Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caDC-08-01356/USCOURTS-caDC-08-01356-0/pdf.json

Parties Involved:
AJF-1, LLC
Amicus Curiae for Appellant
Commissioner of Internal Revenue Service
Appellee
Petaluma FX Partners, LLC
Appellant
Ronald Scott Vanderbeek
Appellant

Document Text:

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 24, 2009 Decided January 12, 2010

No. 08-1356

PETALUMA FX PARTNERS, LLC AND RONALD SCOTT

VANDERBEEK, A PARTNER OTHER THAN THE TAX MATTERS

PARTNER,

APPELLANTS

v.

COMMISSIONER OF INTERNAL REVENUE SERVICE,

APPELLEE

Appeal from the United States Tax Court

Edward M. Robbins Jr. argued the cause and filed the briefs

for appellants. 

Sheldon M. Kay, Thomas A. Cullinan, and Julie P. Bowling

were on the brief for amicus curiae AJF-1, LLC in support of

appellants.

Joan I. Oppenheimer, Attorney, U.S. Department of Justice,

argued the cause for appellee. With her on the brief were

Gilbert S. Rothenberg, Acting Deputy Assistant Attorney

General, and Richard Farber, Supervisory Attorney. Judith A.

Hagley, Attorney, entered an appearance.

USCA Case #08-1356 Document #1225087 Filed: 01/12/2010 Page 1 of 14
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Before: SENTELLE, Chief Judge, and GRIFFITH and

KAVANAUGH, Circuit Judges.

Opinion for the Court filed by Chief Judge SENTELLE.

SENTELLE, Chief Judge: Petaluma FX Partners, LLC

appeals from the Tax Court’s decision that it had jurisdiction

over several partnership-level determinations and that valuation

misstatement penalties applied. Specifically, the Tax Court held

that it had jurisdiction to determine that Petaluma was a sham,

lacked economic substance, and should be disregarded for tax

purposes; that Petaluma’s partners had no outside basis in the

disregarded partnership; and that the gross valuation

misstatement penalty applied. Petaluma FX Partners, LLC v.

Comm’r, 131 T.C. 9, 2008 WL 4682543 (U.S. Tax Ct. Oct. 23,

2008). For the reasons explained below, we affirm the Tax

Court’s holding that it had jurisdiction to determine that

Petaluma was a sham and should be disregarded for tax

purposes, but reverse its holding that it had jurisdiction to

determine that Petaluma’s partners had no outside basis in the

partnership. In addition, we set aside the Tax Court’s holding

that it had jurisdiction to determine whether accuracy-related

penalties applied and that the valuation misstatement penalties

did apply in this case.

I. Background

A. Factual Background

This case involves a “Son of BOSS” tax shelter. Like many

of its kin, this tax shelter employs a series of transactions to

create artificial financial losses that are used to offset real

financial gains, thereby reducing tax liability. In 2000, the

Internal Revenue Service (“IRS”) identified Son of BOSS tax

shelters as abusive transactions. I.R.S. Notice 2000-44, 2000-2

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1

 The stock is not further identified in the parties’ submissions.

C.B. 255; see also Desmet v. Comm’r, 581 F.3d 297, 299 (6th

Cir. 2009). The facts of this case illustrate how this shelter

works. We rely primarily on the Tax Court’s description of the

facts, which is undisputed. Petaluma, 2008 WL 4682543, at

*1–3. Petaluma, a purported partnership, was formed on August

18, 2000. Its ostensible purpose was to engage in foreign

currency option trading. On October 10, 2000, Ronald Thomas

Vanderbeek and Ronald Scott Vanderbeek (collectively, “the

Vanderbeeks”) each contributed pairs of offsetting long and

short foreign currency options to become partners of Petaluma.

The Vanderbeeks increased their adjusted bases in Petaluma to

reflect the long options they contributed, but did not reduce

those bases to reflect Petaluma’s assumption of their short

options. On December 12, 2000, the Vanderbeeks withdrew

from Petaluma, which fully liquidated their interests in the

partnership by distributing cash and shares of Scient stock1

 to

them. In keeping with 26 U.S.C. § 732(b), they took adjusted

bases in the distributed stock equivalent to their adjusted bases

in Petaluma immediately prior to the distribution. On December

26, 2000, the Vanderbeeks sold their Scient stock. Given their

inflated adjusted bases in the stock, these sales created

substantial short-term capital losses that the Vanderbeeks

subsequently claimed on their 2000 federal income tax returns.

For example, Ronald Thomas Vanderbeek sold his Scient stock

for $122,528 and claimed a short-term capital loss of

$17,776,360, which conveniently offset $14,472,420 in longterm capital gains. Likewise, Ronald Scott Vanderbeek sold his

Scient stock for $39,410 and claimed a resulting short-term

capital loss of $7,631,542, thereby offsetting long-term capital

gains of $6,191,778. 

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B. Statutory Background

Although partnerships do not pay federal income taxes, they

must file annual informational returns reporting income, loss,

deductions, and credits. 26 U.S.C. §§ 701, 6031(a); Treas. Reg.

§ 301.6231(a)(3)-1(a)(1)(i). The partners are then responsible

for reporting their distributive shares of the partnership’s income

or loss on their individual federal income tax returns. 26 U.S.C.

§§ 701–702, 704. Congress established the current framework

for adjudicating partnership-related tax matters in the Tax

Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), Pub.

L. No. 97-248, § 402, 96 Stat. 324, 648-67 (codified as amended

at 26 U.S.C. §§ 6221–6232). Prior to TEFRA, all partnership

items were determined at the individual taxpayer level, which

often required duplicative proceedings for different partners and

sometimes resulted in inconsistent treatment of partnership

items from partner to partner. Under TEFRA, partnership items

are now determined in unified partnership-level audit and

judicial proceedings. 26 U.S.C. § 6221. When the IRS

disagrees with how a partnership return reports partnership

items, it may commence an administrative proceeding by issuing

a notice of final partnership administrative adjustment

(“FPAA”) to the partners. § 6223(a), (d). Once an FPAA is

mailed, the partnership’s tax matters partner has 90 days to file

a petition for readjustment of partnership items. § 6226(a). If

the tax matters partner does not file within that period, any other

partner who received the FPAA has an additional 60 days to file

a petition. § 6226(b)(1). Once a petition has been filed, the

reviewing court has jurisdiction to determine all partnership

items for the partnership taxable year addressed by the FPAA.

§ 6226(f).

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C. The FPAA and the Tax Court’s Decision

On April 2, 2001, Petaluma filed a Form 1065 partnership

return for its 2000 taxable year. The Commissioner issued an

FPAA to the Petaluma partners on July 28, 2005. The FPAA

disallowed all partnership items reported on Petaluma’s return,

reducing them from the amount Petaluma originally claimed to

zero. The FPAA also listed “Outside Partnership Basis,” which

was not originally reported on Petaluma’s partnership return,

and reduced its value from $24,943,505 to $0. In addition, it

included a section titled “EXHIBIT A - Explanation of Items,”

which determined that Petaluma’s existence as a partnership had

not been established, that it was formed solely for tax avoidance,

that it was a sham and lacked economic substance, and that it

should therefore be disregarded for tax purposes. The

Explanation also determined that Petaluma’s partners “have not

established adjusted bases in their respective partnership

interests in an amount greater than zero.” Finally, the

Explanation determined that various accuracy-related penalties

set forth in 26 U.S.C. § 6662(a) applied to all underpayments of

tax attributable to these adjustments. On December 30, 2005,

Ronald Scott Vanderbeek, a Petaluma partner who was not the

tax matters partner, filed a petition for readjustment with the Tax

Court.

In the Tax Court, Petaluma and the Commissioner entered

a settlement of stipulated issues in which Petaluma conceded

that the reduction of the line items in its partnership return to

zero was appropriate. Petaluma retained just two

arguments—first, that the Tax Court lacked jurisdiction to

consider certain issues in the FPAA, and second, that the

valuation misstatement penalties did not apply. Both parties

moved for summary judgment, and the Tax Court granted

summary judgment for the Commissioner on October 23, 2008.

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In its opinion, the Tax Court first held that it had

jurisdiction to determine whether Petaluma should be

disregarded for tax purposes. It reasoned that “the determination

whether Petaluma is a sham, lacks economic substance, or

otherwise should be disregarded for tax purposes is a partnership

item over which we have jurisdiction.” Petaluma, 2008 WL

4682543, at *9. Second, it held that because Petaluma had been

disregarded for tax purposes, the court had jurisdiction to

determine that the partners’ outside bases in the partnership

were zero because “there can be no adjusted basis in a

disregarded partnership.” Id. at *10. Third, the court held that

it had jurisdiction over the accuracy-related penalties because

§ 6226(f) gave it jurisdiction to determine “the applicability of

any penalty, addition to tax, or additional amount which relates

to an adjustment to a partnership item.” Id. at *11–12 (quoting

26 U.S.C. § 6226(f)). Fourth, the court held that “the gross

valuation [misstatement] penalty applies when the adjusted basis

of property is reduced to zero because a transaction was

disregarded as a sham or lacking economic substance and the

taxpayer claims an adjusted basis in the property of a greater

amount.” Id. at *14. Petaluma timely appealed.

II. Analysis

A. Jurisdiction and Standard of Review

Petaluma filed a petition for readjustment of partnership

items with the Tax Court under 26 U.S.C. § 6226. The Tax

Court’s decisions concerning such petitions are generally

reviewed by the U.S. Court of Appeals for the circuit in which

the partnership’s principal place of business is located.

§ 7482(b)(1)(E). When a partnership has no principal place of

business, as is the case here, the Tax Court’s decision “may be

reviewed by the Court of Appeals for the District of Columbia.”

§ 7482(b)(1). We review the Tax Court’s decisions “in the same

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manner and to the same extent as decisions of the district courts

in civil actions tried without a jury.” § 7482(a)(1). Since the

facts of this case are undisputed, we review the questions of law

it presents de novo. Andantech L.L.C. v. Comm’r, 331 F.3d 972,

976 (D.C. Cir. 2003).

B. Disregarding the Partnership

Petaluma contends that the Tax Court erred in holding that

it had jurisdiction to determine that the partnership was a sham,

lacked economic substance, and should be disregarded for tax

purposes. Under TEFRA, a court considering a petition for

readjustment has “jurisdiction to determine all partnership items

of the partnership for the partnership taxable year to which the

notice of final partnership administrative adjustment relates, the

proper allocation of such items among the partners, and the

applicability of any penalty, addition to tax, or additional

amount which relates to an adjustment to a partnership item.”

26 U.S.C. § 6226(f). Petaluma argues that the Tax Court had no

jurisdiction to determine that it was a sham and lacked economic

purpose because that determination was not a “partnership item”

within the meaning of § 6226(f). We disagree.

(1) Section 6233

The jurisdiction of the Tax Court over this case is governed

by 26 U.S.C. § 6233. That section addresses instances in which

a partnership return is filed, but the purported partnership either

does not exist or is not actually a partnership. In those

situations, § 6233 mandates that TEFRA’s provisions still apply

“to the extent provided in regulations.” Id. The relevant

regulations state that “[a]ny final partnership administrative

adjustment or judicial determination . . . may include a

determination that the entity is not a partnership for such taxable

year.” Temp. Treas. Reg. § 301.6233-1T(a). Under the

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statutory authority of § 6233, this regulation explicitly

authorized the Tax Court to determine that Petuluma was not a

partnership for the 2000 taxable year.

(2) Partnership Items

The next question raised by Petaluma’s argument is whether

the sham determination was a partnership item. The Internal

Revenue Code states that “partnership item” means “any item

required to be taken into account for the partnership’s taxable

year under any provision of subtitle A to the extent regulations

prescribed by the Secretary provide that, for purposes of this

subtitle, such item is more appropriately determined at the

partnership level than at the partner level.” 26 U.S.C.

§ 6231(a)(3). Thus a partnership item must be (1) “required to

be taken into account . . . under any provision of subtitle A” and

(2) identified by regulation as “more appropriately determined

at the partnership level.” Id. We conclude that the

determination that Petaluma was not a valid partnership meets

both elements of this test.

(a) Required to Be Taken into Account Under

Subtitle A

For the validity of a partnership to be a partnership item, it

must be “required to be taken into account . . . under any

provision of subtitle A,” which is the subtitle concerning income

taxes. We have little difficulty concluding that application of

the income tax provisions of Subtitle A to the tax liability of a

taxpayer who receives income from a purported partnership

entails a determination of the validity of that partnership. As the

Eighth Circuit has stated, “When filling out individual tax

returns, the very process of calculating an outside basis,

reporting a sales price, and claiming a capital loss following a

partnership liquidation presupposes that the partnership was

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valid.” RJT Investments X v. Comm’r, 491 F.3d 732, 736 (8th

Cir. 2007). Thus the first requirement of the test is met.

(b) More Appropriately Determined at the

Partnership Level

In arguing that the second requirement is not met, Petaluma

urges that the term “item” should be interpreted narrowly,

arguing that it only includes accounting elements such as

income, deductions, credit, gain, loss, and basis. As Petaluma

concedes, however, the Code does not define “item.” Moreover,

Petaluma’s attempt to cabin the meaning of “partnership item”

ignores the statute’s plain language authorizing the Secretary to

promulgate regulations that flesh out the definition of that term.

§ 6231(a)(3). The regulations that fulfill that mandate give

examples of partnership items that include “[t]he partnership’s

method of accounting, taxable year, and inventory method.”

Treas. Reg. § 301.6231(a)(3)-1(b). These examples make clear

that the meaning of “partnership item” extends well beyond

technical accounting elements.

Furthermore, the regulations state that the definition of

partnership item includes “the legal and factual determinations

that underlie the determination of the amount, timing, and

characterization of items of income, credit, gain, loss, deduction,

etc.” Treas. Reg. § 301.6231(a)(3)-1(b). The determination that

a valid partnership exists is a sine qua non for determining the

amount and characterization of all other partnership items. For

example, determining whether there is a valid partnership

necessarily controls whether there can be partnership income,

partnership gain, partnership losses, and so forth. This

regulation establishes that the validity of a partnership is “more

appropriately determined at the partnership level,” thereby

meeting the second requirement of the partnership item test.

Thus the determination that a partnership is a sham and lacks

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economic substance is a partnership item because it is a legal

determination that underlies the amount and characterization of

other partnership items. RJT Investments X, 491 F.3d at 737–38;

Keener v. United States, 551 F.3d 1358, 1366 (Fed. Cir. 2009)

(stating that “the nature of a partnership’s transaction—and,

specifically, whether a partnership transaction is a ‘sham’—is a

partnership item”). 

Logically, it makes perfect sense to determine whether a

partnership is a sham at the partnership level. A partnership

cannot be a sham with respect to one partner, but valid with

respect to another. In addition, this conclusion is unsurprising

given that this court has affirmed the Tax Court’s determinations

that a partnership should be disregarded for tax purposes on

several prior occasions. Andantech L.L.C. v. Comm’r, 331 F.3d

972, 980 (D.C. Cir. 2003); ASA Investerings P’ship v. Comm’r,

201 F.3d 505, 506 (D.C. Cir. 2000). Based on § 6233, its

implementing regulations, and the regulations elucidating the

meaning of “partnership item,” we hold that the determination

that Petaluma was a sham, lacked economic substance, and

should be disregarded for tax purposes is a partnership item.

Given the Tax Court’s jurisdiction under § 6226(f) to determine

all partnership items, we conclude that the Tax Court acted

within its jurisdiction when it determined that Petaluma was not

a valid partnership and should be disregarded for tax purposes.

C. Outside Basis

Petaluma also argues that the Tax Court erred in holding

that it had jurisdiction to determine that Petaluma’s partners had

no outside basis in the disregarded partnership. An “outside

basis” is the value assigned to a partner’s investment in his or

her partnership interest. See American Boat Co. v. United

States, 583 F.3d 471, 474 n.1 (7th Cir. 2009). Under § 6226(f),

a court reviewing a petition for readjustment of partnership

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items only has jurisdiction to determine “partnership items.”

Under TEFRA, every item that is not a partnership item is

considered a “nonpartnership item.” § 6231(a)(4). Items that

are affected by one or more partnership items are “affected

items.” § 6231(a)(5). Petaluma argues that outside basis is an

affected item, not a partnership item, and therefore the Tax

Court had no right to determine that its partners’ outside bases

were zero. We agree.

On appeal the Commissioner concedes that outside basis is

not a partnership item in this case. Instead, he asserts that

outside basis is an affected item whose elements are mainly or

entirely partnership items. He maintains that the Tax Court had

jurisdiction to state the “obvious conclusion” that a partner

cannot have any basis in a disregarded partnership. The

correctness of this conclusion is immaterial, however, for the

question is not whether the Tax Court’s determination was

correct, but whether the Tax Court had jurisdiction to make that

determination at all in this partnership-level proceeding. 

Here, the partners’ outside bases are affected items, not

partnership items. Unlike partnership items, affected items are

determined not at the partnership level, but at the individual

partner level. Once the partnership items have been finalized,

the IRS may make a corresponding “computational adjustment”

to each partner’s tax liability. 26 U.S.C. § 6230(c)(1)(A)(ii);

§ 6231(a)(6). When a computational adjustment directly

increases a partner’s tax liability, the IRS can assess the tax and

the partner must bring a refund claim to challenge the

computation. § 6230(c)(1). When a computational adjustment’s

effect indirectly increases a partner’s tax liability and

necessitates partner-level determinations concerning affected

items, however, the IRS must issue a notice of deficiency, and

normal deficiency procedures apply. § 6230(a)(2)(A)(i); Desmet

v. Comm’r, 581 F.3d 297, 302 (6th Cir. 2009) (describing these

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two assessment procedures).

Under § 6226(f), the Tax Court had jurisdiction to

determine partnership items, but it did not have jurisdiction to

determine affected items. We have already rejected the Tax

Court’s conclusion that outside basis was a partnership item in

this case, and we likewise reject the Commissioner’s contention

that outside basis, although it is an affected item, could

nonetheless be determined in the partnership-level proceeding.

The fact that a determination seems obvious or easy does not

expand the court’s jurisdiction beyond what the statute provides.

In other words, it does not matter how low the fruit hangs when

one is forbidden to pick it. We hold that the Tax Court had no

jurisdiction to determine that Petaluma’s partners had no outside

basis in the disregarded partnership. Finally, we note that

nothing about the concept of outside basis indicates that it is

more appropriately determined at the partnership level. If

disregarding a partnership leads ineluctably to the conclusion

that its partners have no outside basis, that should be just as

obvious in partner-level proceedings as it is in partnership-level

proceedings. Moreover, with the invalidity of the partnership

conclusively established as a partnership-level determination,

there is little danger that outside basis will receive inconsistent

treatment at the individual partner level.

D. Penalties

Petaluma also challenges the Tax Court’s jurisdiction over

accuracy-related penalties. The FPAA determined that “the

accuracy-related penalty under Section 6662(a) of the Internal

Revenue Code applies to all underpayments of tax attributable

to adjustments of partnership items of Petaluma FX Partners,

LLC.” Petaluma argues that since the Tax Court lacked

jurisdiction to determine outside basis, it also lacks jurisdiction

to determine that penalties apply with respect to outside basis

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because those penalties do not relate to an adjustment to a

partnership item. We agree. As the Tax Court noted, penalties

were formerly determined at the partner level. Petaluma, 2008

WL 4682543, at *11; American Boat Co. v. United States, 583

F.3d 471, 478 (7th Cir. 2009). In the Taxpayer Relief Act of

1997, Pub. L. No. 105-34, § 1238, 111 Stat. 788, 1026, Congress

amended § 6221 and § 6226(f) so that penalties relating to

adjustments to partnership items would be determined at the

partnership level. American Boat Co., 583 F.3d at 478. Section

6221 now states that “the tax treatment of any partnership item

(and the applicability of any penalty, addition to tax, or

additional amount which relates to an adjustment to a

partnership item) shall be determined at the partnership level”

(emphasis added). Likewise, § 6226(f) now provides that a

court reviewing a petition for readjustment has “jurisdiction to

determine . . . the applicability of any penalty, addition to tax, or

additional amount which relates to an adjustment to a

partnership item” (emphasis added).

The Tax Court held that its determination that Petaluma

should be disregarded for tax purposes sufficed to give it

jurisdiction over accuracy-related penalties. Petaluma, 2008

WL 4682543, at *12. We disagree. True, the determination that

Petaluma should be disregarded for tax purposes is a partnership

item, but the outside bases of the partners are affected items to

be resolved at the partner level. Neither the Tax Court nor the

Commissioner on appeal have forwarded any basis for the

jurisdiction of the Tax Court over affected items in this

proceeding. As it is not clear from the opinion, the record, or

the arguments before this court that the penalties asserted by the

Commissioner and ordered by the Tax Court could have been

computed without partner-level proceedings to determine the

affected-items questions concerning outside bases, we are

unable to uphold the court’s determination of the penalty issues.

While it may be that some penalties could have been assessed

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without partner-level computations, we cannot affirm a decision

that has not yet been made. Therefore, we vacate the opinion of

the Tax Court on the penalties imposition and computation. It

may be that upon remand, a determination can be made for some

portion of the penalties, but neither party has briefed that

question before us. 

III. Conclusion

For the reasons set forth above, the decision of the Tax

Court is affirmed in part and reversed in part. We affirm the

decision of the court that it had jurisdiction to determine the

sham nature of the partnership entity. We reverse the decision

of the Tax Court insofar as it asserted jurisdiction over the

outside-basis issues. We vacate and remand for further

proceedings the Tax Court’s decision on the penalties question.

So ordered.

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