Lesson From The Tax Court: Know Your TMP

In my now 22 years of teaching tax, I have assiduously avoided teaching partnership taxation.  With any luck, I’ll never have to.  Inside and outside basis still confuse the heck outta me.  But I do teach tax procedure, so I’ve been forced over the years to learn something about the rules governing audits of partnerships.

If there is one stand-out lesson I’ve learned, it’s the one Judge Buch teaches us in Trevor R. Pettennude v. Commissioner, T.C. Memo. 2022-79 (July 18, 2022): individual partners are often at the mercy of their Tax Matter Partner (TMP) when it comes to participating in partnership-level determinations.  The burden is on each partner to know their TMP, and to ensure they are in the loop on important partnership matters.  That may even more true post-TEFRA.  In today’s case, Mr. Pettennude was a tiny partner in a large coal tax credit shelter partnership.  The IRS caught on and audited the partnership.  No one told Mr. Pettennude about either the audit or its results (not happy ones) until the IRS told him he owed about $850,000 in additional taxes.  He tried to contest that in a CDP hearing.  It did not go well.  Details below the fold.

Today’s lesson involves the interplay of partnership audit procedure and the Collection Due Process (CDP) rules.  So here’s a brief review of each.

Law: Partnership Procedures, Old and New
Partnerships are pass-through entities.  Yes, they figure out their taxable income (or loss) similar to individuals.  §703.  But then they assign the resulting income (or loss) to each partner, generally in proportion to each partner’s ownership interest in the partnership.  §702.  That’s called the distributive share.  And that is what gets “passed through,” regardless of whether any actual dollars go with it.  United States v. Basye, 410 U.S. 441, 454 (1973).  The legal liability for paying tax remains on the partners and not the partnership.  §701.

The pass-through nature of partnerships creates an administrative difficulty because of the two layers of potential errors.  The partnership might mess up figuring its taxable income (or loss) or the individual partner might mess up how they include (or fail to include) their distributive share.  If the IRS audits the partnership return that will affect each and every partner, yet it is impracticable to open simultaneous audits, especially for larger partnerships.  And if the IRS just audits one partner and discovers the error was at the partnership level, it may be too late to audit the other partners.  That's not entirely fair, is it?

Congress has come up with various procedures over the years to coordinate audits of partnerships with the individual partners whose tax liabilities could be affected by the audit.  Both under the new and old regimes, partnerships of 100 or more partners are treated somewhat differently than electing partnerships of fewer than 100 qualified partners.  Since today’s case involves a really big partnership, I’ll just review those rules.

The Old Regime:  In 1982 Congress passed the Tax Equity and Fiscal Responsibility Act (TEFRA).  TEFRA made the partnership entity responsible for litigating the merits of partnership tax positions while leaving individual partners responsible for litigating the merits of their own returns and paying any additional taxes owed.  After all, it's the partners, not the partnership, that is liable for taxes.  Thus, under TEFRA, each partnership had to designate a Tax Matters Partner or Tax Matters Person (TMP) to be the official point of contact with the IRS.  When the IRS audited the partnership’s tax return, it dealt with the TMP and it was the TMP who decided whether to contest the final result of the partnership audit—as reflected in a document called the Final Partnership Administrative Adjustment (FPAA)—in Tax Court.

The focus of TEFRA was on making partnerships responsible, both before the IRS and before the Tax Court, for the accuracy of what were called “partnership level” items.  When those items were adjusted, then it was just a matter of making computational adjustments to each partner’s distributive share.  Items of the individual partner were left for resolution of the individual partner’s return.  But some partner items might be affected by partnership items and so one complexity of TEFRA involved debate and litigation over which items were appropriately resolved at the partnership level and which items should be resolved at the individual partner level.  See e.g. Allen R. Davison III v. Commissioner, T.C. Memo. 2019-26.

Under TEFRA, when the IRS opened an audit, it had to give notice both to the partnership’s TMP and, generally, to all the partners as well.  When it closed an audit, it also had to send those same folks a copy of the FPAA.  See generally former §6223.  But the IRS did not always have to give notice to every partner.  First, the IRS was not required to send notices to partners who held less than a 1% interest in a partnership when the partnership had more than 100 partners.  Second, the IRS did not have to give notice to any partner unless the IRS had timely received sufficient information for it to figure out whether the partner was even entitled to notice.  The IRS carried out its notice duties using a Passthrough Control System (PCS) database.  See IRM 4.31.3.2.1.

Partners entitled to receive notice about the start and end of the administrative proceeding had full participation rights in the administrative proceeding and full rights to obtain Tax Court review, even if the TMP refused to petition the Tax Court.  However, non-notice partners did not have all these rights.  If they somehow learned about the administrative proceeding, they were entitled to participate, but they were dependent on the TMP, or other partners, to learn about it.  And they were not entitled to petition Tax Court independently of the TMP.  See generally former §6224.  They were, however, deemed to be parties to any Tax Court proceeding and, as such, could participate if someone else properly filed a petition.  See former §6226(c).

Once the partnership level issues were resolved, either by agreement or by a Tax Court decision, the IRS made computational adjustments to each individual partners’ tax liabilities, generally using Letter 4735, Notice of Computational Adjustment.  See IRM 4.31.3.13.6.3 (Examination Report with Affected Items or Partner Level Penalties).  If such computations result in additional tax liabilities, the IRS would simply assess those.  The partner was not entitled to a Notice of Deficiency or to otherwise contest those adjustments in Tax Court.  If the partner wanted to contest the liabilities, they had to first fully pay, then seek a refund.  However, if the IRS had failed to notify a partner who was entitled to notice, that partner could elect to be bound or not be bound by the resulting audit or litigation.  See former §6223(e).

The New Regime: In 2015 Congress revised the TEFRA procedures for tax years that start in 2018.  See Bipartisan Budget Act of 2015.  The new regime not only makes partnerships responsible for partnership level items, but also consolidates the assessment and collection of all resulting underpayments at the partnership level, unless certain elections are made by qualifying partnerships.  That means even though, technically its the partners who are liable for the income taxes, Congress has effectively shifted the tax-payment burden to the partnership, putting it on the partnership to collect the appropriate contributions from each partner.  There are various opt-outs but those are beyond today's lesson.  I’ll comment on the seeming impact of the new regime on notices after the Lesson.  Meanwhile, here’s a nice summary of the changes wrought to partnership audit procedure.

Law: CDP Rules
When a taxpayer has not fully paid an assessed tax, the IRS is entitled to take enforced collection actions such as filing a Notice of Federal Tax Lien and seizing any property or rights to property belonging to the taxpayer.  See §6323, §6331.  Before it can take those actions, however, it must give taxpayers an opportunity for what is called a Collection Due Process (CDP). hearing. See §6320, §6330.

A CDP hearing is generally focused on issues regarding the actual collection of the assessed tax liability.  However, if the taxpayer “did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability,” then §6330(c)(2) permits the taxpayer to contest the underlying liability as part of the CDP hearing.

Today’s case involves how the old TEFRA rules did or did not give non-notice partners an "otherwise" opportunity.  Let’s take a look.

Facts
In 2006, a Florida LLC called Ecotec (electing to be taxed as a parternship) claimed well over $118 million in §45 tax credits related to coal production.  It then set about selling those credits to taxpayers by inviting them to become partners.  Lots did.  More than 100 for sure.  One of them was Mr. Pettennude.  He used the credits to reduce his taxes on his 2009 and 2011 returns.

The IRS is deeply suspicious about such activities.  See generally this 2017 Tax Controversy 360 blog post.  Just as with other areas where Congress targets tax benefits for good reasons—such as conservation easements and micro-captive insurance arrangements—the statutory language also creates the materials from which clever taxpayers can build tax shelter structures.  Thus there is room for disagreement over when taxpayers are using the tax benefits legitimately and when they are not.  And the courts do not always agree with the IRS.  E.g. Cross Refined Coal, LLC v. Commissioner ___ F.4th ___ (D.C. Cir. Aug. 25, 2022) (agreeing with Tax Court that taxpayer’s §45 credits were legit).

The IRS suspicion caused it to audit Ecotec’s returns.  It did so under the TEFRA procedures, eventually sending the TMP an FPAA that disallowed the credits.  The IRS did not notify Mr. Pettennude of the audit nor send him a copy of the FPAA.  Neither did the TMP.  The TMP did petition the Tax Court, however, putting in play its 2008-2011 returns.  Eventually the IRS and the TMP agreed to a stipulated decision that Ecotec was not entitled to the claimed credits.

Once that decision became final, the IRS made resulting computational adjustment to the returns of Ecotec partners.  For Mr. Pettennude that resulted in increased tax liabilities for 2009 and 2011 totaling about $850,000.

He did not pay.  The IRS started collection.  Mr. Pettennude caught the CDP Butterfly and in his CDP hearing he wanted to raise the merits of the §45 tax credits, presumably to say that Ecotec had properly claimed them.  The CDP Settlement Officer refused to let him raise that issue because, although Mr. Pettennude had not received a Notice of Deficiency regarding the liabilities, he did otherwise have an opportunity to dispute such tax liability.

Mr. Pettennude petitioned Tax Court.  He protested that he most certainly had not received an opportunity to dispute the tax liability sought to be collected.  He had not received any notice about the TEFRA audit.  He had not received the FPAA.  The IRS did not send him any notices and “he was unaware of any administrative or court proceedings” until he received a notice about the computational adjustment.  Op.at 3.  Judge Buch accepted all those claims as true.  It did not matter.

Lesson: Know Your TMP
Judge Buch found Mr. Pettennude’s protestations pretty puny.  He explains that “[t]he Commissioner’s issuing FPAAs to Ecotec’s TMP provide a prior opportunity to Mr. Pettennude.”  That is because the TEFRA procedures made the TMP Mr. Pettennude’s agent.  Thus, writes Judge Buch: “The issuance of an FPAA to the TMP constitutes adequate notice to non-notice partners. We have held that the TEFRA provisions denying direct notice to non-notice partners do not violate due process because the TMP ... acts as the agent for the other partners.” Op. at 6 (quotes and citations omitted).

Not only would that be enough in other cases, but in this case, Mr. Pettennude had a further opportunity once the TMP petitioned Tax Court.  That is because Mr. P. was deemed to be a party to the Tax Court proceedings and had full rights to intervene.  Again, it was not the duty or obligation of the government to tell Mr. P. about the litigation.  It was the duty and obligation of his agent, the TMP.  Mr. P. apparently did not know his TMP.

Comment:  The new partnership audit regime seems to put even more pressure on taxpayers to know (and monitor) their TMPs.  It no longer requires the IRS to notify each and every partner about the opening or ending of a partnership audit.  Congress re-wrote §6223 to remove all the notice requirements.  As I read the statute it replaced those with these two rules: (1) a partnership gets to designate one TMP (and allows the IRS can select “any person” as the TMP if the partnership fails to do so or selects an entity); and (2) the TMP has the “sole authority” to act for the partnership and the TMP’s actions bind the partnership and all partners.  The new notice requirements are now found in §6231 and those simply require the IRS to send all notices only “to the partnership and the partnership representative.”  Not the partners.  It does seem that a partnership with fewer than 100 partners (who are qualified partners) can elect out of these new “streamlined” procedures and into the old pre-TEFRA procedures which required the IRS to ignore the partnership and audit each partner’s individual return separately.

Coda: I really like how Lewis (“Don’t Contact Me”) Taishoff ended his blog on this case with a riff on an old movie.  He warns: “keep a close watch on your TMPs. If they look like heading for the airport and the flight to Lisbon with Letters of Transit in their hands, you know what to do.”  For those increasingly few readers who catch the reference, here's lookin' at you ... oldsters. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return every Monday (or Tuesday when Monday is a federal holiday) for another Lesson From The Tax Court.