners and former §6230(f) provided that a TMP’s failure to do so would not affect the legitimacy of the partnership proceedings or results.
The key difference between the status of "notice partner" and mere "indirect partner" (or "pass-through partner") was this: any partner, including an indirect partner and a pass-through partner, had the right to participate in the administrative proceeding. See former §6224(a). But only those indirect partners who were also notice partners could petition the Tax Court if they did not like the FPAA.
In sum: if the IRS had to send you notice about the start and end of the administrative proceeding, you had full participation rights in the administrative proceeding and full rights to obtain Tax Court review, if the TMP punted. If the IRS did not have to send you notice, you could still participate in the administrative proceeding but you were dependent on other partners to tell you about it. And you were not entitled to go to Tax Court. That meant that if no one petitioned the Tax Court, then the proposed adjustment to partnership items in the FPAA were set and you were helpless to change that.
2. Affected Items: once the partnership items were set, the IRS had to decide whether an affected item required further factual development. If so, the IRS needed to open a partner-level audit that would result in the affected partners being sent an NOD. They could then obtain Tax Court review but only as to the affected items, not the partnership items. See generally Chief Counsel Notice CC-2009-011.
As to computational adjustments, however, once the partnership items were set, the IRS could immediately assess the adjustment without giving the taxpayer an NOD. Instead the IRS would send the affected taxpayer a Letter 4735, Notice of Computational Adjustment. See IRM 4.31.3 (TEFRA Examinations). Such taxpayers had no opportunity to contest the computational adjustment because there would be no reason, other than a dispute at the partnership level, to dispute the adjustment. And disputes about partnership items had to be resolved in the partnership proceedings.
In short, resolution of partnership items was central to the entire TEFRA process. It probably still is, but I don’t know for sure. If you want more details about old TEFRA, Mary McNulty, Bob Probasco, and Andlee Meyercord (all who were at Thompson and Knight at the time) wrote this really nice article you can consult.
When the IRS seeks to collect an unpaid tax liability, §6330 requires it to give the taxpayer a Collection Due Process (CDP) hearing before making the first levy. The CDP hearing allows a taxpayer to convince the IRS to accept some type of collection alternative to levy, such as an installment agreement or an Offer in Compromise.
Sometimes, the CDP hearing allows a taxpayer to dispute the underlying tax assessment. Specifically, §6330(c) permits a taxpayer to contest “the existence or amount of the underlying tax liability for any tax period” if the taxpayer did not receive an NOD “or did not otherwise have an opportunity to dispute such tax liability” before the CDP hearing.
The Tax Court reads this statutory language quite broadly to accomplish its underlying purpose. Thus, for example, when a taxpayer self-reports a liability but does not pay it, and the IRS then assesses the self-reported liability and starts collection action, the Tax Court permits the taxpayer to raise the merits of the assessment in a CDP hearing because by self-reporting the taxpayer “did not otherwise have an opportunity to dispute such tax liability.” Montgomery v. Commissioner, 122 T.C. 1 (2004). The Tax Court there pointed out (in an opinion by Judge Panuthos) that the overarching purpose of CDP was to give both taxpayers and the IRS a pre-collection opportunity to review the merits when there had been no prior opportunity. Judge Panuthos noted that taxpayer may have “erred (in the Government's favor) in preparing and filing their tax returns. Given the complexity of the Federal income tax laws, such taxpayer errors may well be common. We conclude that section 6330(c)(2)(B) is fairly read as providing a remedy to such taxpayers.” 122 T.C. at 10.
In short, CDP ensures that taxpayers get at least one pre-collection opportunity to contest the merits of the tax liability assessed against them.
Lesson: When TEFRA Meets CDP, TEFRA Wins
Today’s case illustrates what happens when the broad reading that the Tax Court gives §6330(c) bumps up against the strong policy embodied in §6221 that all partnership items be finally determined in a partnership-level proceeding. What is important to today’s lesson is that the centrality of the partnership level determination of partnership items trumps the CDP policy of ensuring that taxpayers get one pre-collection bite at the Tax Court apple.
Here, Mr. Davison’s tax liability was based, in part, on the partnership items of the two flow-through entities Cedar Valley and TARD. You might think the policy behind §6330(c) (and its plain language) would allow him to contest that linkage as “the underlying tax liability” during CDP. But partnerships do not pay taxes (at least not yet). So to the extent his “underlying tax liability” was based on a determination about partnership items, the time and place to do that was in the partnership level audits of Cedar Valley and TARD.
Mr. Davison’s problem here was that he was an indirect partner but was not a notice partner. That meant he had the opportunity to participate in the administrative proceedings. In Hudspath v. Commissioner, T.C. Memo 2005-83, the Tax Court had held that a taxpayer who had the opportunity to participate in a TEFRA partnership level proceeding could not dispute the partnership item adjustments in a later CDP proceeding.
Judge Ashford says that Davison "is indistinguishable from Hudspath." I’m less sure. Hudspath is different in that there the taxpayer was a notice partner whom the IRS sent a notice (that the taxpayer claimed was not received). Being a notice partner meant the taxpayer there could have sought Tax Court review of a FPAA.
Here, Mr. Davison was just an indirect partner and was not a notice partner. Judge Ashford explains why the IRS had no duty to give him notice. He had structured his relationship with Cedar Valley and TARD too remotely---burrowed under the blanket of the Six-D partnership---to trigger any requirement that the IRS send him a notice. And none of the other entities involved followed the proper procedure to tell the IRS that Mr. Davison was an indirect partner. Therefore, Judge Ashford points out, §6223(f) required the IRS to only send notice to Six-D, and it was totally up to Six-D’s TMP to notify Mr. Davison.
The consequence of Mr. Davison being an indirect partner but not a notice partner was that he had no prior opportunity to dispute the partnership items in Tax Court. So it’s not quite like Hudspath, methinks.
But it’s close enough! The “prior opportunity” language does not mean a prior opportunity for court review. It means only an opportunity for administrative review. The opportunity to go to Appeals is enough to trigger the statutory bar to disputing a liability in a CDP hearing. Treas. Reg. 301-6330-1(e)(3). Mr. Davison had that opportunity, even though he was dependent on Six-D’s TMP to learn about it. “Therefore,” says Judge Ashford, “we find that petitioner had a prior opportunity to challenge his liability or income tax attributable to the computational adjustments resulting from the defaulted TARD Properties FPAA (as well as the defaulted Cedar Valley FPAA) and is precluded from challenging this liability in this case.”
In this way, one might conclude that Mr. Davison was hoisted by his own devices, including his P(artnership) TARD.
Coda: The IRS also hit Mr. Davison with an individual penalty. He could have contested that liability in his CDP hearing because there was no prior opportunity. But he failed to do that. Judge Ashford easily rejected his belated attempt to do so in Tax Court, writing "it is well settled that our review of an Appeals determination under section 6330(c)(3) is limited to the issues that a taxpayer raises before Appeals." Just like with refund claims, one must be careful to get all of ones potential arguments out in the administrative process in order to preserve them for eventual court review.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University (Going For the Championship!) School of Law