Widely Held Partnerships: 

Compliance and Administration Issues 

A Report to The Congress 

Department of the Treasury 

March 1990 
DEPARTMENT OF THE TREASURY 

WASHINGTON 

March 1990 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

House of Representatives 

washington, D.C. 20515 

Dear Mr. Chairman: 

Enclosed is a study of the compliance and administrative 

issues posed by publicly traded and other large partnerships. 

The study is required by section 10215 of P.L. 100-203, the 

Omnibus Budget Reconciliation Act of 1987, and has been prepared 

jointly by the Treasury Department and the Internal Revenue 

Service. The study concludes that the requirements of current 

law, as they apply to large partnerships, their partners and the 

Service, are overly complex and inefficient and that a new system 

to address these concerns is warranted. It is strongly believed 

that such a new system will significantly benefit all parties. 

A copy of the study and a similar letter are being sent 

to Representative Bill Archer. 

~~e.on~ Assistant Secretary 

(Tax Policy) 

Sincerely, 

Fred T. Goldberg, 

Commissioner 

Internal Revenue Se vice 

I 

I 

' i I. 

! 
DEPARTMENT OF THE TREASURY 

WASHINGTON 

The Honorable Lloyd Bentsen 

Chairman 

Committee on Finance 

United States Senate 

Washington, D.C. 20510 

Dear Mr. Chairman: 

March 1990 

Enclosed is a study of the compliance and administrative 

issues posed by publicly traded and other large partnerships. 

The study is required by section 10215 of P.L. 100-203, the 

Omnibus Budget Reconciliation Act of 1987, and has been prepared 

jointly by the Treasury Department and the Internal Revenue 

Service. The study concludes that the requirements of current 

law, as they apply to large partnerships, their partners and the 

Service, are overly complex and inefficient and that a new system 

to address these concerns is warranted. It is strongly believed 

that such a new system will significantly benefit all parties. 

A copy of the study and a similar letter are being sent 

to Senator Bob Packwood. 

~/d~o~ Assistant secretary 

(Tax Policy) 

Sincerely, 

Fred Goldberg, 

Commissioner 

Internal Revenue s 
I. 

II. 

III. 

CONTENTS 

INTRODUCTION • ••••••••••••••.•••••••••••••••••••• 1 

THE GROWTH OF WIDELY HELD PARTNERSHIPS •••••••••• 5 

CURRENT SYSTEM AND REASONS FOR CHANGE ••••••••.•. 9 

A. Reporting Compliance....................... 9 

B. Administration of Widely Held Partnerships. 12 

1. Description of TEFRA Partnership 

Audit Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . 12 

2. Description of Service Audit Procedures 

with Respect to Widely Held 

Partnerships ........................... 13 

3. Problems Faced by the Service in 

Administering Widely Held 

Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . 21 

IV. PROPOSED SIMPLIFIED REPORTING SYSTEM FOR 

WIDELY HELD PARTNERSHIPS .••••••.••••••••••••••.. 27 

A. Introduction............................... 27 

B. Determination of Partnership Items at the 

Widely Held Partnership Level •••••••••••••• 28 

1. In General........ . . . . . . . . . . . . . . . . . . . . 28 

2. Income and Deductions ................. 28 

3. Allocations ............................ 31 

4 . Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2 

a. Consolidated Tax credit ••••.••••.. 32 

b. Separately-Reportable Credits ••.••• 33 

c. Foreign Tax Credit ................ 34 

v. 
5. Other Reporting Issues .••••••••.•. ; •... 36 

6. Reporting Form ......................... 37 

7. Possible Further Simplification •••..•. 38 

8. Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 9 

c. Elimination of Non-Income Items •..•.•••••.• 41 

D. Magnetic Media Filing ...................... 42 

E. Treatment of Large Partners .•••••••••••••.• 42 

F. Summary of Simplified Reporting Issues ••••. 43 

G. Withholding ................................ 44 

H. ownership Changes .......................... 46 

1. Fungibility........................... 46 

2. Constructive Termination Under 

Section 708.. . . . . . . . . . . . . . . . . . . . . . . . . . 48 

3. Accounting Conventions •..•.•.••.•.••.. 49 

4. Information Reporting .•.••.•••••••.••• 51 

V. PROPOSALS FOR CURRENT ASSESSMENT OF DEFICIENCIES 

WITH RESPECT TO WIDELY HELD PARTNERSHIPS....... 53 

A. Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 

B. House Proposal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 

1. Description. . . . . . . . . . . . . . . . . . . . . . . . . . . 54 

2 . Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 

3. Analysis.............................. 56 

c. Deficiencies with Respect to Widely Held 

Partnerships Should be Borne by current 

Partners. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 

D. Partnership Collection Proposal .•••.•••.••• 58 

1. Description. . . . . . . . . . . . . . . . . . . . . . . . . . . 58 

vi. 
2. Basis and Capital Accounts ....•••. ; .•. 60 

3. overstatements and Amended Returns •.•. 60 

4. Insolvent Partnerships •••.•..••..•.... 61 

5. Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3 

6. Discussion. . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 

E. Alternative Proposals ...................... 68 

1. Partner Collection Method .•••••••••••• 68 

2. Non-Flowthrough Method •••••••••••••.... 70 

3. Nonrefundable Credit ••••.•..•.•.•.•.•• 72 

4. Elective Payment of Deficiencies by 

Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . 7 3 

F. Comparison to Deficiency Dividend Procedures 73 

G. Audit Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . 7 4 

VI. PENALTIES. . . . . . . • . . . . • . . . . . . . . . . . . . . . . . . . . . . . . . . 77 

A. overview... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 

B. Accuracy-Related Penalty •••.•.••••••.•.•••• 77 

1 . Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 7 

2. Negligence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 8 

3. Substantial Understatement of 

Income Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 9 

4. substantial Valuation Overstatement .••• 81 

C. Fraud Penal ties. . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 

VII. SCOPE OF THE PROPOSALS--DEFINITION OF A WIDELY 

VIII. 

HELD PARTNERSHIP. • • • • • • • • . • • • • • • • • • . • • • • • • • • . • . . 8 3 

EFFECTIVE DATE CONSIDERATIONS ••.••••••••••••••.. 85 

Appendix I - Proposals for Amendments to TEFRA Rules 

Appendix II - Description of TEFRA Rules 

vii. 
SECTION r. INTROpUCTION 

Section 10215 of the Omnibus Budget Reconciliation Act of 

1987 directs the Treasury Department to conduct a study of (1) 

the issues of treating publicly traded limited partnerships (and 

other partnerships which significantly resemble corporations) as 

corporations for federal income tax purposes, including disincorporation and opportunities for avoidance of the corporate tax, 

and (2) the issues of compliance and administration with respect 

to publicly traded partnerships and other large partnerships. 

This report, which is the product of a joint Treasury and 

Internal Revenue Service study, addresses the second set of 

issues in the requested study. It describes the compliance by 

and administration of widely held partnerships under current tax 

law, and discusses the problems faced by the Internal Revenue 

Service (the "Service" or "IRS") in monitoring compliance, 

determining additional tax due, and collecting tax deficiencies 

attributable to such partnerships and their partners. It concludes that the requirements of current law, as they apply to 

widely held partnerships, their partners and the Service, are 

overly complex and inefficient and that a new system to address 

these concerns is warranted. It is strongly believed that such a 

new system will significantly benefit all parties. 

The report first sets forth the Treasury's analysis of the 

existing situation, and the reasons to provide new procedures in 

order to insure collection of tax attributable to the partners 

who are members of widely held partnerships. The report then 

recommends the adoption of a new administrative system, applicable only to widely held partnerships. In general, the term 

"widely held partnership" would include partnerships with 250 or 

more partners, except for service partnerships such as accounting 

or law partnerships. See Section VII of this report for a more 

complete discussion of the definition of a widely held partnership. This report also discusses matters relating to withholding 

at the widely held partnership level, but does not recommend such 

withholding at this time. In addition, the report includes as 

Appendix I proposed revisions to the unified partnership audit 

rules applicable to all partnerships with more than 10 partners. 2 

1The omnibus Budget Reconciliation Act of 1987, Pub. L. No. 

100-203 (the "1987 Revenue Act"), added section 7704 to the 

Internal Revenue Code of 1986, as amended (the "Code" or 

11 I.R.C. 11 ). Section 7704 treats certain publicly traded 

partnerships as corporations for federal income tax purposes. 

This report discusses the administrative treatment of widely held 

partnerships that are not treated as corporations for federal 

income tax purposes. 

2I.R.c. §§ 6221 et. ~ The unified partnership audit 

rules also apply to certain partnerships with 10 or fewer 

partners. 
2 

The proposed administrative system for widely held 

partnerships would have two principal features. First, widely 

held partnerships would use a simplified system for reporting 

income to the Service and partners. The current Schedule K-1 

reporting form would be replaced by a new Form 1099-K on which 

widely held partnerships would report certain specified and 

limited information. Elections now made by partners would be 

made at the partnership level. Rules applicable in calculating 

taxable income, such as limitations on certain deductions, would 

be applied at the partnership level wherever possible. Transmissions to the service would be made by magnetic media. The 

second principal feature of the system would be a consolidation 

of the tax audit and administration procedures at the partnership 

level, including payment of any tax deficiencies, interest and 

penalties at the partnership level. 

Because of the administrative difficulties currently posed 

by widely held partnerships, it is reasonable to conclude that 

there may be significant loss of revenue to the government. This 

revenue loss is partially attributable to income reported by the 

partnership which is not included on a partner's return, whether 

through inadvertence, .confusion, or conscious failure to report 

income. The revenue loss is also partially attributable to the 

underreporting of income by the partnership itself. We do not 

believe that clearly erroneous reporting positions are commonly 

taken by large partnerships. However, to a significant degree, 

our voluntary reporting system anticipates an adversarial 

relationship between taxpayers and the Service. A taxpayer may 

report a transaction or event as he or she deems appropriate and, 

if the Service disagrees with the taxpayer's analysis, the 

Service has the right and obligation to challenge the taxpayer's 

position. The unwieldy administrative rules currently applicable 

to widely held partnerships make it difficult for the Service to 

fulfill this role, and hampers the proper functioning of the 

voluntary reporting system. 

It is reasonable to assume that the government will receive 

increased revenue as a result of a simplified reporting system 

and more efficient rules governing audits of widely held partnerships. We estimate that implementation of a new reporting system 

with respect to partnerships with 250 or more partners would 

raise between $85 million and $140 million over a five-year 

period, and implementation of a streamlined audit and assessment 

proposal would raise between $100 million and $200 million over a 

five-year period. 

Moreover, apart from revenue considerations, there are sound 

tax policy reasons to alter the tax administration system with 

respect to widely held partnerships. Current law and procedures 

were developed in an era when partnerships were generally 

relatively small, and, to a significant degree, these procedures 

treat partnerships as aggregations of individual taxpayers. This 
3 

approach makes little sense in an era where partnerships may have 

500, 1,000, or an even larger number of partners. An individual 

partner's relationship to the partnership is similar to that of a 

shareholder to a large corporation. We do not assert that widely 

held partnerships should be taxed as corporations; however, we do 

believe that today 1 s large partnerships represent a new type of 

entity that requires a new set of rules. These rules should be 

grounded on the similarity between widely held partnerships and 

corporate entities, and the need to achieve efficient administration. Like corporations, widely held partnerships should use 

a simplified system for reporting to the service and their 

partners, and audits and assessments of deficiencies should be 

conducted at the entity level. 
SECTION II. THE GROWTH OF WIDELY HELD PARTNERSHIPS 

In recent years, the number of widely held partnerships has 

significantly increased. In 1978 some 671 partnerships had 500 

or more partners; by 1987 the number had grown to 1,735. The 

greatest portion of the increase was attributable to partnerships 

with over 1,000 partners, the number of which grew from 288 in 

1978 to 1,224 in 1987. During this period, there was a corresponding increase in the percentage of partners who held their 

interests in large partnerships. In 1978 only 15.1 percent of 

all partners held their interests in partnerships with 500 or 

more partners; by 1987 this percentage was 46.9 percent. Again, 

most of this growth was attributable to partnerships with 1,000 

partners or more, which accounted for 44.6 percent of all 

partners in 1987, nearly four times the figure of 10.8 percent in 

1978. Although comparable 1978 numbers are not available, in 

1987 there were 3,459 partnerships with 250 or more partners 

accounting for 50.4 percent of all partners and 6,845 partnerships with 100 or morJ partners accounting for 53.2 percent of 

all partners in 1987. 

In 1987, sales ot publicly offered partnership interests 

reached record levels. 4 Although sales since 1987 have declined 

sharply, they still are substantial in terms of dollars. Sales 

of partnership interests in public offerings, including traded 

and untraded interests, declined 44 percent from 1987 to 1989 and 

publicly traded interests in master limited partnerships declined 

a substantial 79 percent ($2.9 to $.6 billion). Total sales of 

all such partnership interests were $13.5 billion for 1987 and 

$7.6 billion for 1989. 5 Despite the decline in the rate of 

growth, sales of this magnitude will continue to materially 

increase the growing number of large partnerships. 6 

3Internal Revenue Service, Statistics of Income--Partnershio 

Returns: 1978 and 1980. 1987 figures from unpublished IRS data. 

4see "Record Public Partnership Sales in 1987" The Stanger 

Register, February 1988, p. 13. 

5see Table 1 "Public Partnership Sales" for 1988-1989 The 

Stanger Register, February 1990, p. 35. 

6There are also substantial sales of partnership interests 

in private placements (so-called regulation D offerings exempt 

from certain Securities and Exchange Commission filing 

requirements). The estimated sales of such offerings for 1987, 

1988 and 1989 amounted to $1.5 billion, $2 billion, and $1.4 

billion, respectively (Source: Robert A. Stanger & co.). 

Privately offered partnerships probably have less impact on the 

issues discussed in this report because they are less commonly 

widely held partnerships as the term is used herein. 
6 

This growth in the number of widely held partnerships is 

not surprising. Operating a business or investment activity in 

partnership as opposed to corporate form offers significant tax 

advantages, including the avoidance of an entity-level tax and 

the ability of the members to deduct losses from the activity on 

their own tax returns (subject to certain restrictions). Despite 

these advantages, a number of factors traditionally hampered use 

of the partnership form by widely held entities. Among these 

factors were the administrative complexity for the entity and 

members of applying the partnership tax rules to a widely held 

entity, the reluctance of small investors to invest through the 

less familiar partnership form, and a relative lack of liquidity 

for partnership interests. 

In the late 1970s and 1980s, these limiting factors began 

to weaken. Computer programs and other procedures were developed 

for applying the partnership tax rules to widely held partnerships. Investors became more familiar and comfortable with 

limited partnership investments. In addition, the use of tax ~halters greatly expanded in the late 1970s and early 1980s and 

widely held partnerships became an increasingly popular investment vehicle, in part because they made shelters accessible to 

smaller investors. Finally, a number of widely held partnerships 

began to offer partners a significant degree of liquidity, either 

through the offering of redemption or remarketing programs or, 

more notably, through the listing of partnership interests on 

stock exchanges. Prior to 1980, no partnerships were listed on 

any major stock exchange; as of December 31, 1989, 126 were 

listed. 

The forces encouraging the growth of large partnerships 

have not been unchecked. In particular, the desirability of 

these investments has been limited by a series of tax law 

changes culminating in the enactment of the passive loss rules 

which limited the deductibility of losses by partnership 

investors, 7 and the enactment of section 7704 of the Code which 

limited the ability of publicly traded entities to qualify as 

partnerships for tax purposes. 

Nonetheless, as long as income earned through partnerships 

is subject to a lower effective tax rate than income earned 

through corporations, we believe that the number of widely held 

partnerships will continue to grow. Moreover, we believe that 

interests in many of the widely held partnerships will experience 

significant levels of trading. For example, section 7704 grandfathers all existing publicly traded partnerships for a ten-year 

period, 8 and does not apply to partnerships earning certain 

7see. e.g., I.R.c. § 469. 

81987 Revenue Act Section l02ll(c). 
7 

types of qualifying in~ome, including natural resource and real 

estate related income. 

Administrative difficulties faced by the Service will be 

exacerbated by any growth in the number of widely held partnerships and by significant trading levels of interests in such 

partnerships. In light of the recent and anticipated future 

growth in widely held partnerships, and the likelihood of 

continued significant trading, the issue of compliance and 

administration with respect to large partnerships is a timely 

and important subject. 

9 I.R.C. § 7704(d). 
SECTION III. CURRENT SYSTEM AND REASONS FOR CHAHGE 

A. Reporting Compliance 

Under current law, a partnership must file Form 1065, 

partnership return of income, for each taxable year. The return 

is accompanied by a Schedule K-1 for each partner, reporting the 

partner's share of allocable items of the partnership's income 

and deductions, credits and other specified information. A copy 

of the Schedule K-1, or a substituted form, is furnished to each 

partner to be used in reporting such items on the partner's 

income tax return. 10 

In the case of many partnerships, such reportings to 

partners are voluminous and complex due to the considerable 

number of passthrough items. on the 1989 Schedule K-1 there are 

nine different categories of passthrough items with more than 

forty possible individual amounts to be included in the partner's 

return or schedules related thereto. comments received from 

taxpayers during various IRS Town Meetings held around the 

country during the 1989 filing season invariably included 

references to the complexity of the Schedule K-1. Furthermore, 

widely held partnerships frequently send out information to 

partners in a format which differs from the Schedule K-1. This 

is permissible as long as the official Schedule K-1, or an 

approved substitute Schedule K-1, is filed with the Service and 

the required information is provided to the partner. This lack 

of uniformity in information reporting forms is also a frequently 

mentioned matter of concern expressed when Service representatives meet with practitioner groups. Illustrative of the extent 

of this problem is a recently issued prospectus describing the 

proposed merger of two partnerships (assets over $300 million) 

into a corporation intended to qualify as a real estate investment trust. The prospectus states that one of the principal 

benefits of the merger is the ability to provide to investors a 

tax information form (Form 1099) which is less complex and easier 

to understrnd than the Schedule K-1 currently required to be 

provided. The complexity of the Schedule K-1 as compared to 

10schedule K-1 is an information return used to furnish 

information to partners pursuant to section 603l(b). The form 

lists specific types of income (11 entries), deductions (4 

entries), 7 types of credits (12 entries), tax preference items 

(6 entries), investment interest (3 entries), self-employment 

amounts (3 entries), and recapture of investment tax and lowincome housing credits (2 entries). 

11ProspectusfProxy Statement of CRI Liquidating REIT, Inc., 

and CRI Insured Mortgage Association, Inc., dated August 17, 

1989, pages 1 and 11. 
10 

interest and dividend reporting on Form l099s, may in and of 

itself discourage proper reporting by the partners. 

The Service has insufficient data to determine the 

extent of underreporting of income by partners in widely held 

partnerships. However, statistics show a material level of 

noncompliance in the case of reporting of payments of interest, 

dividends and capital gains. 12 While an estimated 99.5 percent 

of wages and salaries were voluntarily reported in 1987 by 

individuals who filed tax returns, 94.5 percent of interest and 

dividends were reported13 and only 88.3 percent of capital gains 

were reported. These figures do not include the failure to 

report such income by persons not filing a required tax return. 14 

By analogy, it can be inferred that a material percentage of 

income from widely held partnerships is not reported by partners. 

Furthermore, even in cases where partners make good faith efforts 

to report items attributable to widely held partnerships, given 

the complexity of the Schedule K-1, it seems reasonable to 

conclude that some additional percentage of income attributable 

to widely held partnerships is not properly reported. 

12A Form 1099 information return is required to be filed by 

any person making payments of interest or dividends above a 

certain amount and by brokers upon certain sales of assets. 

I.R.C. §§ 6042, 6045, and 6049. 

13see Table I-2, "Income Tax Compliance Research: Gross Tax 

Gap Estimates and Projections for 1973-1992, 11 Publication 7285 

(March 1988) ("Gross Tax Gap Estimates and Projections"). The 

94.5 percent compliance figure resulted in underreported interest 

and dividends for 1987 of $13.2 billion. 

14The Service is concerned that partners who hold their 

interest through nominees may not be receiving Schedule K-ls from 

the partnership or the nominees. The service has anecdotal 

information that in the past some brokerage houses holding 

partnership interests as nominees destroyed information returns 

received from such partnerships instead of forwarding those 

returns to their customers. However, such information predates 

the enactment of section 603l(c). Section 603l(c), which was 

added by the Tax Reform Act of 1986, Pub. L. No. 99-514, requires 

any person who holds an interest in a partnership as a nominee 

for another person to furnish to the partnership information 

concerning such other person to the extent prescribed by the 

Secretary. This section is effective for taxable years beginning 

after October 22, 1986. Section 10l5(a) of the Technical and 

Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, extended 

the section 6722 penalty to cover returns required under section 

603l(c). 
11 

The Service currently has the technical capability to match 

information reported to the Service by partnerships with the 

information reported by partners on their returns. However, the 

application of the matching program is significantly complicated 

by the fact that each partner's Schedule K-1 information may 

consist of numerous items (over forty separate items possible) 

which, in many cases, are limited or modified at the partner 

level and are required to be reported in a variety of different 

places on the partner's Form 1040 and related schedules. 

Furthermore, in contrast to cor~orations that file substantial 

numbers of information returns, 5 widely held partnerships are 

not required to use magnetic media filing to report Schedule K-1 

information16 and in almost all cases file such information on 

paper returns. The Service must manually transcribe paper 

returns before matching can occur. These systemic barriers mean 

that matching partnership data is more expensive and time 

consuming than matching other types of reported information. 17 

The reporting system for widely held partnerships is thus 

needlessly complex and inefficient. It is important to solve 

these deficiencies in the compliance system, not only to protect 

the fisc, but also to.provide a system that is workable for the 

public and administrable by the Service. It is also important to 

recognize in our tax system the changing economic and capital 

structure of the country and to adapt the system to changes in 

order to protect the interests of the public and the government. 

15Notice 90-15, 1990-7 I.R.B. 23. 

16Publication 1437 (Rev. l-90). 

17The difficulties in the operation of a matching program 

are also faced by the Information Returns Program ("IRP"). An 

IRP program involves the matching of data contained in 

information returns filed by payers and flow-through entities 

with the data reported on tax returns filed by payees and 

investors in flow-through entities. An IRP program normally 

results in assessment of additional tax in cases where a taxpayer 

agrees with the proposed adjustment to his or her reported 

income, and issuance of a statutory notice of deficiency in the 

event the partner fails to agree or respond. Under the unified 

partnership audit rules discussed below, the Service may be 

authorized to proceed directly to assessment under its authority 

to make a computational adjustment in a case in which a partner 

fails to report consistently with the partnership return and 

fails to disclose such inconsistency. I.R.C. S 6222. However, 

to institute the IRP procedure, the Service would have to locate 

and obtain the partners' returns for purposes of making the 

computational adjustment. The IRP procedure is not cost 

efficient under current law when applied to widely held 

partnerships. 
12 

A proposal for a simplified reporting system to help accomplish 

these objectives is discussed in Section IV below. 

B. Administration of Widely Held Partnerships 

1. Description of TEFRA Partnership Audit Rules 

Prior to the enactment of unified partnership audit rules by 

the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA11 ), 

adjustments to items of income, gain, loss, deduction and credit 

relating to a partnership had to be made in separate proceedings 

with the respective partners. Similarly, settlements and 

judicial determinations were only binding on those partners that 

were parties to the agreement or judicial proceeding. This 

system was not an efficient means of auditing tax shelters and 

other large partnerships, because each partner was entitled to 

separate administrative and judicfrl review of partnership items 

that were common to all partners. The TEFRA partnership audit 

rules consolidate the administrative and judicial review of all 

partnership items at the partnership level. Congress, noting the 

potential conflict between investors and tax shelter promoters, 

balanced the consolidated audit provisions with considerable 

protections for individual partners. 

The TEFRA partnership audit rules apply to all partnerships, 

except for partnerships with ten or fewer partners in which each 

partner's share of any partnership item is the same as his or 

her share of every other item (~, there are no special 

allocations) and each partner is f natural person (other than a 

nonresident alien) or an estate. 1 The tax treatment of all 

partnership items is determined at the partnership level. 20 

Generally, all partners must treat items on their individual 

18see General Explanation of the Revenue Provisions of the 

Tax Equity and Fiscal Responsibility Act of 1982, at 267-68 

(hereinafter referred to as "TEFRA General Explanation"). 

19r.R.C. § 623l(a) (1) (B). All partners of a partnership for 

the partnership taxable year under audit generally are subject to 

the TEFRA partnership audit rules. However, under certain 

circumstances, the inclusion of a partner in a unified proceeding 

would interfere with the efficient enforcement of the tax law. 

I.R.c. § 623l(c). When special enforcement considerations exist 

with respect to a partner, that partner's partnership items will 

be treated as nonpartnership items and the partner is removed 

from the partnership proceeding. Examples of special enforcement 

situations include the filing of a bankruptcy petition naming a 

partner as the debtor or the criminal investigation of a partner. 

Id.; Temp. Treas. Reg.§§ 301.623l(c)-4T through ST. 

20 I.R.c. s 6221. 
13 

returns consistently with the treatment of those items on the 

partnership return unless they notify the Service of an inconsistent treatment. 21 If the Service challenges a reporting 

position of a partnership subject to the TEFRA rules, it conducts 

a single administrative proceeding to resolve the issue with 

respect to all partners. similarly, if a partnership decides to 

challenge an administrative determinati~n of the Service, a 

single judicial proceeding will occur. 

The central figure in a TEFRA partnership proceeding is the 

tax matters partner ("TMP"). The TMP is the representative of 

the partnership who serves as a liaison between the partnership, 

the Service and the court with respect to the unified audit and 

litigation proceedings regarding the tax treatment of partnership 

items attributable to the partnership. As such, the TMP serves 

as the focal point for service of all notices, documents and 

orders on the partnership, and concomitantly has many rights and 

duties both at the administrative stage of the proceeding and in 

the course of litigation. The Code provides that the TMP is the 

general partner designated by the partnership to serve as the TMP 

or, if there is no such designation, the general partner having 

the largest profits interest as of the close of the taxable year 

involved. 23 If the Service determines that it is impracticable 

to apply the largest profits interest r~je, the service may 

select any partner to serve as the TMP. 

The TEF~ partnership audit rules are described in detail in 

Appendix II. 

2. Description of Service Audit Procedures with Respect to 

Widely Held Partnerships 

The Service has elaborate procedures for auditing 

partnerships and assessing and collecting partner deficiencies 

after the amount of the audit adjustment has been finally 

determined. This section provides a detailed description of the 

steps that are followed in conducting an audit of a large 

partnership. 

21 I.R.C. § 6222(a) and (b) • 

22 See I.R.C. § 6226. 

23 I.R.C. § 623l(a) (7); Temp. Treas. Reg. 

§ 301.623l(a)(7)-1T. 

24IsL.; see Rev. Proc. 88-16, 1988-i C.B. 691. 

25Proposals for amendment of these rules are described in 

Appendix I. 
14 

There are ten Internal Revenue Service Centers ("Service 

Centers") located throughout the country. Each Service Center 

processes income tax returns of individuals and entities which 

reside (or have their principal place of business) within the 

geographical jurisdiction of the center. The Service also has 63 

district offices which may have jurisdiction over a single state 

or a smaller geographical area in more densely populated states. 

The primary functions of each district office are the examination 

of tax returns (Examination Division), the collection of delinquent tax (Collection Division), the enforcement of criminal 

penalties for tax crimes (Criminal Investigation Division), and 

the response to taxpayer requests for assistance (Taxpayer 

Service Division). The Appeals Division's field function is 

organized by region, with branches located in some but not all 

district offices. The Appeals Division is responsible for 

settlement of disputes between the Examination Division and the 

taxpayer based on the merits of a given case as well as the 

hazards of litigation. The Appeals Division is also responsible 

for settlement of some collection disputes. 

When a Service Center receives a partnership return, certain 

return jnformation is. entered into a Service Center computer 

system2 and transmitted to the Martinsburg Computing Center. 27 

Partnership returns with high audit potential scores are then 

screened by classifiers at the Service Center in order to 

determine which returns should be audited. 28 Lists of returns 

with high audit potential are transmitted to their assigned 

district offices. 29 The district office then obtains the 

26After a period of time, depending on the return in 

question and on the available space at the Service Center, the 

tax returns are transported to one of several Federal Record 

Centers for further storage and ultimate destruction. 

27The Martinsburg Computing Center is responsible for 

various data processing functions within the IRS. 

28Partnership returns are assigned a "Discriminate Function" 

or DIF score at the Martinsburg computing Center based on the 

values of various line items and the interrelationships of 

certain line items. DIF scores on partnership returns, just as 

on individual returns, are a numerical rating of the potential of 

significant errors being present on a particular return. If a 

return has a DIF score above a certain level, it goes into the 

DIF inventory and is ordered out by the Examination function as 

work is needed. It is then screened for audit potential by the 

Classification Branch at the Service Center where the return was 

filed. 

29Partnership audits are generally assigned to the district 

in which the partnership has its principal place of business. 
15 

original partnership return (with any associated files), and the 

case is assigned to a revenue agent of the Examination Division. 

The revenue agent sends the TMP a Notice of the Beginning of 

the Administrative Proceeding (which is required to be issued at 

least 120 days before a notice of Final Partnership Administrative Adjustment is mailed to the TMP). 30 The revenue agent then 

has 45 days to determine whether the items of the partnership are 

correctly reported. 31 If the revenue agent determines that there 

should be no changes to items as reported, the Notice of the 

Beginning of the Administrative Proceeding must be withdrawn 

within 45 days of its issuance (otherwise, a notice of Final 

Partnership Administrative Adjustment must eventually be 

issued) • 32 

If the revenue agent determines that an audit is warranted, 

he or she reconciles all of the Schedule K-ls with the partnership return. 33 The information drawn from the Schedule K-ls 

regarding individual partners is forwarded from the district 

office to the Examination Support Unit~ of the Service Center 

with jurisdiction over the partnership return (the "partnership's 

Service Center"). The. Examination Support Unit then enters this 

information into the Partnership Control System computer programs, which automatically generates requests for all partner 

returns in the Federal Records Centers which are then transferred 

to the various Service Centers with jurisdiction over each 

partner's return (the "partner's Service Center") • 35 It takes 

30 I.R.C. § 6223 (d) (1). 

31Temp. Treas. Reg. § 301.6223(a)-2T(a). 

32Id. 

33copies of the Schedule K-ls are filed with the original 

partnership return and continue to be associated with the 

original partnership return throughout the audit process. The 

reconciliation process involves adding the partner profits 

percentage indicated on each Schedule K-1 to determine whether 

the percentages total 100 percent (in order to ensure that all 

partners have been accounted for). 

~An Examination Support Unit is located in each of the ten 

Service Centers. The units, which are part of the Examination 

Division, are principally responsible for coordinating the notice 

and assessment procedures with respect to individual partners of 

partnerships subject to the TEFRA partnership audit rules. 

35 If a partner's return is not currently under examination, 

the Examination Support Unit of that partner's Service Center may 

review this return for possible audit. 
16 

an average of two to three months from the date a return is 

ordered to loca~t and forward the return to the appropriate Service Center. The Partnership Control System of the 

partnership's Service Center generates Notices of the Beifnning of the Administrative Proceeding to each notice partner. 

When the examination of a partnership return is completed, 

the revenue agent arranges a conference with the TMP and any 

other partner who wishes to attend. 38 Prior to the conference, 

the revenue agent issues a preliminary report to the TMP 

summarizing the revenue agent's initial conclusions, which 

are subject to change as a result of legal or factual arguments 

presented at the conference. 

At the conference, the revenue agent and the TMP (and any 

other partners present) discuss the issues raised in the audit. 

Even if the revenue agent and the TMP reach an agreement 

regarding a proposed adjustment, by statute the TMP is only 

authorized to bind non-notice partners, 39 and in practice will 

rarely exercise that authority. If, as is typically the case in 

an audit of a widely held partnership, the revenue agent does not 

obtain an agreement regarding a proposed adjustment that covers 

all of the partners of the partnership, the agent prepares a 

final report containing facts, analysis of law, statement of 

taxpayer's position, and the agent's conclusions on each issue. 

36If a partner is itself a pass-through entity, the 

procedure must be repeated with respect to its members. It takes 

approximately four to six months to locate all partner returns 

for each tier in a multi-tier partnership. 

37All partners whose names and addresses have been furnished 

to the Service are entitled to receive such notice from the 

Service in partnerships having 100 partners or less. I.R.C. 

§ 6223(a) (1). For partnerships having more than 100 partners, 

only partners having a one-percent or greater profits interest or 

the designated member of a group of partners who form a fivepercent "notice group" are entitled to receive notice from the 

Service. I.R.c. § 6223(b). The TMP is under an obligation to 

forward such notices to non-notice partners (with certain 

exceptions including indirect partners who have not been 

identified to the TMP). Temp. Treas. Reg.§ 30l.6223(g)-1T(a). 

38The burden of notifying all partners of the conference is 

placed on the TMP. Temp. Treas. Reg. § 301.6223(2)-lT(b) (1) (i). 

39I.R.C. § 6224(c) (3) (A). However, under section 

6224(c)(3)(B), a non-notice partner may file a statement with the 

service providing that the TMP is not authorized to enter into a 

settlement on such partner's behalf. 
17 

This report may be reviewed by the Quality Review staff40 in the 

district office responsible for the partnership audit. 

The Quality Review Staff then prepares a 11 60-day letter 

package" and forwards it to the Examination Support Unit of the 

partnership's Service Center. The Exam!pation support Unit then 

mails a copy of the package to the TMP. The 60-day letter 

package contains a letter notifying the partners of the time 

period to protest the proposed adjustments to the Appeals 

Division. The package also contains a copy of the revenue 

agent's report and an agreement form for use by the partner in 

the event he or she decides to accept the proposed adjustments. 42 

The TMP files his or her protest with the Quality Review 

Staff of the district responsible for the partnership audit. 

Other partners must file their protests with the Examination 

Support Unit of the partnership's Service Center. The 

Examination Support Unit forwards any protests it receives to the 

Quality Review staff, which in turn forwards all protests to the 

Appeals Division office with jurisdiction over the partnership's 

district. 

If no protest is.received, the Quality Review Staff of the 

partnership's district office prepares a notice of Final 

Partnership Administrative Adjustment, which is reviewed by the 

District Counsel office for the district. Copies of the notice 

are mailed to the TMP and each notice partner or the designated 

member of each notice group by the partnership's Service Center. 

The TMP is required to forward copies of the notice to each 

non-notice partner within 60 days after the mailing by the 

Service. 43 

If a protest is received, an Appeals Division settlement 

conference is held at which any partner is entitled to 

participate. If a settlement covering all of the partners is not 

reached at the conference, the Appeals Officer prepares a 

settlement package which the Examination Support Unit of the 

partnership's Service Center mails to all partners who have not 

40The Quality Review Staff is a branch of the Examination 

Division with responsibility for review of completed audit 

reports in order to determine whether proper procedures have been 

followed and to review revenue agents' determinations. 

41The TMP would then be responsible for notifying nonnotice partners. Temp. Treas. Reg. S 301.6223(g)-1T(b) (l)(ii). 

42A copy of the 60-day letter and the agreement form (Form 

870-P or 870-L) is sent to all notice partners. 

43Temp. Treas. Reg.§ 301.6223(g)-1T(a) (2). 
18 

yet settled. 44 If not all partners accept the proposed 

settlement, the Appeals Division office prepares a notice of 

Final Partnership Administrative Adjustment, which is reviewed by 

District Counsel and sent to the TMP. Copies of the notice of 

Final Partnership Administrative Adjustment are mailed to each 

notice partner or the designated member of each notice group by 

the Exafjnation Support Unit of the partnership's Service 

Center. Although the Appeals Division may have developed a 

settlement position (under the above-described procedure), the 

notice of Final Partnership Administrative Adjustment generally 

will reflect the litigati~r position of the Service (rather than 

the settlement position). 

The TMP has 90 days from the date of mailing of the notice 

of Final Partnership Administrative Adjustment to file a 

petition with the Tax Court, the Claims Court, or a federal 

district court. 47 If the TMP fails to file a petition within the 

90-day period, any notice partner or any group having in the 

aggregate a five-percent interest in profits may file a per~tion 

during the 60 days following the end of the 90-day period. 

Every partner of the partnership is treated as a .party to an 

action brought by the TMP or notice partner (or five-percent 

group), and is entitled to participate in the action, unless the 

partner's partnership items have been converted to nonpartnership 

items or the statute of limitations has expired with respect to 

that partner. 

After a final determination has been made with respect to a 

partnership level adjustment, the Examination Support Units 

located in the partners' Service Centers are responsible 

for assessing deficiencies against the partners. The tax must be 

assessed with respect to each partner within one year of the date 

44The Appeals Division may determine in certain situations 

that it is not efficient to mail settlement packages to nonnotice partners. 

45 I.R.C •. § 6223 (a) (2). 

46If any settlement was entered into between a partner and 

the Service, any other partner may still obtain consistent terms 

by making a request within a prescribed time period. See I.R.C. 

§ 6224 (c) (2). 

47 I.R.C. § 6226 (a). 

48r.R.C. § 6226(b) (1). The "five-percent group" for 

purposes of filing a petition need not be the same partners that 

were members of a five-percent "notice group." Temp. Treas. Reg. 

§ 30l.6223(b)-1T(e). 
19 

on which the adjustment became final as to that partner. 49 Each 

of these Service Centers reviews the returns of the partners 

within their jurisdiction, computes the deficiency, and mails a 

notice of computational adjustment to the partners. A computer 

generated notice of assessment and demand for payment is then 

mailed to each partner from the various partners' Service Centers 

within 60 days of the date of assessment of that partner. 

Payment is due within 10 days of the mailing of the first notice 

and demand for payment. If a partner fails to make payment 

within that time period, a tax lien is created by operation of 

law at the end of the 1~ day period. The lien relates back to 

the date of assessment. 0 Shortly after the 10 day period, 

computer generated notices are transmitted to the partners who 

have not yet paid. TWo to five notices (including the abovementioned notice of assessment and demand for payment) are 

transmitted depending on the amount of money involved. The last 

notice, identified as "Final Demand and Notice of Intent to 

Levy," must be issued before enforced collection by levy can 

occur and must either be sent by certified mail to the partner's 

last known address, hand-delivered to the partner, or left at the 

partner's home or place of employment. 51 Absent exigent circumstances which would support the making of a jeopardy levy 

(usually the same circumstances that would support a termination 

or jeopardy assessment), the Service cannot levy for 30 days from 

the date of the final notice. 

After the notices have been transmitted, if the amount of 

the deficiency is below a set tolerance level, no action is taken 

by Service personnel; however, any potential levy sources (such 

49The one-year assessment period must be calculated on a 

partner-by-partner basis, because some partners may settle their 

cases separately on different dates while other partners may 

choose to await the outcome of the litigation. 

50If any person fails to pay the tax (including any related 

interest or penalty) after notice and demand, a statutory lien is 

created in favor of the United States upon all property and 

rights to property of that person. I.R.C. S 6321. The lien 

imposed by section 6321 arises as of the date of assessment and 

continues until the liability is paid or becomes unenforceable by 

reason of lapse of time (usually due to the running of the 

statute of limitation on collection six years after assessment). 

I.R.C. S§ 6322 and 6502. 

51At this stage, the debt is classified as a "taxpayer 

delinquent account." The average cost to the Service to close 

such accounts during 1986, 1987 and 1988 was $196.04, $198.48 and 

$234.00, respectively. The amount of tax owed thus must be 

relatively substantial for collection of these accounts to be 

cost effective. 
20 

as refunds due) are identified by computer, and the amount of any 

such refund will be offset by the outstanding liability. A 

delinquent account with a balance due above the tolerance level 

is then entered into the Automated Collection System computer, 

which sets collection priorities based on potential yield (the 

amount of the liability is only one of several factors considered). After priorities have been set, revenue representatives of the Collection Division located at 21 locations 

throughout the country commence efforts to collect the liability. 

The revenue representatives telephone, and in some cases 

correspond with, the partners. Any information obtained from the 

partner or third party sources is entered into the Automated 

Collection System computer for future reference. If a revenue 

representative identifies a levy source, he or she may issue a 

notice of levy or file a notice of federal tax lien. 

If the partner still has an outstanding liability at the 

conclusion of the above-described process, the account is placed 

into an automated queuing system. The automated queuing system 

is a computerized listing of outstanding accounts with priorities 

based on expected amounts of collection. If the amount of 

expected collection is high enough, the case is automatically 

transferred to the district where the partner resides and 

assigned to a revenue officer. Even if the amount of expected 

collection is not high enough to be immediately transferred to 

the district, the amount may be transferred and assigned later if 

circumstances warrant. However, many smaller accounts (even 

though above the set tolerance level) are never assigned to a 

revenue officer and therefore the amount due generally would not 

be collected. 

After an account has been assigned to a revenue officer, the 

officer contacts the partner in an effort to collect the amount 

due. If this contact does not lead to payment of the liability, 

the revenue officer is empowered to take various collection 

actions, including seizure of the partner's property. If all 

efforts to collect are unsuccessful, a determination may be made 

that the debt is currently uncollectible. 

The Service has similar, although less well developed 

procedures, for handling Requests for Administrative Adjustment 

("RAA"), which are the TEFRA equivalent of a refund claim or an 

amended return. An RAA could be filed in the many situations in 

which a partnership level deficiency flowed through to partners 

in a TEFRA proceeding and leads to a related overpayment in 

another year for all such partners. 52 Many of the steps 

discussed above would essentially have to be repeated in such a 

case. 

52see section III(B)(3)(6). 
21 

3. Problems Faced by the Seryice in Administering 

Widely Held Partnerships 

The present audit and assessment system applies to all 

partnerships with more than ten partners (and in certain cases to 

even smaller partnerships). Because of the breadth of its 

coverage, the system provides procedural protections and rules 

that are generally desirable for partnership administration, but 

that may not be appropriate when applied to the type of widely 

held partnerships that are becoming common today. The sheer 

number of partners in a large partnership (one for instance had 

more than 90,000 partners in its first year of operation) may 

cause a myriad of problems in the areas of filing, audit, 

settlement, litigation, assessment and subsequent proceedings. 

The following is a summary of these problems. 

(1) Partners may take filing positions inconsistent with 

the partnership return. Although in widely held partnerships 

this right may not be frequently exercised because the partner 

does not have adequate information to take such a position, the 

possibility does exist. If the Service is not notified by the 

partner as required, the inconsistent treatment in most cases 

will never be detected. If notified, the Service may challenge 

the inconsistency and conduct a partnership audit or deal with 

the items as nonpartnership items. In either case, there is a 

significant potential burden in trying to monitor inconsistent 

positions of partners in widely held partnerships absent a 

mandatory magnetic media filing requirement with a fully 

implemented matching procedure. 

(2) To conduct an audit of a widely held partnership, the 

Service must obtain and monitor information concerning each 

individual partner. The actual audit of a large partnership's 

books and records ordinarily proceeds in a manner similar to an 

audit of a large corporation; however, in a corporate audit, the 

service is not required to develop and track information concerning each shareholder. 53 In a partnership audit, the Service 

must first identify each partner. To do so, the Service must 

reconcile individual Schedule K-1s to determine that it has 

accounted for 100 percent of the interests in profits and losses 

in the partnership. This process is especially difficult in a 

publicly traded partnership because there may be numerous 

transfers of partnership interests during any taxable year. 

Furthermore, information provided by the partnership regarding 

53Generally, jurisdiction of the Service Centers is based on 

the residence of the partners (or principal place of business in 

the case of corporate partners). Several (and possibly all) 

Service Centers would necessarily become involved in auditing, 

assessing and collecting deficiencies from the partners of a 

widely held partnership. 
22 

individual partners is often incomplete or incorrect, thus 

requiring the Examination Division to expend considerable 

resources (particularly in the case of larger partnerships) in 

order to determine the proper identity of the partners and to 

develop sufficient information to make assessment possible. 

The Service must then obtain the individual returns of all 

partners. It takes an average of two to three months to obtain 

the return of a partner once it is ordered from the appropriate 

Federal Records Center. If a partner is itself a passthrough 

entity, the process must be repeated. It takes approximately 

four to six months to obtain all partner returns for each tier of 

a multi-tier partnership. The Service also must keep track of 

the statute of limitations for every partner, because, for a 

variety of reasons, partners may have differing statutes of 

limitation. Thus, the Service is required to obtain and monitor 

a significant amount of information concerning each partner. In 

the audit of a large partnership, the cumulative effect of these 

monitoring and information-gathering activities offsets the 

efficiencies afforded the Service by the TEFRA rules. 

(3) The TMP is authorized to exten~ the statute of 

limitations on behalf of all partners. 5 However, if the 

Service is unable to obtain a consent from the TMP which binds 

all partners to an extension of the statute of limitations for 

assessment, the Service must solicit a consent from each 

partner. 55 If one partner fails or refuses to extend the statute 

of limitations for assessment, the Service is forced to issue a 

premature notice of Final Partnership Administrative Adjustment 

(applicable to all partners) or else allow the statute of 

limitations to expire as to the nonconsenting partner. 

(4) A settlement agreement entered into with the TMP will 

not be binding on notice partners and will only bind non-notice 

partners if the TMP expressly makes the settlement binding on 

such partners. Since the TMP of a widely held partnership will 

rarely, if ever, elect to bind other partners, the Service 

generally must deal with the individual partners if it desires to 

settle the entire case. As a result, as the size of the 

partnership increases, there is less incentive on the part of the 

Service to actively attempt to settle the case. This is because 

the Service cannot realistically expect to reach an agreement 

with all of the partners in a widely held partnership, even if 

the TMP agrees to the settlement offer. Since the refusal of 

just one partner to settle could force the Service to litigate 

the case, it would be in the Service's best interests to take a 

hard-line position in settlement negotiations. Consequently, in 

54r.R.C. § 6229 (b) (1) (B). 

55see I.R.C. § 6229(b) (1) (A). 
F-. 

{; 

,. 

23 

the context of a widely held partnership, the existing rules are 

an impediment to resolving the dispute through settlement and 

increase the likelihood of litigation. 

If the Service does enter into a settlement agreement with 

any partner with respect to partnership items, any other partner 

may request consistent settlement terms within (1) 150 days of 

the mailing of the notice of Final Partnership Administrative 

Adjustment ("FPAA") to the TMP or, (2) if l~cer, within 60 days after the settlement agreement was reached. This right 

continues even if all settlement offers have subsequently been 

withdrawn. In widely held partnerships, if the Service follows a 

de minimis approach by not pursuing small adjustments, those with 

greater tax deficiencies may contend they are entitled to the 

same treatment of no adjustment. Thus, the consistent settlement 

rules add to the administrative complexity of dealing with widely 

held partnerships. 

(5) Because each partner has the right to participate in 

both administrative and judicial proceedings, the Service may be 

faced with numerous representatives in a single partnership 

proceeding. This may result in considerable complexity and cause 

confusion both to the Service and the taxpayers' representatives. 

(6) Once adjustments are finalized at the partnership level, 

the Service must compute the tax for each partner, including 

indirect partners, i.e., those holding an interest through a 

passthrough entity or nominee. After the notices are issued, a 

partner who disagrees with the computational adjustment must pay 

the tax, and then may file a claim for refund followed by a 

refund suit if the claim is disallowed. This again raises the 

potential for multiple actions resulting from a single partnership adjustment, although such actions arr limited to the 

computational aspects of the adjustment. 

(7) Deficiencies in one year will frequently give rise to 

refund claims in subsequent years. This can result, for example, 

from timing differences or basis adjustments. The claims may be 

filed by each partner for the overpayment years, thus again 

opening up the possibility of handling large numbers of 

56I.R.C. § 6224(c) (2); Temp. Treas. Reg. 

§ 30l.6224-3T(c)(3)(ii). The TMP is required to forward a copy 

of the notice of FPAA to all non-notice partners within 60 days 

of the date the notice of FPAA was mailed to the TMP. The TMP is 

also required to provide non-notice partners with information 

regarding the Service's acceptance of any settlement offer within 

30 days of receiving information of such acceptance. Temp. 

Treas. Reg.§ 301.6223(g)-1T(b). 

57 I.R.C. § 6230(c). 
24 

individual cases that relate to a single or a few partnership 

adjustments. 

(8) Penalties attributable to a taxpayer's investment in a 

TEFRA partnership must be asserted in separate proceedings with 

the respective partners follo~jng the conclusion of the 

partnership-level proceeding. The assertion of penalties 

against the investors in a widely held partnership is administratively burdensome and significantly increases the inventory of 

cases both under audit and in the Tax Court. Moreover, since 

these penalty proceedings are generally duplicative, conducting a 

separate proceeding with each partner is an inefficient use of 

resources at both the administrative and judicial level and 

seriously undermines one of the principal objectives of having a 

unified, partnership-level proceeding to determine the tax 

treatment of items flowing from the partnership. 

In summary, the audit and administrative procedures were not 

designed for nor do they effectively accommodate widely held 

partnerships. These procedures reflect a balancing between 

certain entity concepts and individual partner protections. This 

balancing is appropriate when applied to small to medium size 

partnerships, in which the number of partners is manageable from 

an administrative standpoint and where there is a substantial 

likelihood that most partners will have a significant investment 

in the partnership. However, when applied to widely held 

partnerships, the individual partner protections seem disproportionate to the rights in need of protection, and present 

significant administrative obstacles. 

Widely held partnerships resemble large corporations in 

their method of operation and capitalization, ~. a large 

number of partners contributing capital to a centralized 

operating organization. Each partner of a widely held partnership generally has an investment comparable to that of a 

shareholder in a comparably sized corporation in terms of dollars 

invested, role in management and rights under state law. In 

auditing a corporation, the Service does not need to deal with 

shareholders directly, but in auditing a widely held partnership, 

the service must deal directly with hundreds or thousands of 

partners in order to complete an examination that results in even 

the simplest adjustment. Moreover, adjustments to the income of 

a widely held partnership that in the aggregate are substantia~ 

are relatively small when applied to the individual partners. 5 

58 I.R.C. § 6230(a)(2)(A) (i); N.C.F. Energy Partners v. 

Commissioner, 89 T.C. 741 (1987). 

59The relative cost of making an adjustment with respect to 

a widely held partnership is likely to increase under the present 

system. In past years, partnership audits were mainly directed 
25 

The present system, when applied to widely held partnerships, 

creates a burden on and results in an inefficient use of the 

valuable and limited resources of the Service. Partners in these 

partnerships should be treated for administrative purposes in a 

manner similar to that of shareholders in a corporation (which is 

subject to entity-level audit), rather than receiving the same 

procedural protections accorded partners in small to medium size 

partnerships. Accordingly. a proposal for a new administrative 

system applicable to widely held partnerships is discussed in 

Section v. 

at tax shelters in which the average annual deficiency per 

partner was substantial (the average deficiencies for tax 

shelters audited from 1983-87 ranged from approximately $18,500-

$22,000). As post-1986 years become subject to audit, due in 

large measure to the enactment of the passive loss rules of 

section 469, tax shelter audits will be reduced and should be 

replaced by audits of partnerships generating income, including 

widely held partnerships. In that setting, although overall 

partnership deficiencies may be substantial, the average 

deficiency on a per partner basis is likely to be relatively 

small. The average size of deficiencies may be further reduced 

with respect to partners in widely held partnerships that are 

actively traded in that interests are often held for short 

periods of time. 
SECTION IV. PROPOSED SIMPLIFIED REPORTING SYSTEM FOR WIDELY HELD 

PARTNERSHIPS 

A. Introduction 

In order to simplify reporting for widely held partnerships, 

encourage correct reporting by partners and aid the Service in 

its compliance monitoring, a simplified system of reporting by 

widely held partnerships is recommended. Such reporting to the 

partners and Service would be accomplished by use of a Form 

1099-K designed for use bv widely held partnerships in lieu of 

the current Schedule K-1. 60 

The present Schedule K-1 is used by all partnerships to 

report their partners' distributive shares of partnership income, 

gain, loss, deduction or credit. The Schedule K-1 form and 

instructions are complex and result in voluminous amounts of 

paperwork being filed with the Service and sent to partners by 

widely held partnerships. While magnetic media filing of 

information returns is permissible, and generally required for 

corporations, few widely held partnerships use magnetic media to 

file with the Service, The volume of Schedule K-1 information 

and the manner in which it is reported on each partner's Form 

1040 does not lend itself to efficient integration into the 

matching programs presently maintained by the Service. The use 

of a Form 1099-K with limited categories of information, as 

described in detail below, would encourage compliance due to its 

simplicity. In addition, reporting limited information would 

ease the reporting burden on widely held partnerships and 

requiring magnetic media filing would provide the Service with a 

more efftpient means of matching partnership data with partner 

returns. 

60section 603l(b) currently requires that partners be 

furnished with either a Schedule K-1 or substituted form by the 

due date of the partnership return (April 15 for a calendar year 

partnership unless extended). If the proposal for the Form 

1099-K is adopted, it is recommended that the due date for 

furnishing the Form 1099-Ks to partners be the same as provided 

in section 603l(b), rather than the January 31 due date 

applicable to other information returns. 

61Although only the term "magnetic media" is used, it is 

meant to encompass any future improvements to include information 

transferred in machine readable form by other means, such as 

electronic filing. 
28 

B. Determination of Partnership Items at the Widely 

Held Partnership Level 

1. In General 

The key to simplification of the reporting of partnership 

income is reduction of the number of items that must be separately reported to partners. Under current law, the Code and 

regulations specifically enumerrte many items that must be passed through separately to partners , and under regulations, any item 

not enumerated must also be passed through if separate treatment 

would affert the calculation of the partner's income tax 

liability. 3 

In the simplest of passthrough systems, an entity such as a 

widely held partnership could in theory pass through a single 

item of income or loss. In such a system, information reporting 

would be as simple as the reporting of interest and dividends 

under current law. For a number of reasons, this level of 

simplicity is not realistically achievable (and may not be 

desirable) at the present time for widely held partnerships. 

However, we believe it would be possible and desirable to 

significantly reduce the number of items to be separately passed 

through to partners of widely held partnerships. 

Set forth in this section is an outline of a proposed 

simplified system for determining and reporting the distributive 

items of widely held partnerships. We recognize that legislation 

amending many sections of the Internal Revenue Code would be 

necessary to implement such a system and that the proposed 

changes would have a substantive impact on the calculation of a 

partner's tax liability. We also recognize that this outline 

does not address all questions that would arise in developing the 

system and in identifying legislative changes that will be 

required to allow for the simplified system. However, we believe 

that implementation of the general approach articulated below 

would represent a significant step towards rationalizing the 

reporting system for widely held partnerships. 

2. Income and Deductions 

Under the proposed approach, all income and expense, 

including capital gains and losses, would be netted at the 

partnership level. In calculating a partnership's net income, 

the application of any limitation with respect to a deduction 

would be determined at the partnership level. For example, under 

current law an election may be made under section 194 to amortize 

62see I.R.C. § 702(a) and Treas. Reg. § 1.702-1. 

63Treas. Reg. § 1.702-l(a) (8) (ii). 
29 

certain reforestation expenditures over a seven year period. The 

maximum ~rount eligible for the election in any taxable year is 

$10,000. In the case of a partnership, this maximum is 

applicable at both the partnership and the partner leve1. 65 

Consequently, a partnership must separately report amortization 

deductions under section 194 to permit partners to calculate 

their individual limitations. Under the simplified reporting 

approach, the section 194 limitation would apply solely at the 

widely held partnership level. Thus, amortization deductions 

under section 194 would be reflected in the widely held 

partnership's net income reported to partners, and would not be 

separately reported. 

Any elections relevant to deductible items would be made by 

the widely held partnership. For example, section 617 allows a 

taxpayer to elect to deduct certain mining exploration expenses. 

If the election is made and the mine eventually reaches the 

producing stage, the expenses must be "recapturlf' by inclusion 

in income or by denial of depletion deductions. Under current 

law, each partner independently decides whether to make the 

election under section 617. 67 Under the simplified reporting 

approach, the section.617 election would be made by the widely 

held partnership, and recapture of section 617 expenses would be 

determined at the partnership level. Thus, any deduction or 

recapture of section 617 expenses would be reflected in the 

widely held partnership's net income. 

Where a limitation on a deduction results in a carryover of 

a deduction, the amount would be carried over at the widely held 

partnership level. For example, under section 175 a taxpayer is 

permitted to deduct soil and water conservation expenses. 

However, the deduction may not exceed 25 percent of the taxpayer's gross income from farming; any excess is carried ovefs 

until the taxpayer has sufficient gross income from farming. 

Therefore, a partnership if required to separately report its 

gross income from farming. 9 Under the simplified reporting 

approach the 25 percent limitation and any resulting carryover 

would be determined at the widely held partnership level. 

64 I. R. C. § 194 (b) (1). 

65 I. R. C. § 194 (b) (2) (B). 

66 I.R.C. § 617 (b). 

67 I.R.C. § 617(b)(2). 

68 I.R.C. § 175(b). 

69see Treas. Reg. § 1. 702-1 (c) (1) (iv). 
30 

Most interests in widely held partnerships are held by 

limited partners who are subject to the passive loss rules of 

section 469 because they do no~ materially participate in any of 

the partnership's activities. 7 Under current law, a widely held 

partnership's operations may be multiple activities for purposes 

of the passive loss rules. In that case, the partnership must 

separately report items of income and deduction from each of its 

activities. One reason separate reporting is necessary is that a 

partner who holds both passive and nonpassive activities through 

a partnership takes only the items from the passfve activities 

into account in applying the passive loss rules. 1 In addition, 

a partner cannot compute the suspended loss allowed on the fully 

taxable disposition of the partner's entire interest in a passive 

activity conducted through the partnership unless the partnership 

has separately reported items from the activity. 72 

Under the simplified system, a limited partner's interest in 

a widely held partnership would be treated as a single activity 

for purposes of section 469. For passive limited partners, all 

items of income and deduction from widely held partnerships will 

be either passive or portfolio. 73 Thus, the only information the 

limited partner would.need to apply section 469 would be the net 

passive income or net passive loss for the partnership as a 

whole, and the partnership would report this information rather 

than separately reporting items from multiple activities. 

Portfolio income (~, interest and dividends) would be 

reported separately from other income, and would be reduced by 

70Temp. Treas. Reg. § 1.469-ST provides that a limited 

partner's participation in an activity is material only if it 

exceeds 500 hours during the taxable year or satisfies one of two 

other tests that consider multi-year participation. It may be 

appropriate to provide that a limited partner's interest in a 

widely held partnership is always passive. 

71This is a minor consideration in the case of limited 

partners because, as noted above, they typically do not 

materially participate in any of the partnership's activities. 

72This is a concern only if the partnership is not publicly 

traded. Under section 469(k), the activities of a publicly 

traded partnership are treated as a single activity for purposes 

of this rule. 

73Expenses that are not treated as passive activity 

deductions under Temp. Treas. Reg.§ 1.469-2T(d)(2) and are not 

portfolio items under section 469(e)(l) would be treated as 

passive deductions for this purpose. For example, charitable 

deductions of a widely held partnership would be treated as 

passive. 
31 

portfolio deductions and allocable investment interest expense. 

Further, to reflect the 2 percent floor limitation imposed on 

miscellaneous itemized deductions at the individual level, it 

will be necessary to reduce such deductions by an arbitrary amount(~, 50 percent). To the extent there is excess 

investment interest, it would be carried over at the partnership 

level. 

Netting of capital gains and losses would occur at the 

widely held partnership level. Thus, capital gains would be 

consolidated with other reported income, and an individual 

partner would not be able to net partnership capital gains and 

losses on his or her individual income tax return. Any excess of 

capital losses over capital gains would be carried over at the 

widely held partnership level. Therefore, an individual partner 

would not receive the benefit of the limited annual offset of 

capital loss against ordinary income allowed under current law. 

If a capital gains preference is enacted, a widely held partnership should be able to take advantage of a preferential rate 

without reporting its capital gains separately. If a deduction 

(or exclusion) is permitted for long term capital gains, as under 

pre-1987 law, the partnership would determine its long term 

capital gains, compute the appropriate deduction, and reduce net 

income to be flowed through to partners. 

Alternative minimum tax adjustments and preferences would be 

combined and allocated to partners. To apply the passive loss 

rules, it will be necessary to report portfolio income minimum 

tax items separately from other minimum tax items. Tax-exempt 

interest would be shown as a passthrough information item because 

of its significance in the taxation of social security benefits. 

3. Allocations 

Under the simplified reporting system, a single amount of 

net taxable income or loss would be reported to each partner. 

Therefore, widely held partnerships would not be able to report 

to partners specially allocated items of income or deduction. 

This does not mean, however, that widely held partnerships would 

be required to allocate all items on a pro rata basis. Pro rata 

allocations would deprive partnerships of any flexibility in 

income allocations, and would cause serious transitional 

difficulties for existing partnerships. 

A degree of flexibility could be achieved by allowing 

special allocations of those items which are separately reported 

on the Form 1099-K.~ Taxable income would therefore be 

~Allocations would, of course, be required to satisfy the 

rules of section 704(b) and the regulations thereunder (~, the 

substantial economic effect test). 
32 

allocable on a bottom line basis. For example, assume 

Partnership X has $10 million of rental income, $3 million of 

depreciation deductions attributable to its rental activities, 

and no other items. On a bottom line basis, it would allocate $7 

million of passive income among its partners. Portfolio income 

could similarly be allocated on a bottom line basis. Alternative 

minimum tax adjustments would be allocated in accordance with the 

allocation of passive and portfolio taxable income. Tax exempt 

interest and credits would be reported separately, so that 

separate allocation of these items should be feasible under the 

simplified reporting system. 

Further flexibility could be achieved by allowing widely 

held partnerships to allocate gross income (whether portfolio or 

passive) and total allowable deductions as determined at the 

partnership level. Partnership X could therefore allocate the 

$10 million rental income and the $3 million depreciation 

deductions independently, although each partner would still be 

reported a single item of passive income or loss. Where a 

limitation on a deduction applies at the partnership level, it 

would reduce the total allowable deductions. This approach would 

permit a particular deduction to be effectively allocated to a 

particular class of partners, without requiring reporting of the 

deduction separately from the partners' share of other income or 

deductions reported on the Form 1099-K. 

4. Credits 

a. Consolidated Tax Credit 

Under the proposed simplified approach, credits would 

generally be determined at the partnership level and would be 

passed through to partners as a single combined item on the Form 

1099-K. Each credit typically has its own set of special rules (~, carryover provisions) l these rules would have to be 

examined and altered where necessary to apply at the partnership 

level. We believe that in most cases it will be possible to 

restructure credit limitations to permit consolidation. In the 

case of credits which are consolidated for reporting purposes, 

recapture would necessarily occur solely at the partnership 

level, as a partner would not be able to determine his or her 

recapturable amount upon disposition of a partnership interest. Thu~itre~apture of any type of nonseparately-reported investment ~~~ wo ~dght occur if the partnership disposed of the property, 

It wou~d ~ot occur upon disposition of any partner's interest. 

rcenta a so be possible to deem the transfer of a specified ~thouqhg~h~f interests in a partnership to be a recapture event, 

treataent ofsw~~p~oach would not be consistent with entity-level 

either offset c edl-held partnerships. The partnership could 

any recapture l~:bii·recapture against current credits, satisfy ~ty itself, or could increase taxable income 
33 

in the year of recapture by the amount necessary to recapture the 

credit assuming a partner-level tax rate. 

It should be possible to consolidate many credits for 

reporting as a single item. However, at least three credits (low 

income housing credit, rehabilitation credit, and credit for 

withheld taxes) may require separate reporting. The foreign tax 

credit also poses a number of particular issues. These credits 

are discussed below. 

b. Separately-Reportable Credits 

The low income housing credit and the rehabilitation credit 

are subject to special favorable treatment under the passive loss rules.~ It would be impossible for partners to take advantage 

of these rules without separate reporting of each credit. On the 

other hand, most widely held partnerships will not generate these 

credits. To keep the Form 1099-K as simple as possible in most 

cases, only partnerships which are significantly engaged in 

activities anticipated to generate these particular credits 

should be permitted to report them as separate items. For 

example, unless a partnership's assets are substantially comprised (~, at least 50 percent) of low income housing, it 

would not be permitted to separately report the low income 

housing credit. Similarly, unless a partnership's assets are 

substantially comprised of real property, it would not be 

permitted to separately report the rehabilitation credit. If a 

partnership not substantially engaged in the relevant activity 

were to generate one of these two credits, it would.report the 

credit together with any other credits as part of the general tax 

credit (line 5) reported on the Form 1099-K. 

Under the Partnership Collection Proposal, a partner may be 

entitled to a credit for partnership payments which would be 

refundable to the extent it creates an overpayment.n The 

refundability feature would distinguish this credit from other 

credits, and would require the credit for partnership payments to 

~Section 469(i) exempts these credits from the passive 

credit limitations to the extent they are equivalent in their 

effect on tax liability to a specified amount of deductions. The 

deduction equivalent of the credits allowed under this rule is 

generally $25,000, but the $25,000 amount is reduced by the 

amount of losses and the deduction equivalent of other credits 

allowed under section 469(i) and, in the case of the 

xehabilitation credit, by 50 percent of the amount by which 

adjusted gross income (computed with certain modifications) 

exceeds $200,000. 

usee Section V (D) of this report. 
34 

be reported separately.n Since it will not be common for 

partnerships to have such a credit, the Form 1099-K will report 

this item only for partnerships that have had a final 

determination during the taxable year. 

c. Foreign Tax Credit 

Under current law, taxpayers have the option of choosing to 

deduct or claim a credit against u.s. tax for certain foreign 

taxes paid or accrued by the partnership.~ Most taxpayers 

choose to credit their foreign income taxes against U.S. income 

tax. The credit option is subject to a complex set of limitations. Under section 904, creditable foreign taxes must be 

allocated to a specific basket or category of income, and within 

each basket the foreign tax credit is subject to a ceiling that 

is determined by reference to the amount of income in that 

basket. In determining the amount of income in each basket and 

the amount of foreign taxes paid or accrued with respect to that 

income, a partner of a partnership is treated as directly earning 

his or her distributive share of the partnership's income and 

directly paying the foreign tax, i.e., a partnership generally is 

treated as an "aggregate" rather than as an "entity" for this 

purpose. Under current law, each partner's distributive share of 

foreign taxes paid or accrued by the partnership is separately 

stated on Schedule K-1, in order to provide the partner with the 

information necessary to combine foreign taxes paid or accrued by 

the partnership with other foreign taxes paid or accrued by the 

partner in computing his or her foreign tax credit limitation. 

Partnership Level Credit. In order to avoid the complexity 

associated with a separate listing of foreign taxes and income on 

Form 1099-K, the foreign tax credit limitations should be applied 

at the widely held partnership level. All elections and 

computations concerning foreign tax credits would then be 

determined at the partnership level, as are other elections and 

computations under the simplified reporting system. A widely 

held partnership would have an annual election to deduct or 

credit foreign taxes paid or accrued; any carryovers of such 

items would be at the partnership level. In order to apply this 

concept, the credit for foreign taxes paid or accrued would be 

determined by using an assumed u.s. tax rate for the partnership. 

The amount of foreign taxes paid or accrued by the partnership 

which could be claimed as a credit against u.s. tax on the income 

in a particular foreign tax credit limitation basket would be 

limited to an amount equal to u.s. taxes (calculated at the 

nThe same issue would arise if in the future partnership 

withholding were to be instituted. See Section IV (G) of this 

report. 

~ I.R.c. §§ 901 and 903; I.R.c. § 164 (a) (3). 
35 

assumed rate) on the foreign source income in that basket. All 

partnership income would be reported at the partner level as 

having a u.s. source. 

This approach could be applied by using all of the 

limitations and separate baskets provided under current law. The 

foreign tax credit passed through to the partners would be the 

sum of all the separate foreign tax credit limitations. This sum 

would be included as part of the consolidated tax credit on the 

partners' Form 1099-Ks, and reported by partners directly on 

their tax returns. 79 The choice of an assumed tax rate for the 

partnership in making the foreign tax credit calculation would 

have a substantial effect on the partners. A low assumed rate 

would reduce the amount of foreign tax credits available to 

offset u.s. income tax liability of the partners and would be 

detrimental to those partners whose marginal rate is higher than 

the assumed rate. Conversely, if a higher assumed rate were used 

by the partnership, those partners who actually are subject to a 

lower marginal rate would receive the benefit of foreign tax 

credits to which they would otherwise not be entitled. 

Partner Level Credit. As an alternative method, foreign 

income and foreign taxes paid could be reported separately to 

partners on the Form 1099-K. An additional line on the Form 

1099-K would show the foreign source portion of any income item, 

and another line would show the amount of foreign tax paid or 

accrued (the amount which results from netting lines 17(e) and 

17(f) of the current Schedule K-1). 

As stated above, foreign taxes paid or accrued generally are 

creditable only against u. s. income tax on the specific baskets 

of income to which the foreign taxes relate. Special rules apply 

to limited partners (and corporate general partners) who own 

less than 10 percent of the value of the partnership (based on 

profits or capital interests). These partners must treat their 

distributive shares entirely as passive income for foreign tax 

credit purpoies, regardless of the type of income earned by the 

partnership. 0 There are two exceptions under current law to 

passive income treatment which it may be possible to eliminate in 

order to facilitate simplified partner level reporting. Under 

the first exception, the distributive portion of each partner's 

interest income which is "high withholding tax interest" continues to be treated as such for foreign tax credit purposes. 

Under this rule, interest income which would otherwise be in the 

passive basket is placed in a separate basket if such income is 

subject to a foreign withholding tax of 5 percent or more. The 

79with respect to the treatment of foreign partners of a 

widely held partnership, see footnote 104. 

80Treas. Reg. § 1.904-5(h). 
36 

effect of the high withholding tax basket is generally unfavorable to taxpayers, because tax credits associated with such 

income cannot be used to offset u.s. tax on low-taxed or untaxed 

income in the passive basket. While some revenue loss would 

result from eliminating this exception, the effect would not be 

large if the proposal were applied only to a limited class of 

partnerships. Under the second exception to passive income 

treatment under current law, a distributive share from a partnership interest held in the ordinary course of the partner's active 

trade or business receives look-through treatment for purposes of 

section 904. This exception generally applies to small corporate 

general partners in the oil and gas industry, and is a special 

relief provision for those taxpayers. Eliminating this exception 

would adversely affect a small number of taxpayers. If these 

exceptions were eliminated for partners owning less than 10 

percent of the partnership interests, reporting of foreign source 

income and foreign taxes would require no more than two 

additional lines on the Form 1099-K. 81 

5. Other Reporting Issues 

As proposed, the.Form 1099-K would not require the separate 

reporting of unrelated business .taxable income ("UBTI"). Under 

currey} law, all income of a publicly traded partnership is 

UBTI, but this is not the case for other widely held partnerships. To prevent evasion of the UBTI rules, it might be 

necessary to require separate reporting of income that would be 

UBTI to tax exempt partners or treat all income of any widely 

held partnership as UBTI. 

Oil and gas issues present special concerns, in large part 

because of the unique treatment of oil and gas properties held by 

partnerships. Under the Code, percentage depletion is disallowed 

to certain taxpaKers, and is significantly restricted for all 

other taxpayers. 3 Partnerships must allocate basis in and 

81These exceptions should probably not be eliminated for 

partners holding 10 percent or more of the interests in a widely 

held partnership. Thus, the treatment of the foreign tax credit 

may have an impact on whether large partners should be excluded 

from the simplified reporting system. See Section IV (E). 

82 I.R.C. § 512 (c) (2). 

83Retailers and refiners are prohibited from claiming 

percentage depletion with respect to oil and gas properties. 

I.R.C. § 613A(d). Other taxpayers are permitted to claim 

percentage depletion on production not in excess of the 

taxpayer's depletable oil quantity of 1,000 barrels of production 

per day, subject to a number of other restrictions. I.R.C. 

§ 613A(c). 
37 

production from oil and gas properties to partners. 84 In 

addition, partnerships must report a significant amount of 

information on a property-by-property basis to each partner to 

permit the partner to calculate his or her depletion limitation.85 These allocation rules are inconsistent with the basic 

goals of the simplified reporting proposal. 

Detailed reporting of oil and gas items could be avoided by 

prohibiting the use of percentage depletion by widely held 

partnerships, and instead require cost recovery of their 

properties to occur through the generally less favorable cost 

depletion method. Alternatively, partnerships could be permitted 

to claim the amount of percentage depletion permitted a single 

taxpayer, with any remaining depletion calculated under the cost 

method. This alternative would allow the benefit of percentage 

depletion to partners who would not otherwise be eligible with 

respect to the partnership's properties, either because, for 

example, a partner is ineligible for percentage depletion or the 

partner's share of production from other properties exceeded the 

maximum allowable depletable production. This effect would, 

however, be relatively minor with respect to any partner, as a 

widely held partnership's percentage depletion deductions would 

be spread among its many partners. Under either method, items 

relating to depletion would not be reported separately. However, 

this would not allow depletion to be calculated by each partner, 

as under current law. 

To permit partners in widely held partnerships to calculate 

percentage depletion separately as under current law, it would be 

necessary to design a special reporting form for widely held 

partnerships engaged in oil and gas exploration and production. 

Standards would have to be established to determine eligibility 

for this special reporting. The unique tax treatment of oil and 

gas properties held by partnerships may justify a more complex 

reporting form. 

6. Reporting Form 

To summarize, the following categories or spaces would 

appear on the simplified reporting Form 1099-K: 

(1) Passive income (loss) 

(2) Portfolio income (loss) 

(3) Passive AMT adjustments and tax preferences 

(one amount) 

(4) Portfolio AMT adjustments and tax preferences 

(one amount) 

84I.R.C. § 613A(c) (7) (D). 

85IJ;L_ see Prop. Treas. Reg.§ 1.613A-3(j). 
38 

(5) Tax credit 

(6) Tax-exempt interest 

All widely held partnerships would be required to provide a 

standard Form 1099-K to their partners. No substitute or 

alternative versions of the form would be permitted. Thus, 

partners in widely held partnerships would receive uniform 

information documents. 

7. Possible Further Simplification 

The simplified system discussed above represents a general 

approach to determining and reporting partnership income for 

widely held partnerships that would substantially reduce the 

reporting burdens of partnerships and their partners and the 

administrative burden of the Service. The particular items 

listed on the proposed Form 1099-K are illustrative of the 

suggested simplification. The list of separately reported items 

could of course be expanded, although at the cost of additional 

complexity. On the other hand, the number of items on the 

1099-K could be further reduced. For example, the "Tax credit" 

line could be eliminated by converting the credit amounts into 

deductions. The net credit amount would be "grossed up" into a 

deduction at the partnership level by using an assumed tax rate. 

Thus, if a partnership had credits of $5,000, the grossed-up 

deduction would equal $22,727 if 22 percent were used as the 

assumed tax rate for this puri~se (midway between the 15 percent and the 28 percent brackets). This amount would be treated the 

same as any other partnership deduction and would be reflected as 

an adjustment to taxable income reported to partners on the Form 

1099-K. 

The "Tax-exempt Interest" item could also be eliminated, but 

only by treating such interest as taxable. If interest is taxexempt, separate reporting is essential in order to provide 

individual taxpayers receiving social security benefits wkth the 

data necessary to calculate their separate tax liability. 7 

Hence, the "Tax-exempt Interest" item could only be eliminated by 

removing the tax exemption on such interest for partners of these 

partnerships and by treating interest that is currently tax 

exempt in the same manner as other taxable interest includible in 

portfolio income. Separate reporting of the low income housing 

credit and the rehabilitation credit could also be prohibited for 

widely held partnerships, even those substantially engaged in 

86A higher assumed tax rate would result in a larger 

grossed-up deduction and a lower rate would result in a smaller 

deduction. 

87social security benefits become taxable when certain 

income levels are reached. 
39 

these activities. This would prevent partners from taking 

advantage of the special treatment afforded these credits under 

the passive loss rules. The resulting inability of partners to 

take advantage of the current law favorable treatment of taxexempt interest and the low income housing and rehabilitation 

credits illustrates that there may be adverse consequences to 

further simplification of the reporting form. 

8. Examples 

The following examples illustrate the operation of the 

simplified reporting system in a number of fact patterns. 

EXAMPLE 1 Assume the individual taxpayer receives a Schedule 

K-1 under present law which indicates the following items: 

Ordinary income $ 400 

Net rental loss 300 

Dividends 55 

Interest 125 

Net short-term capital 

losses 500 

Net long-term capital 

gains 400 

Investment interest 

expense $90 

Charitable contribution 5 

Misc. portfolio deductions 20 

The individual is a limited partner and the ordinary income and 

rental loss result from passive activities. The capital losses 

and gains result from assets held for investment purposes and the 

miscellaneous deductions are subject to the 2 percent limitation. 

Assuming the net capital loss, charitable contributions and 

miscellaneous deductions can be fully deducted on the 

individual's8return, taxable income of $65 would result under 

current law. Under the proposal, the only reportable items 

would be passive income of $9j and portfolio income of $80, for a 

total taxable income of $175. 9 

The difference of $110 ($175-65) in the calculation of 

taxable income under current law and the proposal is due to the 

net capital loss of $100, which under the proposal carries over 

at the partnership level and can be used in a later year, and $10 

representing the 50 percent adjustment to the miscellaneous 

deductions not allowed under the proposed treatment. 90 Both of 

88current law: $400-300+(55+125)-(500-400)less(90+5+20)=$65. 

89Proposal: $400-300-5=$95 Passive. 

$55+125-90-l0(20x50%)=$80 Portfolio. 

90This represents an adjustment to reflect the 2 percent 

floor limitation on miscellaneous itemized deductions. 
40 

these items, the capital loss and the miscellaneous deduction, 

may or may not be deductible at the taxpayer level due to various 

limitations. In this example, two items would be reported on 

Form 1099-K versus nine on the present Schedule K-1. 

EXAMPLE 2 The individual is a partner in a publicly traded 

partnership and the Schedule K-1 under present law indicates the 

following items: 

Ordinary loss 

Net rental loss 

Dividends 

Interest 

$ 200 

500 

400 

300 

Misc. portfolio deductions$100 

Investment interest 

expense 800 

The losses are passive and taxable income or loss under both the 

current and proposed system would be zero. There would be a 

passive activity loss carryover of $700 in both cases and an 

investment interest expense carryover of $200 under current law 

to the indiv~pual partner assuming no other interest to offset 

the expense. Under the proposal there would be a carryover of 

$150 to the partnership due to the excess investment interest 

(because of }re 50 percent allowance for miscellaneous 

deductions). In this example, two items would be reported on 

Form 1099-K versus six on the present Schedule K-1. 

EXAMPLE 3 The individual is a partner in a publicly traded 

partnership and the Schedule K-1 under present law indicates the 

following items: 

Ordinary loss 

Net rental loss 

Sec. 179 expense 

Targeted job credit 

Recapture of low-income 

housing credit 

$ 700 

100 

70 

20 

10 

Foreign taxes paid 

Foreign source income 

(included in ordinary 

loss) 

$ 5 

150 

The losses are passive and under current law the partner would 

report a passive activity loss of $870 (including the $70 section 

179 deduction) and a disallowed passive activity credit of $20. 

The foreign tax credit is not subject to the passive loss rules. 

91current law: $200+500=$700 Passive loss. 

$400+300-100-{800-200 carryover)= $0 Portfolio. 

92Proposal: $200+500=$700 Passive loss. 

$400+300-50(lOOx50%)-(800-150 carryover) = $0 Portfolio. 
41 

The partner would incur a current recapture tax of $10. 93 Under 

the proposed system, the reportable items would include a 

disallowed passive loss of $875 and a disallowed passive activity 

credit of $10 (as~fming the recaptured credit was offset against 

the jobs credit). In this example, two items would be reported 

on Form 1099-K versus seven on the present Schedule K-1. 

c. Elimination of Non-Income Items 

The present Schedule K-1 reports a substantial amount of 

non-income information. Items A through J of Schedule K-1 report 

information concerning each partner, including whether the 

partner is general or limited, a domestic or foreign person, the 

type of entity, the partner's share of liabilities, the partner's 

percentage interest and acquisition date. In addition, the form 

requests the following information about the partnership: where 

the return was filed, Tax Shelter Registration Number, if any, 

whether publicly traded, foreign countries to which taxes were 

paid, and whether the current Schedule K-1 is an amended one. As 

proposed, none of these items would be reported on the Form 

1099-K. The only non-income information reported on the Form 

1099-K would be the taxpayer's name, address and taxpayer 

identificatior number and the same information for the 

partnership. 9 Any additional relevant information could be 

furnished upon examination or on separate schedules with the 

partnership return of income. 

Item K on the present Schedule K-1 records the partner's 

capital account activity for the year. The amounts in the 

capital account analysis reflect various additions and deductions 

to the account during the taxable period, including contributions of capital and distributions to the partner, as well as 

taxable income or loss and other amounts reflected on the 

return. The capital account information is probably not 

necessary for an individual partner's computation of his or her 

separate tax liability. In contrast, it is necessary for 

partners to maintain information as to the bases of their 

partnership interests. Although neither basis nor capital 

account information is included on the Form 1099-K, partnerships 

93current law: $800+70=$870 Passive loss. 

section 179 deduction is not limited by section 

partner level. 

This assumes the 

l79(b) at the 

94Proposal: $700+100+70+5=$875 Passive loss. 

$20-10=$10 Disallowed credit. The result in the example assumes 

that the partnership has elected to deduct foreign taxes paid. 

95we recognize that in implementing this proposal certain 

other non-income items may be determined necessary for inclusion 

on the Form 1099-K. 
42 

should be required to separately provide basis information. 

Similarly, partnerships should be required to reflect any section 

743(b) adjustments in computing the partners' shares of taxable 

income. Even without a specific requirement, however, we assume 

that partnerships would generally provide the information 

necessary for partners to compute and fUbstantiate their tax 

bases in their partnership interests. 9 

D. Magnetic Media Filing 

Each widely held partnership would be required to provide 

Form 1099-K data to the Service by magnetic media. Partnerships 

are now fermitted, but not required, to use such means for 

filing. 9 Once a partnership is required to file using magnetic 

media under this provision the requirement would continue 

indefinitely, as a partnership that meets the definition of a 

widely held partnership will continue to be treated as such until 

the Commissioner grants permission for a change in status. 98 

The instructions for the Form 1099-K would cover the 

items mentioned above and key each item, where appropriate, to a 

specific line on Form.1040 and its schedules or to a special 

schedule which would be used to accumulate Form 1099-K 

information from partnerships and thus facilitate the matching of 

information from widely held partnerships to the partner's 

return. 

E. Treatment of Large Partners 

It is not clear whether partners holding significant 

percentage interests in a widely held partnership should 

participate in the simplified reporting system. Interests held 

by such partners are excluded from the current assessment system 

proposed by this report, 99 but the considerations are somewhat 

different under the reporting system. The calculation of taxable 

96currently, no complete basis information is provided to 

the partners. The capital account information included on the 

Schedule K-1 may correspond to a partner's tax basis (excluding 

the partner's share of liabilities) in his or her partnership 

interest. 

97Although this recommendation of mandatory filing by 

magnetic media would apply only to widely held partnerships, no 

inference should be drawn with respect to whether such filing may 

be required of other partnerships in the future. 

98see Section VII of this report. 

99see discussion at Section v (D) (1) and V (D) (5) of this 

report. 
43 

income may become substantially more complex if the income 

reported to partners with at least a five or ten percent interest 

is determined separately from the income reported to the 

remainder of the partners. On the other hand, if large partners 

were allowed to use the simplified reporting system, they might 

in some cases be able to use widely held partnerships to avoid 

various restrictions. For example, depending on the manner in 

which the foreign tax credit is calculated by widely held 

partnerships, taxpayers may derive a material advantage from 

generating certain income through such a partnership. Until the 

precise rules of the simplified reporting system have been 

formulated, it is difficult to predict the extent to which 

simplified reporting for large partners would present opportunities for tax abuse. Accordingly, this report makes no 

recommendation with respect to the treatment under the simplified 

reporting system of partners holding significant interests in 

widely held partnerships. 

F. Summary of Simplified Reporting Issues 

The potential advantages of a simplified reporting system 

are threefold: 

(1) The widely held partnership would experience a 

significant reduction in the number of forms and correspondence 

sent to the Service and to partners with a corresponding 

reduction in associated costs. 

(2) The partner would receive a one page form, similar to 

other information forms such as a Form w-2 for wages or the Form 

1099 used for interest, which would be familiar and relatively 

simple. Such a system would be more understandable than the 

present system and would thus encourage compliance. 

(3) The Service would receive data by magnetic media which 

would be used to provide a more efficient matching of data to the 

information reported by partners on their returns and would 

thereby enhance compliance with reporting requirements. 

By implementing a simplified reporting system, the 

calculation of income and related items would be altered with 

respect to widely held partnerships. The goal of these proposed 

changes is not to increase or decrease the overall tax due with 

respect to such partnerships. Rather, the goal is to produce a 

simplified system that, within the constraints of a radically 

simplified Schedule K-1, approximates the current law calculation 

of taxable income and related items as closely as possible. 

Nonetheless, we recognize that the total income tax attributable 

to a partnership subject to the simplified reporting system would 

almost certainly vary to some degree from the total income tax 

under the current rules. This raises two principal concerns. 
44 

The first concern is that, given the recent history of tax 

law changes that have adversely affected investment partnerships, 

the redefinition of the calculation of a widely held partnership's income will be structured to increase the overall tax due. 

That is not the intent of the proposed simplified reporting 

system. The goal of the proposal is to simplify the reporting 

system rather than to raise revenue, other than revenue 

attributable to improved compliance. 

The second concern is that certain partnerships will be 

able to take advantage of any variations in income calculation by 

selecting the most beneficial system. For example, a partnership 

with 200 partners might restrict entry of new partners if it 

feared that the simplified reporting system would significantly 

increase overall taxable income. If the system is properly 

designed, any income calculation advantage or disadvantage to a 

partnership will be minimal, thus reducing r~s incentive to 

target growth for a marginal tax advantage. Furthermore, once 

a partnership becomes subject to the simplified reporting system 

as a widely held partnership, it will not be able to wir~draw 

from the system without permission of the Commissioner. 1 

Therefore, partnerships will not have the ability to move in and 

out of the simplified system at will. These factors should 

minimize the impact of any variations in income calculation that 

may arise under the simplified reporting system. 

G. Withholding 

As a general matter, in tax administration, it is axiomatic 

that if third parties report to the Service the income they pay 

to individuals, compliance in reporting that income markedly 

improves. Withholding of tax at the source has generally proven 

to be an even more effective means of assuring compliance. At 

present, withholding is mainly imposed on certain limited categories of items, including wages, tips, supplemental unemployment 

benefits, and gambling and lottery winnings. Dividends and 

interest are subject to information reporting, but not withholding unless the backup withholding provisions apply. 102 Not 

100Nonetheless, as noted above, the possibility of 

differences in income calculation may necessitate the exclusion 

of large partners from simplified reporting. 

101see Section VII of this report. 

102I.R.c. § 3406. In certain instances, withholding is 

voluntary (~, pension distributions, annuity payments, sick 

pay). I.R.C. §§ 3402 and 3405. 
45 

surprisingly, service studies indicate that complfcrce levels are 

highest in areas in which withholding is imposed. 

Partnership distributions are different from wages, interest 

or dividends, in that partnership distributions may consist not 

only of current income, but also advances on estimated income 

(drawings), or return of capital. Under current law, neither 

income nor distributions of a domestic partnership ar~ fUbject to 

withholding, except as to nonresident alien partners. 0 

103Gross Tax Gap Estimates and Projections, at 5-6. 

10411 Inbound transactions," that is transactions giving rise 

to income from U.S. sources paid to foreign persons, are subject 

to a reporting and payment system which operates in addition to 

and independently of the reporting system applicable to partners 

generally. The reporting and withholding system applicable to 

foreign partners is beyond the scope of this report and will not 

be affected by the proposals made herein. 

Section 1446, as amended in 1988, currently requires a u.s. 

or foreign partnership with effectively connected taxable income 

allocable to a foreign partner to pay a u.s. withholding tax with 

respect to that partner's allocable share of that income in the 

time and manner prescribed by the service. Rev. Proc. 89-31, 

1989-20 I.R.B. 136 (May 15, 1989), implements this section and 

provides that affected partnerships must generally pay a 

withholding tax, without regard to distributions, on a quarterly 

basis based upon 28 or 34 percent of the effectively connected 

taxable income allocable to foreign noncorporate and corporate 

partners, respectively. The Revenue and Reconciliation Act of 

1989 amended section 1446 to clarify that the Service is 

authorized to apply the corporate estimated tax rules and 

penalties to partnerships to compute and enforce the quarterly 

payment requirement. Publicly traded partnerships are allowed to 

withhold on distributions at a flat 28 percent rate, but these 

partnerships may elect to make quarterly payments without regard 

to distributions. 

Section 1446 withholding overrides section 1445(e) (1) 

withholding. Under section 1445(e) (1), a domestic partnership is 

required to withhold 34 percent of a foreign partner's net gain 

attributable to the partnership's disposition of a u.s. real 

property interest. Generally, section 1445(e)(1) withholding is 

to be made by the partnership within 20 days of the disposition 

of u.s. real property, but publicly traded partnerships and any 

other partnerships with more than 100 partners generally defer 

the payment of the section 1445(e) (1) withholding tax until a 

distribution attributable to the sale proceeds is made. 
46 

We do not recommend withholding for widely held partnerships 

at this time. Under the proposed reporting system with required 

magnetic media filings, it is expected that the Service will be 

able to include the Form 1099-K information in its document 

matching program and the Information Returns Program procedures. 

Moreover, the ability of partnerships and the Service to 

determine the identity of persons holding interests has been 

significantly improved through the enCJctment of the nominee 

reporting system of section 6031(c). 1 5 Thus, the Service should 

be able to more efficiently match Form 1099-K information with 

that reported on the partner's return. 

The Service continues to evaluate the level of compliance 

by partners of widely held partnerships and the possibility of 

recommending the institution of withholding, if necessary, to 

ensure that adequate standards of reporting and collection are 

maintained. 

H. Ownership Changes 

The issues arising under subchapter K of the Code that have 

particular relevance to widely held partnerships generally relate 

to the tax impact of ownership changes of interests in these 

partnerships. The ownership change issues are especially important to publicly traded partnerships because interests may be 

frequently traded and must remain fungible in the marketplace. 

This section will briefly discuss the subchapter K issues with 

respect to (1) fungibility, {2) constructive terminations, 

(3) accounting conventions for allocations of income, and 

(4) information reporting. 

1. Fungibility 

For partnership interests to be fungible, any interest 

purchased must possess the same tax characteristics to the buyer, 

regardless of the tax characteristics that interest had in the 

hands of the seller. Under current law, application of certain 

technical rules of subchapter K can result in buyers holding 

105under I.R.C. § 6031(c)(1), any person who holds an 

interest in a partnership as nominee for another person is 

required to furnish to the partnership the name and address of 

such other person, and any other information for such taxable 

year as may be prescribed by form and regulation. The nominee is 

also required to furnish such other person with the information 

provided by the partnership on the Schedule K-1. 
47 

partnership interests that are identical, as an economic matter, 

but that possess substantially differing tax characteristics 

depending on the identity of the seller of each interest. 

In general, under subchapter K, the purchaser of a 

partnership interest takes a basis in partnership assets equal to 

his or her pro rata share of the partnership's basis in those 

assets. If an election is made under section 754, however, the 

purchaser's basis in partnership assets will be adjusted under 

section 743{b) to reflect the purchase price of his or her 

partnership interest. The basis adjustment is made with respect 

to the purchaser only, and does not affect any other partner's 

proportionate share of basis in partnership assets. Under the 

regulations for section 743{b), the purchaser partner's share of 

basis in partnership assets prior to adjustment is determined by 

reference to the transferor partner's share of basis in those 

assets. Publicly traded partnerships typically make a section 

754 election so that purchasers will not inherit tax attributes (~, unrealized appreciation) unrelated to the purchase price 

of their units. Moreover, under current law, a section 754 

election may be necessary to prevent different units in a 

publicly traded partnership from having different tax attributes, 

i.e., to make the units fungible. 

Under section 704{c), income, gain, loss, and deduction with 

respect to contributed property must be shared among partners so 

as to take account of the variation between the basis of the 

contributed property in the partnership and its fair market value 

at the time of contribution. The object of that section is to 

prevent gain or loss inherent in property at the time of 

contribution from being shifted from the contributing partner to 

noncontributing partners. ~ As a result of section 704{c), 

partnership units may have different tax attributes because they 

are subject to different allocations under section 704(c). A 

basis adjustment under section 743(b), however, generally will 

eliminate any difference between partnership units caused by 

section 704{c) unless the "ceiling rule" has affected the 

application of section 704(c). 

The "ceiling rule" of section 1. 704-1 (c) (2) of the 

regulations may prevent section 704(c) allocations from eliminating the disparity between adjusted basis and fair market value 

106The principles of section 704 (c) are also to be applied 

when a partnership revalues its property for purposes of section 

704(b) upon the occurrence of certain events, including the 

admission of a new partner. Treas. Reg. § 1.704(b)-l{b) {4) (i). 

See also Treas. Reg. §§ 1.704(b)-l(b}(2) (iv) (f) and (g). 

Allocations made pursuant to such a revaluation are frequently 

referred to as "reverse section 704(c) allocations," and the 

discussion herein applies equally to. such allocations. 
48 

of contributed property over time. Under the ceiling rule, the 

total depreciation, depletion, or gain or loss allocated to the 

partners cannot exceed the amount of gain or loss realized by the 

partnership or the depreciation or depletion allowable to the 

partnership. If the ceiling rule applies, allocations under 

section 704(c) cannot prevent gain or loss inherent in 

contributed property from being shifted to noncontributing 

partners. Moreover, a basis adjustment under section 743(b) 

cannot eliminate differences between partnership units caused by 

the application of the ceiling rule. Accordingly, if the ceiling 

rule limits the allocations that may be made under section 

704(c), different units carry different tax characteristics even 

after section 743(b) adjustments have been made, and the units 

thus are not fungible. 

Regulations under section 704(c) may address the problems 

caused by application of the ceiling rule. 

2. Constructive Termination Under Section 708 

Section 708(b) (1)(Bl provides that a partnership will be 

considered as terminated 0 if within a 12-month period there is 

a sale or exchange of 50 percent or more of the total Jnterests 

in partnership capital and profits. The regulations 0 clarify 

that multiple sales of the same interest during the 12-month 

period are treated as the sale of a single interest for purposes 

of applying the 50 percent rule. In addition, a disposition of a 

partnership interest by gift, bequest or inheritance, or the 

liquidation of a partnership interest is not a sale or exchange 

for purposes of section 708(b)(l)(B). 

Because it is generally impractical for publicly traded 

partnerships to match transferors and transferees of particular 

units traded on the securities market, publicly traded 

partnerships in many cases will be unable to determine whether a 

termination under section 708 has occurred during a given 

year. 109 Moreover, the administrative proposals recommended 

107Treas. Reg. § 1.708-1(b) (1) (iv) provides that in a 

constructive termination under section 708(b)(1)(B) there is a 

deemed distribution of all partnership property and a deemed 

contribution of such property to a "new" partnership. 

108Treas. Reg. § 1.708-1(b) (1) (i). 

109Publicly traded partnerships generally will be unable to 

determine whether a particular unit has been transferred more 

than once during a year, or whether a transfer was made by gift, 

bequest or inheritance. In certain situations, however, publicly 

traded partnerships will be able to determine whether a 

termination under section 708(b)(l)(B) has taken place(~, if 
49 

herein disregard terminations under section 708(b) (1) (B) for 

audit and collection purposes. Accordingly, consideration should 

be given to narrowing or eliminating the application of section 

708 to widely held partnerships. 

3, Accounting Conventions 

Under section 706(c) (2), the taxable year of a partnership closes with respect to a partner who disposes of his or her 

entire interest in the partnership. Section 1.706-l(c) (2)(ii) of 

the regulations provides that the distributive share of a partner 

whose entire interest is sol~~ay be computed either through an 

interim closing of the books 1 or, bY. agreement among the 

partners, through a proration method. 111 Under section 706(d), 

added by the Tax Reform Act of 1984, each partner's share of 

income, gain, loss, deduction or credit must be determined by 

taking into account his or her varying interests in the 

there was a large block transfer of over 50 percent of the 

interests during the year, or if less than 50 percent of the 

interests were transferred during the year). 

110under the interim closing of the books method, the 

partnership traces all partnership items to the particular 

segment of the partnership taxable year in which such item arose. 

111under the proration method, partnership items are 

allocated to portions of the taxable year (~, days, months) by prorating the entire year's items regardless of when the item 

arose. The regulation provides that the proration may be based 

on the portion of the taxable year that has elapsed prior to the 

sale (i.e. , a daily convention) or "under any other method that 

is reasonable." 
50 

partnership during the partnership taxable year. 112 Certain 

items are required to be allocated on a daily basis. 113 

It appears that most widely held partnerships have adopted a 

monthly convention for determining when a purchaser of a unit 

becomes a partner both in the case of partial and complete 

dispositions of partnership interests. Thus, widely held 

partnerships typically treat transfers of interests occurring at 

any time within a month-long period as if all s¥cf transfers had 

occurred on a specified day within that period. 1 An interim 

closing of the books or use of a daily convention is probably 

impractical in the context of publicly traded partnerships. 

Because publicly traded partnership interests are normally 

transferred in anonymous transactions over a securities market, 

there does not appear to be significant potential tax avoidance 

resulting from the use of a monthly convention as long as the 

convention is uniformly applied. Partnerships that are not 

publicly traded within the meaning of section 7704(b) typically 

·will not have sufficient trading activity to create material 

distortion. To provide for the unusual case where tax avoidance 

is of concern, the Conference Committee Report to the 1984 Act 

states that the Service "may deny the use of any convention when 

the occurrence of significant, discrete events (~, a large, 

unusual gain or loss) would mean that use of a convention could 

result in significant tax avoidance." Regulations might also 

prevent the application of a convention to large block transfers 

112The Conference Committee Report to the 1984 Act expresses 

an expectation that regulations under section 706(d) will provide 

for a monthly convention, apparently only with respect to 

dispositions of less than an entire partnership interest. 

H.R. Rep. No. 861, 98th Cong., 2d Sess. 858 (1984). In News 

Release IR 84-129, the Service permitted the use of a semimonthly convention in the case of a partial disposition of a 

partnership interest for partnerships using the interim closing 

of the books method. The news release did not change the general 

requirement of a daily convention for partnerships using the 

proration method. The Blue Book to the 1984 Act, referring to 

dispositions of less than an entire partnership interest, stated 

that the use of any "reasonable convention" would be permitted 

until regulations are issued under section 706(d). staff of the 

Joint Committee on Taxation, General Explanation of the Revenue 

Provisions of the Deficit Reduction Act of 1984, 221-222 (1984). 

113 I.R.C. § 706(d) (2). 

114The specific methods vary among partnerships. For 

example, some partnerships treat all transfers during a month as 

occurring on the first day of that month or the first day of the 

following month. 
51 

{~, transfers in excess of 5 percent of outstanding interests) 

where the potential for tax avoidance may exist in connection 

with an extraordinary transaction. 

4. Information Reporting 

It is difficult or impossible for widely held partnerships, 

and especially publicly traded partnerships, to comply with a 

number of information reporting and gathering requirements 

applicable to partnerships generally. Under section 6050K and 

the regulations thereunder, upon certain transfers of partnership 

interests subject to section 751, a partnership is required to 

file Form 830~ feporting both the transferor and transferee of 

the interest. 1 This requirement cannot be satisfied for 

transactions occurring on an exchange because the buyer and 

seller of any given interest cannot be matched. Similarly, 

widely held partnerships may be unable to comply with certain 

requirements imposed under the tax shelter registration rules. 

For example, the seller of an interest in any partnership which 

is classified as a tax shelter under section 6111 must furnish a 

document containing specified information to the purchaser of the 

interest; this requirereft cannot be satisfied for a transfer on 

a securities exchange. 1 Additionally, any partnership subject 

to registration under section 6111 is required to maintain a list 

of all investors in the partnership which must be available for 

inspection within 10 days of a request by the Service. 117 The 

10-day requirement cannot be satisfied by any partnership in 

which interests are owned through nominees. To the extent these 

provisions continue to be imposed by the Code, 118 consideration 

115Treas. Reg. § 6050K-l{b) {1). Under Treas. Reg. 

§ l.605K-l{a){2), a partnership need not file a Form 8038 with 

respect to any transfer which must be reported under Code section 

6045 {reporting by brokers, etc.). However, many types of 

transfers are exempted from reporting under section 6045. See 

Treas. Reg.§ 5f.6045-l{c){3). 

116Temp. Treas. Reg. § 301.6111-lT, Q & A 51 et. ~ In 

addition, the required tax shelter list must specify the 

transferor of any interest held by a transferee partner. Temp. 

Treas. Reg. § 301.6112-lT, Q & A 17. Again, this type of 

matching of buyers and sellers is not possible for a publicly 

traded entity. 

117Temp. Treas. Reg. § 301.6112-lT, Q & A 21. 

118The recently completed study of civil tax penalties made 

no recommendation with respect to the tax shelter registration 

rules, concluding that the "area should continue to be monitored 

to assure that the registration requirement continues to be 

needed." Report on civil Tax Penalties by Executive Task Force, 
52 

should be given to amending the regulations so that widely held 

partnerships will be able to comply. 

Commissioner's Penalty Study, Internal Revenue Service, 1989, at 

VI-28. 
SECTION V. PROPOSALS FOR CURRENT ASSESSMENT OF DEFICIENCIES WITH 

RESPECT TO WIDELY HELD PARTNERSHIPS 

A. overview 

Much of the administrative inefficiency and complexity 

facing the Service in the administration of widely held 

partnerships stems from the fact that a deficiency must be 

assessed against taxpayers who were partners in the year in which 

the understatement of tax liability arose. This requires the 

Service to locate and monitor the returns of all taxpayers who 

were partners in that year, and eventually assess each former 

partner's share of the deficiency. If an adjustment covers 

several .years, the complexity of the task is compounded. 

These administrative burdens could be partially alleviated, 

from the point of view of the service, by requiring the 

partnership to perform many of the tasks required to convert a 

partnership level adjustment into assessments with respect to 

individual partners. The partnership could be required to file 

amended returns for the years to which the adjustment relates, 

and issue amended Form 1099-Ks, including penalties and interest, 

to the partners in those years. The filing of amended returns 

and the issuance of amended Form 1099-Ks would be required within 

a reasonable period from the date of the final determination. As 

under current law, taxpayers who had related adjustments in subsequent years would be entitled to file refund claims based on 

their overpayments of tax in those years. 

This approach cannot be viewed as a satisfactory means of 

improving the administration of widely held partnerships. 

Although part of the burden of tax administration would be 

shifted to partnerships and partners under this approach, the 

Service would still face the prospect of handling claims for 

refund from thousands of partners upon an adjustment with respect 

to any sizable partnership, and would be responsible for 

monitoring compliance by both partnerships and partners. 

Furthermore, there would be no net reduction in the overall 

effort necessary to achieve assessment and collection of 

deficiencies with respect to widely held partnerships. 

The key to streamlining the assessment of deficiencies with 

respect to widely held partnerships is to devise an assessment 

system that significantly reduces this overall effort. This 

section of the report reviews proposals for achieving this goal. 

The first proposal discussed was considered in connection with 

the formulation of the 1987 Revenue Act; this report concludes 

that this proposal would not materially reduce complexity and 

thus should not be enacted. Other proposals, the Partnership 

Collection Proposal and the alternative current assessment 

proposals, have been developed in the preparation of this report. 

While this report concludes that the Partnership Collection 

' 
54 

Proposal is the preferred approach, it is believed that the 

enactment of any of these current assessment proposals would 

produce a system under which it would be feasible to conduct 

audits of widely held partnerships. 

B. House Proposal 

1. Description 

The bill originally passed by the House of Representatives119 

during formulation of the Revenue Act of 1987 contained a proposal for collecting deficiencies from certain partnerships (the 

"House Proposal"). Under the House Proposal, underpayments of 

tax resulting from "applicable return adjustments" with respect 

to certain partnerships would have been collected either from the 

partnership or from each partner. For this purpose, an "applicable return adjustment" meant a final partnership administrative 

adjustment (if no court proceeding had been timely commenced), a 

court decision that had become final, an amended return filed by 

the partnership, or a settlement agreement binding on the 

partners. Any "shortfall" (Le., any understatement of taxable 

income, overstatement 9f taxable loss, overstatement of credits, 

or any combination thereof for a given partnership taxable year) 

resulting from an applicable return adjustment would have been 

subject to notice and demand by the Service in the same manner as 

if the tax were originally imposed on the partnership. The 

partnership would have been required to pay tax at the highest 

rate (individual or corporate) applicable for the taxable year of 

the shortfall. The amount of the shortfall would have been 

reduced to the extent the partnership could have proven that a 

partner had reported consistently with the applicable return 

adjustment in the partner's original or amended return. 

Under the House Proposal, the payment of tax by the 

partnership would have been treated as payment of tax by each 

partner of his or her allocable share of the payment determined 

in accordance with his or her interest in the partnership in 

the year to which the adjustment related. To the extent the 

payment by the partnership created an overpayment with respect to 

any partner (~, where the partner's marginal tax rate was 

lower than the rate paid by the partnership), that partner would 

have been entitled to file a claim for credit or refund of the 

overpayment. The partnership would have had the right to recover 

the amount of payment made on behalf of a partner from that 

partner. 

Neither the House Bill nor the House Ways and Means 

Committee Report specified the capital account or basis 

119 H.R. Rep. No. 3545, lOOth cong., 1st Sess. (1987). 
55 

adjustments to be made in connection with a partnership payment. 

Presumably, the partners' capital accounts would have been 

adjusted for the redetermined amounts of income, deductions, or 

credits in the year of the shortfall. The payment of tax by the 

partnership presumably would have been treated as a partnership 

distribution, with the partners in the year to which the adjustment related receiving a credit for the amount of tax paid. The 

House Proposal treated adjustments on a year-by-year basis, with 

no reference to related offsetting adjustments in other years. 

The House Proposal did not include any provision for the payment 

of interest and penalties with respect to a partnership 

deficiency. 

The House Proposal would have applied to any partnership 

with interests required to be registered under federal or state 

laws regulating securities, or sold under an exemption from 

registration requiring the filing of a notice with a federat or 

state agency regulating the offering or sale of securities. 20 

2. Examples 

The following examples illustrate the application of the 

House Proposal. 

EXAMPLE 1 In its return for the 1992 taxable year, partnership 

X understates its income by $1 million, with no offsetting 

adjustments in later years. In 1998, a final assessment is made. 

X would pay tax at the highest applicable rate for 1992 (assume 

34 percent for purposes of these examples). The applicable 

return adjustment would be allocated among X's 1992 partners in 

accordance with their interests in the partnership. The 1992 

partners would be entitled to file a claim for refund for any 

excess tax paid on their behalf (~, amounts attributable to 

marginal tax rate differentials). X would have a right to seek 

reimbursement from partners, including former partners, of tax 

paid on their behalf by X. The partners' bases and capital 

accounts would presumably be adjusted to reflect the allocation 

of additional income. Presumably, the payment of .tax by X would 

be treated as a deemed distribution to the partners. The net 

effect of these adjustments would be to increase the adjusted 

bases of the partnership interests as of the end of 1992. 

Consequently, any 1992 partner who sold an interest in the 

partnership between 1992 and 1998 presumably would be entitled to 

file a claim for refund of tax for the year of sale to reflect 

reduced gain or increased loss from the sale. 

EXAMPLE 2 In 1992, Partnership Y reports a deduction of $1 

million that should have been reported in its 1993 taxable year. 

In 1998, a final assessment is made. Because the House Proposal 

120~ 
56 

applies on a year-by-year basis, it would not permit an offset of 

underpayments and related overpayments occurring in different 

years. Thus, the results would be identical to those described 

in Example 1 above, with Y paying tax on the deficiency for 1992 

at the highest rate in effect for that year (34 percent). Y's 

1993 partners would be entitled to file claims for refund for 

their overpayments in that year. 

EXAMfLE 3 In 1992, Partnership z deducts $1 million that 

should have been amortized on a straight-line basis over ten 

years. In 1998, a final adjustment is made. The result would 

generally be the same as in Example 2 above. The applicable 

return adjustment to be paid by z for 1992 would equal $900,000 

($1 million minus $100,000 allowable amortization). Z's partners 

from 1993 through 1997 would be entitled to file claims for 

refund for their overpayments (attributable to Z's $100,000 

deduction understatement in each year) in those years. 

3. Analysis 

The House Proposal attempted to address problems that 

exist under current law in assessing and collecting deficiencies 

from partners of widely held partnerships by collecting the 

deficiency directly from the partnership. Under the House 

Proposal, the tax paid by the partnership would have been treated 

as paid by persons who were partners during the year to which the 

adjustment related, and any partners who had a marginal tax rate 

that was less than the maximum tax rate applicable under sections 

1 or 11 would have been entitled to file claims for refund. 

Since the maximum corporate rate currently exceeds the maximum 

individual rate, apparently all individual partners would have 

been due such refunds. In addition, the proposal would not have 

offset understatements of income with directly related overstatements of income, resulting in refunds due to partners who 

had a directly related negative adjustment to income in a 

different taxable year. Thus, thousands of potential refund 

claims would have been created with respect to partnerships with 

substantial numbers of partners. A significant paperwork burden 

would have been imposed on the Service and taxpayers to the 

extent these refund claims were pursued; to the extent the refund 

claims were not pursued, the proposal would have resulted in the 

collection of more tax than the government was due. The House 

Proposal would have imposed further record maintenance responsibilities on the Service by permitting a reduction of a shortfall 

to the extent the partnership could have demonstrated that its 

partners reported the matter on their own returns consistently 

with the applicable return adjustment. Thus, while the House 

Proposal provided greater assurance of collection of partnership 

deficiencies, it might have actually increased the Service's 

paperwork burden. Furthermore, because it involved collection of 

deficiencies directly from the partnership, the House Proposal 

would have created the same partnership liquidity problem 
57 

discussed below in connection with the Partnership Collection 

Proposal. 

The House Proposal endeavored to continue to impose the 

burden of payment of the tax deficiency on the partners who 

originally benefited from the understatement of income. This was 

accomplished by providing that the partnership would be entitled 

to recover from those persons who were partners in the year to 

which the adjustment related any amounts paid on their behalf. 

We do not believe it appropriate for the Internal Revenue Code to 

grant a private right of action. Furthermore, it often would 

have been difficult or impossible for a widely held partnership 

to obtain reimbursement from former partners for tax payments. 

The difficulty and expense of locating these partners, combined 

with the partners' probable unwillingness to reimburse the 

partnership voluntarily, would have likely rendered the right of 

reimbursement merely theoretical in most cases. Thus, 

notwithstanding the reimbursement provisions under the House 

Proposal, the tax on deficiencies would have been borne chiefly 

by the persons who held partnership interests during the year in 

which the final partnership adjustment occurred, and not those 

who held interests during the year to which the shortfall 

related. Yet the House Proposal did not provide the partners in 

the year in which a final adjustment occurred with any credit for 

tax paid or with any increase in the bases of their partnership 

interests. Thus, the House Proposal would have had the effect of 

attributing income to current partners without providing the 

adjustment to basis normally afforded partners who recognize 

income. 

Furthermore, the House Proposal did not eliminate the 

administrative difficulties of assessing and collecting tax 

deficiencies of partners in partnerships covered by the 

proposal--it merely shifted the initial burden of dealing with 

these difficulties to the partnership. In cases where the amount 

of the deficiency for the average partner was small, partnerships 

would have been unlikely to have sought reimbursement from former 

partners, and partners with potential refund claims would have 

been unlikely to have filed them. Just as the Service may avoid 

the administrative problems of current law by not attempting to 

assess deficiencies with respect to widely held partnerships, 

such partnerships and their partners would have been expected to 

avoid them under the House Proposal by acquiescing in the 

collection of excessive amounts of tax. In cases where 

partnerships and partners would have decided to pursue refund 

claims, the Service would have continued to be faced with a 

paperwork burden that is similar to that existing under current 

law. For these reasons, we do not recommend that Congress adopt 

the House Proposal. 
58 

c. Deficiencies with Respect to Widely Held Partnerships 

Should be Borne by Current Partners 

The House Proposal would not have materially reduced 

complexity because it retained the current law approach of 

looking back to prior-year partners as ultimately responsible for 

adjustments. This approach may be logical with respect to 

smaller partnerships, which correspond to the traditional view of 

partnerships as aggregations of individual taxpayers; however, 

widely held partnerships are best viewed as entities in this 

context and it is not necessary to treat the adjustments as 

personal to prior partners. The present system has the effect of 

isolating current partners from the impact of adjustments made 

with respect to the business of the partnership. contrast this 

with the treatment of a shareholder in a large corporation. 

Assume that a shareholder owns stock from 1990 through 1992 in a 

corporation which substantially understates its taxable income 

for 1990. In 1993, a deficiency is assessed, and causes the 

value of the corporation's stock to drop materially. Meanwhile, 

the original shareholder has sold his stock. The cost of the 

deficiency is borne by the stockholder who purchased in 1992. 

This report proposes an assessment structure for widely held 

partnerships which treats partners in a manner roughly comparable 

to the treatment of current and former shareholders in corporations. A current partner would bear the risk of tax adjustments 

relating to prior years; if a partnership interest is purchased 

without knowledge of the possibility of a substantial tax 

adjustment, the purchaser may pay too much for the partnership 

interest. It is important to note, however, that the basis 

adjustment rules of section 705 would mitigate both the 

"windfall" to the former partner and the unanticipated burden to 

the purchasing partner. Any deficiency to be collected from 

current partners would be adjusted to take into account 

offsetting adjustments in years other than the year of the 

shortfall. Offsetting related adjustments would greatly simplify 

the administration of widely held partnerships. 

This proposal would involve a significant departure from 

traditional subchapter K principles. However, we believe that 

such a departure is warranted in view of the substantial costs 

and difficulties faced by both the Service and partnerships in 

applying these subchapter K principles to widely held 

partnerships. 

D. Partnership Collection Proposal 

1. Description 

The central features of the Partnership Collection Proposal 

are: (1) the treatment of a partnership shortfall in a prior 

year as a current item of income in the year in which a final 
59 

determination of the adjustment is made; (2) the collection of 

tax, interest, and penalties with respect to the shortfall 

directly from the partnership; and (3) the netting of related 

adjustments in other years. As under the House Proposal, a 

shortfall is defined as any understatement of taxable income, 

overstatement of taxable loss, overstatement of credits, or any 

combination thereof for a given taxable year. 

Under the Partnership Collection Proposal, a widely held 

partnership would be treated as the taxpayer with respect to any 

partnership shortfall. The partnership would pay tax and 

interest as if it were a corporate taxpayer subject to tax at the 

highest rate applicable under section 1 or 11 for the year of the 

final determination. In computing the tax, interest, and 

penalties that would be paid by the partnership with respect to a 

partnership shortfall, the Partnership Collection Proposal would 

allow an offsetting adjustment for any directly related overstatement of taxable income, understatement of taxable loss, or 

understatement of credits for any other taxable year intervening 

between the taxable year to which the shortfall relates rrd the 

year in which the final partnership adjustment is made. 1 The 

offsetting adjustment would be computed by treating the partnership as if it were a corporate taxpayer that had paid tax on the 

related overstatement at the maximum rate applicable under 

section 1 or 11 of the Code for the year of the final 

determination. 

The Partnership Collection Proposal would treat a 

partnership shortfall attributable to an understatement of 

taxable income or an overstatement of taxable loss (less any 

offsetting adjustment) as a positive adjustment to the taxable 

income of the partnership for the taxable year in which the final 

partnership adjustment is made. Each partner's share of the 

adjustment would be reported on the partner's Form 1099-K and 

included in the partner's income for such year. The income would 

be deemed to have arisen pro rata throughout the year, so that 

all partners during the year of the final determination would 

share the income. Any tax paid by the partnership with respect 

to such shortfall would be treated as tax paid by such partners, 

effectively treating the tax paid by the partnership as a credit 

allowable to the partners which would be refundable to the extent 

an overpayment can be established. Thus, although tax would be 

withheld at the maximum rate (and interest would be calculated on 

such basis), the tax would actually be imposed at the marginal 

rates of the partners in the year the final adjustment is made. 

The partnership would also pay interest and penalties with 

respect to the shortfall based on tax calculated at the maximum 

rate. Interest and penalties would not be refundable and would 

be nondeductible by the partners. 

121 See I.R.C. § 660l(f). 
60 

A constructive termination of a partnership under section 

708(b) (l)(B) would not affect the Service's right to make an 

entity-level assessment against the partnership for a taxable 

year preceding the year of termination. In addition, regulations 

would be authorized to govern the application of these rules to 

partnerships that have been liquidated, and exclude partnerships 

or their partners from the operation of these rules in appro- priate or abusive situations. Partners holding a significant 

percentage of interests (~, at least five percent or ten 

percent) in a partnership in the year of the understatement 

would be excluded from the current assessment system. Thus, 

such partners would continue to be responsible for their allocable share of deficiencies even if they sold their interests prior 

to the final determination. The remainder of the deficiency 

would be allocated among all other current partners. 

2. Basis and Capital Accounts 

For purposes of maintaining the partners' capital accounts 

and determining the bases of their partnership interests, a 

partnership shortfall would usually be treated as a posftlve 

adjustment to the partners' capital accounts and bases, 2 any 

tax paid by the partnership would be treated as a distribution of 

cash to the partners, any interest or penalty paid by the 

partnership would be treated as a nondeductible partnership 

expense. 

3. Overstatements and Amended Returns 

If an audit determines that an overstatement was made in 

reporting a prior year's taxable income, the adjustment could 

also be treated as a current item by allowing a deduction in the 

year of the final determination. Related understatements would 

be offset against overstatements to produce a single adjustment. 

Interest due on such an overpayment (determined after application 

of section 660l(f)) would be calculated on the basis of an 

assumed rate and paid directly to the partnership. Appropriate 

basis and capital account adjustments would be made. 

122Partners' bases and capital accounts would not be 

adjusted where a final determination relates to an item that has 

already been reflected in their bases and capital accounts. For 

example, when a partnership reports tax exempt interest, a 

partner's basis and capital account are increased by his or her 

share of the interest. See I.R.C. § 705(a) (l)(B). Therefore, 

upon a determination that the interest was not tax exempt, no 

further basis or capital account adjustment would be appropriate. 
61 

Amended partnership returns123 would pose a number of issues 

under the Partnership Collection Proposal, regardless of whether 

the amended returns sought to increase or decrease previously 

reported income. If a partnership were allowed to treat an 

adjustment resulting from an amended return as a current item, 

partnerships arguably would have a measure of flexibility in 

determining when to claim a deduction or to report income. For 

example, if it were known that tax rates would increase in the 

next year, a partnership might fail to claim a deduction in the 

current year and then amend its return the next year to claim the 

deduction when it was worth more to its partners. This tactic 

would probably be successful only where there existed some 

legitimate uncertainty concerning the allowance of the deduction 

in the initial year, as the initial return might otherwise be 

found to contain a false statement. However, it is not improbable that in certain situations partnerships would be able to 

manipulate the system to use amended returns to their advantage 

if such returns were to produce a current adjustment. On the 

other hand, if adjustments arising from amended returns were to 

relate back to prior year partners, management of a partnership 

might be faced with a conflict of interest if it were aware at 

the commencement of an audit that a reporting position in a prior 

year is likely to result in an adjustment, regardless of whether 

the adjustment were an increase or decrease in taxable income. 

If management were to file an amended return, the adjustment 

would accrue to prior owners, while if the audit were allowed to 

run its course the adjustment would accrue to current owners. 

One possible solution would provide that amended returns would 

relate back to prior years, but that no such return could be 

filed after an audit has commenced. This would, however, place a 

great deal of significance on the commencement date of the audit. 

If the Partnership Collection Proposal is enacted, specific rules 

would be needed to deal with amended returns. 

4. Insolvent Partnerships 

A mechanism for collection from partners is necessary for 

situations in which a widely held partnership is unable to 

satisfy a deficiency. our recommended approach would permit the 

Service to proceed against both current and former partners to 

collect the amount owed, but would also take into account the 

partners' tax status in determining ultimate liability. Under 

this approach, current partners would be required to pay amounts 

of tax liability not collected from the partnership, in effect 

requiring them to pay tax on the deficiency at a 34 percent rate. 

The amounts could be collected either by sending the current 

partners notices of deficiency or by reporting the liability as 

123As noted above, an RAA is the procedure applied under the 

unified partnership audit rules for filing an amended return or 

refund claim. 
62 

an amount owed on the Form 1099-K. This flat percentage 

liability would be collected from all current partners, including 

tax exempt partners, regardless of their personal tax rates. A 

procedure should also be established to take into account the 

partners' individual tax status. This might be accomplished, for 

example, by having the partners add their share of the deficiency 

to their income for the year of the final determination or a 

subsequent year, and allowing a refund to the extent their 

payment exceeded the amount of tax owed on that income computed 

at their actual marginal tax rate. 

If within a specified time period the amount of tax 

collected from the partnership and current partners was less than 

the amount owed by the partnership using the 34 percent rate, 

taxpayers who were partners in the year of the understatement 

(and who had since sold their interests) would be liable for 

their share of the amount owed (again applying a 34 percent tax 

rate). 124 In addition, a rule could be provided under which a 

former partner who was neither a partner in the year of the 

understatement or in the year of the final determination would be 

liable if his or her interest was transferred to a dummy or in 

any other transfer deedgned to reduce the overall tax liability 

or to avoid payment of the deficiency. The procedure would be 

similar to that described for current partners. Tax would be 

collected at the flat percentage tax rate based on their 

interests in the partnership, and a mechanism would be provided 

to take into account their actual tax status. While the 

collection approach described above would be somewhat cumbersome, 

it would permit collection of deficiencies with respect to 

insolvent partnerships even when interests are held at the time 

of determination by dummy or sham partners. 125 

Under the proposed collection approach, a general partner 

would essentially be treated the same as the other partners. 

Thus, the general partner would not be liable for more than the 

share of the underpayment attributable to his or her interest in 

124This would apply to partners other than those holding a 

significant percentage interest in the year of the shortfall. As 

discussed above, those partners would be excluded from the 

current assessment system. 

125There are, of course, alternative approaches for 

proceeding against partners directly. If the Service is unable 

to fully collect a deficiency from the partnership, the current 

partners could be responsible for payment of any additional 

amounts owed under rules similar to the partner collection method 

discussed below. The current partners' tax liability would then 

be entirely determined by their individual tax status. Under 

this approach, collection against former partners probably would 

only be pursued in cases involving abusive transfers. 
63 

the partnership126 and would not be liable for unpaid taxes on 

behalf of all current partners. 127 

5. Examples 

The following examples illustrate the application of the 

Partnership Collection Proposal. 

EXAMPLE 1 In its return for the 1992 taxable year, partnership 

X understates its income by $1 million, with no offsetting 

adjustment in a later year. In 1998, a final assessment is made. 

X would pay a tax at the highest applicable rate for 1998 (assume 

for purposes of these examples that the maximum tax rate is 34 

percent), plus interest from 1992. In X's partnership return in 

1998, $1 million would be added to partnership income, and the 

partners would be treated as having received a distribution of 

cash equal to the amount of tax paid ($340,000). The partners' 

bases and capital accounts would be adjusted to reflect the 

allocation of additional income and interest expense and the 

deemed distribution. The partners also would be given a 

refundable credit for the tax paid on their behalf. Thus, a 

partner whose marginal tax rate is less than 34 percent would use 

this credit to satisfy his or her tax liability on other income 

or would claim a refund. 

EXAMPLE 2 In its return for the 1992 taxable year, partnership 

Y reports a deduction of $1 million that should have been 

reported in its 1993 taxable year. In 1998, a final assessment 

is made. No additional liability for tax would be imposed in 

1998. However, Y would pay the interest imposed on the 

underpayment of tax in 1992 under section 6601, taking into 

account any credit against the underpayment under section 660l(f) 

as a result of the overpayment of tax in 1993. Any interest on 

126of course, in certain cases, the rules described above 

regarding transferee liability would apply to general partners 

following a transfer of partnership assets out of partnership 

solution. 

127Even though not personally liable for an underpayment of 

a deficiency, a general partner could have increased exposure to 

personal liability for partnership business obligations as a 

result of collecting the tax from the partnership. For example, 

partnership funds used to satisfy the deficiency would not be 

available to satisfy other debts of the partnership for which the 

general partners might be personally liable. Analogously, the 

collection of deficiencies from the partnership may have a 

disproportionate impact as between classes of limited partners 

with different interests in partnership allocations and 

distributions. 
64 

the 1992 underpayment would be treated as a nondeductible 

partnership expense. 

EXAMPLE 3 In its return for the 1992 taxable year, partnership 

Z reports a deduction of $1 million for an expenditure that 

should have been amortized on a straight-line basis over 10 

years. In 1998, a final assessment is made. The understatement 

of taxable income by Z for 1992 would be offset in part by Z's 

overstatement of taxable income for the taxable years 1993 

through 1997. The adjustment in tax would equal 34 percent of 

the amounts previously expensed and not yet properly amortized 

($400,000). In addition, z would pay the interest imposed on the 

underpayment of tax in 1992 under section 6601, taking into 

account any credit against the underpayment under section 660l(f) 

as a result of the overpayment of tax in 1993 through 1997. In 

Z's partnership return for 1998, $400,000 would be added to 

partnership income, and the partners would be treated as having 

received a distribution equal to the amount of tax paid ($136,000). The partners• bases and capital accounts would be 

adjusted to reflect the allocation of additional income and 

interest expense and the deemed distribution. The partners also 

would receive a refundable credit for the tax paid. Any interest 

on the 1992 underpayment would be nondeductible. 

6. Discussion 

In General. The Partnership Collection Proposal would 

simplify the administrative process by treating a prior year 

deficiency and any related overstatements as an adjustment for 

the year of the final determination of the deficiency. The 

Partnership Collection Proposal may also offer the Service 

greater assurance than under current law that a tax deficiency 

attributable to a widely held partnership will in fact be paid. 

As in the case of full withholding, partner-level noncompliance 

would be avoided by collecting tax directly from the partnership. 

In addition, the Partnership Collection Proposal may be preferred 

by some partnerships to the "partner collection" method discussed 

below because of the fact that tax attributable to prior years 

would not be imposed directly on current partners. 

Shifting of Tax Liabilities and Manipulation Concerns. 

Under the Partnership Collection Proposal, tax liabilities would 

follow ownership of a partnership interest and would not, as 

under current law, be personal to the owner of the interest in 

the year of the understatement. This approach would represent a 

divergence from normal partnership tax principles. The most 

significant consequence of this divergence is the potential 

shifting of tax liability among taxpayers. This raises two 

principal concerns. 

The first concern is that such a rule appears to give a 

windfall to a partner who held a partnership interest in the year 
65 

income was understated and to impose an unfair burden on a 

partner buying into the tax liability. Although this is a valid 

concern, the windfall and burden are less than initially appear. 

Because the failure to report income generally will result in an 

understated basis, the windfall to the selling partner is limited 

to a change in the character of income and deferral of the tax 

from the year of the ¥rderstatement to the year of the sale of 

his or her interest. 1 Similarly, the burden to the purchasing 

partner generally will be limited to the interest and any 

penalties imposed on the understatement, the delay in utilizing 

the tax benefit represented by the positive basis adjustment 

produced by the allocation of income, and possible character 

differences. This burden is not fundamentally different from 

that resulting from other liabilities that are assumed by a 

partner purchasing a partnership interest (including unaccrued 

tax liabilities on items such as built-in gains of a partnership 

that has not made a section 754 election). As a result of these 

basis adjustments, the detriment to a partner who buys into a tax 

liability of a widely held partnership under the current 

assessment approach would be less than the detriment to a 

shareholder who buys into a corporation with a similar tax 

liability. 

The second concern is that taxpayers may be able to 

manipulate the rules to avoid payment of tax. As an initial 

matter, it should be noted that it would not be possible to avoid 

taxes by simply distributing partnership assets. Since widely 

held partnerships would be treated comparably to corporate 

taxpayers for this purpose, the partnership level deficiencies 

should have the same status as deficiencies with respect to 

corporate taxpayers. Thus, for example, in order to collect a 

deficiency from a widely held partnership, the Service could 

apply the summary assessment, levy and seizure procedures of 

section 6331. In addition, section 6901 would be amended to 

provide that transferees of partnership assets (including 

partners) would be subject to transferee liability. Hence, 

distribution of partnership assets woy~d not prevent the 

government from collecting taxes due. 9 

128under section 705, a partner's basis in his partnership 

interest is increased by the allocation of both taxable and taxexempt income. Consequently, if a partnership, rather than 

underreporting income, mischaracterizes taxable income as 

tax-exempt, the selling basis will not be understated and his or 

her windfall will not be so limited. 

129As discussed in section V(D)(4) above, we recommend that 

procedures be adopted to collect from current and former partners 

when the partnership is unable to satisfy a deficiency. 
66 

Since in general the amount of liability under the 

Partnership Collection Proposal is ultimately dependent on the 

tax status of the partners in the year of the final 

determination, the central manipulation concern would be the 

potential for shifting of tax liabilities from high bracket 

taxpayers to low bracket taxpayers. To achieve a material 

reduction in a widely held partnership's tax liability, a 

significant portion of the interests would have to be transferred 

to lower bracket taxpayers (including tax exempts). The 

likelihood of such transfers would be reduced by the exclusion 

from the current assessment approach of any partner holding a 

significant percentage of interests (~, at least five percent 

or ten percent) in a widely held partnership in the year of the 

understatement. As under current law, such a significant owner 

would be liable for his or her allocable share of a deficiency 

even if the interest were sold prior to the year of final 

determination. The remainder of the deficiency would be 

allocated among the current partners. The Service would be able 

to administer adjustments with respect to the large partners 

covered by this exclusion. Because these partners will be more 

likely to know of an impending adjustment and to arrange 

transfers to lower bracket taxpayers, opportunities for 

manipulation will be reduced if these partners are not permitted 

to shift tax liability by transferring their interests. 

Even though adjustments with respect to interests held by 

large partners will be excluded from the current assessment 

system, a problem would arise if a significant portion of 

interests were transferred to lower-bracket taxpayers, and in 

particular tax-exempt entities, through normal market transactions. Existing constraints reduce the likelihood that 

tax-exempt entities would acquire a significant percentage of 

interests in a widely held partnership through such transactions. 

If the partnership is publicly traded (within the meaning of 

section 7704), tax-exempt investment would be discouraged by 

section 512(c) (2), which characterizes all income from a publicly 

traded partnership as unrelated business taxable income. If a 

widely held partnership is not publicly traded, section 7704 in 

many cases would discourage the transfer of a significant 

percentage of partnership interests in any given year. 130 

Even with the adoption of anti-manipulation rules such as 

those discussed above, it is possible that the collective tax 

rate of partners in the year of final determination would be 

130see Notice 88-75, 1988-27 I. R. B. 29. However, under 

section 7704, partnerships which derive substantially all of 

their income from certain types of investment activity (~, 

real estate, oil and gas) will not be taxed as a corporation even 

if they are publicly traded. 
67 

somewhat lower than that in the year of an understatement. 

Collection of interest on deficiencies at the·partnership level, 

calculated on the assumption of a high effective rate of tax, 

would reduce the impact of such a rate shift. It would also be 

possible to impose a punitive interest rate on deficiencies, as 

is done under the Regulated Investment Company ("RIC") and Real 

Estate Investment Trust ("REIT") deficiency dividend rules, to 

further minimize the effect of a rate shift. 131 

Section 704Cbl. Adjustments under section 704(b) may 

present difficulties under the Partnership Collection Proposal; 

while certain partners would effectively have their distributive 

shares of income increased, the corresponding decrease in other 

partners' distributive shares would result in no overall 

partnership level deficiency (except as to any differential in 

interest rates on deficiencies and overpayments). one answer 

would be to simply conclude that section 704(b) adjustments would 

have to be handled under current law. However, if enforcement of 

section 704(b) with respect to widely held partnerships must 

proceed under an extremely unwieldy system while other 

adjustments that arise under audit can be processed through a 

simplified system, the government might be essentially forfeiting 

enforcement of section 704(b) in these cases. If the Partnership 

Collection Proposal were to be enacted, further consideration 

will need to be devoted to the treatment of section 704(b) 

adjustments under the system. 

Liquidity Issues. Because it involves entity-level 

collection, the Partnership Collection Proposal might create 

liquidity problems for certain partnerships. Liquidity problems 

are of particular concern to rental real estate partnerships, 

many of which experience deficits in the early years of operation, are highly leveraged, and have insufficient cash reserves 

to finance tax liabilities without selling off partnership 

assets. Some partnerships would presumably be able to borrow 

against assets; in some cases, however, a partnership could be 

forced to sell assets to satisfy a deficiency. A forced sale of 

assets at an inopportune time could result in significant losses 

to the partnership. While this may be a significant concern for 

partners in existing partnerships, partnerships formed after the 

effective date C£~ld presumably establish reserves for possible 

tax liabilities. 2 

131see I.R.C. § 860(c)(l). Under these rules, interest is 

calculated based on the amount of the deficiency, rather than 

based on the amount of tax owed. 

132see Section VIII of this Report concerning effective date 

issues. 
68 

summary. The Partnership Collection Proposal would 

eliminate several fundamental problems that severely hamper the 

Service's ability under current law to audit and collect 

deficiencies attributable to widely held partnerships. The 

proposal would eliminate the need to obtain and monitor the 

individual returns of partners for the year to which the audit 

relates and to assess and attempt to collect deficiencies for 

that year. It would also avoid creating offsetting refund claims 

in later years. Collection of deficiencies would be greatly 

simplified. Adoption of the proposal would dramatically reduce 

the Service's burden in auditing widely held partnerships. 

E. Alternative Proposals 

Much of the simplification offered by the Partnership 

Collection Proposal could be achieved under a number of 

alternative current assessment approaches. The adoption of any 

of the approaches discussed below would significantly improve the 

administration of widely held partnerships. 

1. Partner Collection Method 

The treatment of deficiencies with respect to widely held 

partnerships as current income items could also be implemented by 

collecting deficiencies directly from current partners. This 

approach is referred to in this report as the "partner collection" method. In most respects, these rules would parallel those 

discussed above in connection with the Partnership Collection 

Proposal. The following discussion focuses on areas where the 

two approaches would differ. 

Under the partner collection approach, understatements 

arising from erroneous reporting positions taken by a partnership 

in prior years (less any offsetting adjustments) would be: (1) 

included as an income item on the partnership's return (Form 

1065) in the year a final adjustment is made; (2) included on the 

Form 1099-Ks sent to the partners in that year; and (3) reflected 

as an item of income on the partners' income tax returns (Form 

1040 or 1120) in that year. Thus, under the partner collection 

approach, tax on prior year partnership deficiencies would be 

paid by the partners in the year of the final determination at 

the marginal tax rates in effect in that year. To the extent tax 

rates changed between the year of the understatement and the year 

of the final determination, the tax owed with respect to a 

deficiency would likewise vary from that which would have been 

due had the income been properly reported in the year of 

understatement. A shortfall reflecting an overstatement of 

credits in a given year (less any related understatement of 

credits in a different year) would be included as a separate item 

on the partnership's return in the year a final determination is 

made and would be similarly included in the partners' Form 
69 

1099-Ks in that year. Thus, the partners in the year of the 

final determination would be responsible for the repayment of 

credits as part of their separate tax liability. 

Interest and penalties with respect to a deficiency could 

either be passed through to partners or paid directly by the 

partnership. If interest and penalties were to be passed through 

to partners along with the underlying deficiency, a system could 

be devised under which each partner's interest and penalties were 

calculated with respect to the partner's actual tax on the 

deficiency. However, this would require the partnership to 

provide the partner with an interest rate and a penalty rate to 

be applied to the partner's tax. While this approach would 

tailor each partner's interest and penalties to his or her actual 

tax, deficiency income would need to be reported to partners 

separately from other income and guidance would be required to 

determine the amount of each partner's total tax liability that 

would be treated as attributable to the deficiency income. Only 

then could the partner use the special interest rate and penalty 

rate to determine his or her interest and penalties. It is not 

clear that this approach could be efficiently administered within 

the partnership's normal reporting system. Furthermore, it would 

not be possible to apply computer matching to these amounts since 

the Service would not be independently reported the amount of any 

partner's interest and penalties. The alternative approach to 

passing interest and penalties through to the partners would be 

to calculate the amount of interest and penalties by assuming a 

partner-level tax rate and showing the resulting interest and 

penalties as tax due on the partners' Form 1099-Ks. The service 

would be able to match these amounts. However, while partners 

would be likely to properly report additional income shown on a 

Form 1099-K, they are more likely to be confused by and object to 

a Form 1099-K that reports additional tax attributable to 

interest and penalties attributable to a prior year deficiency. 

Thus, this approach could result in new compliance problems. It 

would also require partners not otherwise subject to tax to pay 

penalties and interest on a deficiency. 

The passthrough of interest and penalties to partners is 

perhaps the most significant barrier to designing a pure 

passthrough of partnership deficiencies and related items. An 

alternative would be to have partnerships pay interest and 

penalties, while deficiencies were flowed through to partners. 

This would lessen the administrative savings from passing 

deficiencies through to partners as part of the normal deficiency 

process, and would require the use of an assumed tax rate. 

Assuming partners were not permitted to seek refunds of penalties 

and interest, this approach would be relatively simple. 

Therefore, if the partner collection method were to be adopted, 

it would be preferable to have partnerships pay interest and 

penalties. 
70 

For purposes of maintaining the partners' capital accounts 

and determining the bases of their partnership interests, an 

increase in taxable income would be treated as a positive 

adjustment to the partners' capital accounts and bases of their 

interests, and any interest or penalty paid by the partnrffhip would be treated as a nondeductible partnership expense. 

Interest or penalties paid by a partner would be treated as any 

other interest or penalties paid by a taxpayer with respect to a 

tax deficiency. 

Like the Partnership Collection Proposal, the partner 

collection method would simplify the administration of widely 

held partnerships by providing for a single entity level 

determination that would eliminate the need for the Service to 

obtain and monitor returns of each prior year partner, and by 

combining related adjustments as a single current item. The 

partner collection approach would not offer the Service the 

opportunity to satisfy a deficiency from a single source. It 

would also raise a number of the same concerns as the Partnership 

Collection Proposal, including questions of rf.ansferring tax 

liability and fairness to incoming partners. 4 On the other 

hand, the partner collection method would not pose the concerns 

raised by illiquid partnerships under the Partnership Collection 

Proposal, although payment of interest and penalties by the 

partnership would raise such issues to a lesser degree. 

Furthermore, it is arguable that the partner collection method 

would represent less of a shift from current law as the 

collection of deficiencies could be entirely subsumed within the 

normal reporting procedure. 

2. Non-Flowthrough Method 

The current assessment system could also be implemented by 

collecting deficiencies from the partnership without treating the 

adjustment as current income. The partnership would pay tax at a 

fixed rate(~, the maximum individual rate). Income would not 

flow through to partners, no partner-level credit would be 

133see I.R.C. § l62(f); Treas. Reg.§ 1.162-2l(b) (1) (ii). 

134Under the partner collection method, the possibility 

exists that an understatement of income for an earlier year could 

result in a tax liability for the current partners that exceeds 

the value of their partnership interests. This could also occur 

under the Partnership Collection Proposal in the case of an 

insolvent partnership. In the case of widely held partnerships, 

we believe this possibility is remote. Partners in these 

partnerships are unlikely to incur a tax liability that is 

disproportionate to the size of their investment (particularly 

where related amounts are offset). Moreover, a special rule 

could be provided for such a situation. 
71 

allowed for taxes paid by the partnership, and no adjustments 

would he made to the bases of partners in their partnership 

interests (although capital accounts would be adjusted). 

This non-flowthrough approach would be relatively simple to 

administer, because partnerships would need to make few adjustments as a result of a partnership deficiency. As a consequence 

of the absence of basis adjustments, however, the approach could 

cause partnership income with respect to a deficiency to be taxed 

twice. Conversely, allowing a partnership to claim a refund 

under this method for an overstatement of partnership income 

could result in a double benefit to the partners. 

Double taxation of a deficiency could be avoided by using 

the non-flowthrough method with basis adjustments. Deficiency 

income would not flow through to partners, and partners would not 

receive a credit for their allocable share of taxes paid by the 

partnership. However, partners would receive a basis adjustment 

for their share of the deficiency income, less tax paid by the 

partnership. Although at first glance it might appear anomalous 

to adjust a partner's basis even though the partner was not 

allocated taxable income, similar adjustments are made under 

current law for certain items that are not reflected in a 

partnersyjj's taxable income (~, tax-exempt interest 

income). Basis adjustments would also prevent a double 

benefit to partners if refund claims are treated as giving rise 

to current adjustments. 

Whether or not basis adjustments are made, the nonflowthrough approach would tax a partnership's deficiency income 

at a single rate, regardless of the rates of its partners. By 

not taking the varying tax rates of its partners into account, 

this approach would not seek to place the partnership and its 

partners in approximately the same position they would have been 

in had the income been properly reported initially. As a result, 

unlike the Partnership Collection Proposal, it would not permit 

the reduction of tax due by a shift in the composition of the 

partners toward tax exempt entities or other lower bracket 

taxpayers. In addition, the non-flowthrough method would 

establish a fixed amount of tax due (independent of partner tax 

rates) which could be collected first from the partnership, 

second frrr6 the current partners, and third from former 

partners. 

135see I.R.C. § 705(a) (1) (B) and (C). 

136unlike the Partnership Collection Proposal, no adjustment 

procedure would he required to reflect the partners• actual 

marginal tax rates. 
72 

By taxing deficiency income at a single rate, the 

non-flowthrough approach would, to a certain degree, reflect an 

entity treatment of widely held partnerships. If basis 

adjustments were permitted, the approach would recognize the 

flowthrough nature of a partnership and would not tax deficiency 

income twice, nor provide a double benefit for a refund on an 

overstatement. On the other hand, basis adjustments would add a 

measure of complexity to an otherwise extremely simple entityoriented system. 

On balance, we believe an assessment method that taxes a 

deficiency at the rates of the partners is the preferable 

approach, and have therefore recommended the Partnership 

Collection Proposal. However, as discussed above, taxing a 

deficiency at the partners• rates opens up the possibility that 

deficiency income may escape taxation through a shift in the 

composition of the partners. If it is concluded that the antimanipulation rules discussed in connection with the Partnership 

Collection Proposal will not act as sufficient deterrent, serious 

consideration should be given to the non-flowthrough approach to 

taxing deficiencies of widr}1 held partnerships, either with or 

without basis adjustments. 

3. Nonrefundable credit 

The current assessment approach could also be implemented 

with a nonrefundable partner-level credit for taxes paid by the 

partnership with respect to a deficiency, in contrast to the 

refundable credit under the Partnership Collection Proposal. 

Under the nonrefundable credit approach, taxes would be collected 

from the partnership at a single rate. Income attributable to a 

deficiency would flow through to partners and would be reported 

on their Form 1099-Ks, along with a nonrefundable credit for the 

partner's share of tax paid by the partnership with respect to 

the deficiency. Partners would have their bases and capital 

accounts adjusted to reflect the additional income (less tax paid 

by the partnership). 

This method is similar in effect to the non-flowthrough 

method discussed above, except that taxable investors with a rate 

lower than the rate at which the partnership paid tax would be 

able to use the nonrefundable credit to offset tax on other 

income during the year, and, if the credit could be carried to 

other years, to offset tax on income in other years. Thus, under 

a system using a nonrefundable credit, depending on their 

individual circumstances and whether the credit could be carried 

137A rule could be provided that basis adjustments would 

only be made with respect to deficiencies exceeding a certain 

size. 
73 

over, taxable partners might be able to achieve full use of the 

credit (at least over time). Fully tax-exempt partners would 

never be able to benefit from the credit. Thus, a partnership's 

deficiency income would be taxed at a rate which might exceed the 

collective tax rate of its partners. 

4. Elective Payment of Deficiencies by Partnerships 

It might also be possible to combine the Partnership 

Collection Proposal and the partner collection method by making 

payment of deficiencies by the partnership optional. Thus, if a 

partnership were determined to have a relatively small 

deficiency, management might prefer to pay the deficiency 

directly rather than allocate it as income to the partners. In 

cases where management determined that this was not a viable 

alternative, such as in the case of an illiquid partnership, the 

deficiency could be flowed through to partners as additional 

income. This approach might, however, create conflict of 

interest issues for the management of a partnership. If an 

election approach were adopted, it would be necessary to determine whether the election could be made on a case-by-case or 

year-by-year basis or whether it would be a more general (perhaps 

binding) election. It would also be necessary to provide 

specific rules for making the election and notifying the Service. 

F. Comparison to Deficiency Dividend Procedures 

While the treatment of adjustments as current items would 

represent a departure from subchapter K principles, the Code does 

provide analogous treatment of other widely held passthrough 

entities. This section discusses the deficiency dividend rules 

of section 860 of the Code under which the tax attributable to a 

prior year's deficiency is borne by current investors. Under 

these rules, a RIC or a REIT may declare a dividend in the year 

in which a deficiency is finally determined with respect to a 

prior year. 138 A deficiency dividend is treated as if it had been 

paid in the prior year for purposes of determining the dividendspaid deduction of the RIC or REIT for the prior year. 139 This 

permits the RIC or REIT to ensure it has satisfied the applicable 

minimum distribution requirements with respect to the prior year 

and to avoid any corporate level tax for that year. 140 This 

procedure places the cost of the prior-year deficiency on current 

RIC or REIT shareholders. For example, assume that a RIC determines that for 1984 its ordinary income prior to allowance of a 

deduction for dividends paid is $900. The RIC distributes $900 

~I.R.C. § 860(f). 

~I.R.C. § 860(a). 

140I.R.C. § 852 (a) (1). 
74 

to shareholders, thus apparently reducing its taxable income to 

zero. X, who owns 1 percent of the stock in the RIC, sells his 

stock to Y on December 31, 1985. In 1986, when Y still owns the 

stock, the RIC is determined to have understated its income for 

1984 by $100. The RIC declares in 1986 a deficiency dividend of 

$100, which is taken into account in determining the RIC's 

dividends-paid deduction for 1984 and allows the RIC to satisfy 

the distribution requirement and to reduce its taxable income to 

zero. If the RIC's 1984 income had been properly reported, X 

would have received a distribution of $1 more than he actually 

received, and the value of X's interest in the RIC would have 

been correspondingly reduced by $1; therefore, the incorrect 

reporting position permitted X to convert $1 of ordinary income 

to capital gain on the sale of the stock. Meanwhile, the 

distribution of the deficiency dividend causes Y to recognize $1 

of ordinary income in 1986 and creates an unrealized $1 capital 

loss in Y's RIC stock (assuming no other change in asset value). 

Furthermore, interest and penalties with respect to the 

deficiency must be oaid by the RIC, which further reduces the 

value of Y' s stock. 141 

Under the deficiency dividend procedure, current 

shareholders in a RIC or REIT bear the tax cost of a prior year 

deficiency. While not providing an exact analogy to the 

Partnership Collection Proposal or any of the alternatives, these 

rules demonstrate that federal income tax already employs a 

current assessment approach for certain passthrough entities. 

G. Audit Procedures 

Under the Partnership Collection Proposal or any of the 

alternatives discussed above, deficiencies with respect to widely 

held partnerships would be determined and assessed on an entitywide basis rather than on a partner-by-partner basis. To 

facilitate this process, it will be necessary to provide a new 

audit system which is separate from and independent of the 

current TEFRA partnership audit rules of Code sections 6221 

through 6233. This new audit system would be applicable only to 

widely held partnerships which are subject to current assessment, 

and would not.otherwise affect the application of the TEFRA audit 

procedures. This section briefly outlines the approach to be 

followed under such an audit system. 

141A RIC or REIT utilizing the deficiency dividend procedure 

is subject to a penalty interest charge. Specifically, interest 

and penalties are charged on the gross amount of the dividend, 

rather than on the additional tax that would be imposed on 

receipt of the dividend. I.R.C. § 860(c)(l). 
75 

In general, the authority of the TMP to act as the 

partnership's representative in tax matters would be greatly 

expanded while the rights afforded each partner under the TEFRA 

rules generally would be eliminated. Partners would be required 

to report consistently with the partneffpip return, and a penalty would be imposed for failure to do so. Notification of the 

commencement of an administrative proceeding and of a final 

adjustment would be provided only to the TMP, who would no longer 

be required by the Code to keep partners informed of proceedings. - Partners would have no right to participate in administrative 

proceedings. Partners would have no right to file suit 

independently or otherwise participate in proceedings before a 

court. They would have no right to seek a refund independently 

with respect to a partnership item. 

Only the TMP would be permitted to participate in the 

decision to extend the statute of limitations. The TMP would 

control any litigation relating to partnership deficiencies and 

refund claims. Settlements of administrative or judicial proceedings with respect to partnership items could be made only by 

the TMP, and would be binding on all partners. Thus, the TMP 

would no longer have the option to refuse to bind other partners, 

and other partners would no longer have the right to prohibit the 

TMP from settling on their behalf. Naturally, it would be 

necessary to provide protections for partners and the partnership 

in the event a designated TMP failed to take certain actions or 

in the event there was a conflict of interest between the TMP and 

the other partners. 

It is unlikely that the removal of these statutory rights 

and protections would render individual partners powerless in the 

determination of deficiencies. First, the TMP undoubtedly would 

have a duty to treat other partners reasonably and fairly. 

Second, it is likely that partnership agreements will replace 

these statutory rights with comparable contract rights. Thus, a 

partnership agreement might require the TMP to keep all partners 

informed of administrative or judicial proceedings. A partnership agreement might also provide for a committee to advise or 

control settlement actions of the TMP. All partners might have 

the right to .have some input through the committee in settlement 

or litigation decisions. It is possible that such provisions 

would complicate the task of the TMP, but if complexity is 

142It would be necessary to provide some type of relief from 

the consistent reporting rule for taxpayers who receive a clearly 

erroneous Form 1099-K (~, a Form 1099-K incorrectly reflects a 

partner's ownership of 60 partnership units rather than his or 

her actual ownership of 50 units). This exception would apply 

only if the partner disclosed the inconsistent position, and only 

to items relating to a partner's personal tax position and not to 

items relating to overall partnership income. 
76 

inherent in the system it should burden the partnership and the 

TMP rather than the service. 

These proposals would invest significant power and 

responsibility in the TMP. This would in turn exacerbate the 

problems that have been caused under normal TEFRA ff:les where 

there is confusion as to which partner is the TMP, 3 or where a 

partner has been unwilling to serve as TMP. 144 Furthermore, the 

increased power of the TMP would add to the conflict of interest 

issues that face the Service when it appoints a TMP. 145 

By limiting the authority of each partner to act 

independently of the partnership as to the reporting and 

determination of partnership items, this type of audit system 

would reflect the fact that a widely held partnership should be 

treated as a single entity for purposes of deficiencies. Such an 

audit system is essential to the implementation of the Partnership Collection Proposal or any of the alternative current 

assessment approaches. 

143see, e.g., PAE Enterprises v. Commissioner, 55 TCM 875 

(1988); Sente Investment Club v. Commissioner, 55 TCM 1565 

(1988). 

144see. e.g., Computer Programs Lamba Ltd. v. Commissioner, 

90 T.C. 1124 (1988). 

145see I.R.C. § 623l(a) (7); Rev. Proc. 88-16, 1988-l C.B. 

691. 
SECTION VI. PENALTIES 

A. overview 

A significant amount of the administrative cost and 

logistical difficulty in performing an audit of a widely held 

partnership stems from the fact that penalties are not 

partnership1flems and thus are not covered by the TEFRA audit 

procedures. Penalties must be applied to the partners 

individually, and therefore must be asserted on a partnerby-partner f2fis through the use of the statutory notice 

procedures. Furthermore, the assertion of penalties must 

await the completion of the related TEFRA proceeding. 148 The 

implementation of a system for the efficient administration of 

widely held partnerships should include provisions to facilitate 

the imposition of penalties where appropriate. 

An erroneous reporting position, as to a matter of either 

law or fact, that leads to. the assertion of penalties in the 

widely held partnership context is realistically the position 

taken by the partnership. In almost all cases, a partner in a 

widely held partnership will not have sufficient information to 

reasonably take a position different from that of the partnership. The Partnership Collection Proposal and the alternative 

current assessment approaches each represent a shift away from an 

aggregate approach and towards an entity approach with respect to 

the administration of widely held partnerships. Consistent with 

this shift in focus, it is recommended both from the standpoint 

of fairness and efficiency that penalties related to underpayments of tax by partners of widely held partnerships generally 

be determined and imposed at the entity level. 

B. Accuracy-Related Penalty 

1. Background 

The omnibus Budget Reconciliation Act of 1989, Pub. L. No. 

101-239 (the "1989 Act") consolidated into one part of the Co~e 

the major penalties relating to the accuracy of tax returns. 1 9 

The penalties consolidated as the "accuracy-related penalty" were 

the negligence penalty, the substantial understatement penalty, 

and the valuation penalties. These consolidated penalties were 

146see I.R.C. § 623l(a) (3). 

147I.R.C. § 6230(a) (2) (A) (i) • 

148N.C.F. Energy Partners v. Commissioner, 89 T.C. 741 

(1987); Maxwell v. Commissioner, 87 T.C. 783, 792 (1986). 

149 I.R.C. § 6662. 
78 

also coordinated with the fraud penalty. 150 The accuracy-related 

penalty is imposed at a rate of 20 percent and, as relevant to 

widely held partnerships, applies to the portion of any underpayment that is attributable to (1) negligence, (2) substantial 

understatement of income tax, or (3) substantial valuation 

overstatement. 

This section will discuss the accuracy-related penalty as 

related to widely held partnerships. In general, it is 

recommended that the penalty be determined at the partnership 

level and imposed against the partnership. The amount of the 

addition to tax would be determined by applying the 20 percent 

penalty against the partnership underpayment attributable either 

to negligence, substantial understatement or substantial valuation overstatement. The amount of the partnership underpayment 

would be deemed to equal the product of the net adjustment to 

partnership income or deductions multiplied by the maximum tax 

rate (either individual or corporate) for the year of the final 

determination. 

2 • Negligence 

If part of an underpayment is due to negligence or disregard 

of rules or regulations, a penalty is impose~ on the portion of 

the underpayment attributable to negligence. 51 Negligence 

includes any careless, reckless, or intentional disregard of 

rules or regulations, as well as any failure to make a reasonable 

attempt to comply with the provisions of the Code. 152 In 

addition, the 1989 Act repeals the presumption under prior law 

that an underpayment is attributable to negligence if the 

underpayment is due to a failure to include on an income tax 

return an amount shown on an information return. 153 

Under current law, even following the enactment of the 1989 

Act, the penalty for negligence is determined at the partner 

level. This treatment seems inappropriate when applied to 

partners of widely held partnerships who report their income 

consistently with the partnership return. In that case, the 

penalty relates to the position taken or course of conduct of the 

partnership, and should be assessed at the partnership level and 

collected from the partnership. In certain instances, however, 

the penalty for negligence should continue to be imposed on the 

150I.R.C. § 6663. 

151I.R.C. § 6662(b)(1). 

152I.R.C. § 6662(c). 

153such presumption was formerly included in I.R.C. 

§ 6653(g). 
79 

partners directly. A partner of a widely held partnership 

generally should be subject to a negligence penalty (and possibly 

a fraud penalty in some cases) if he or she fails to report 

partnership income on a return or takes a position on a r~turn 

that is inconsistent with that taken by the partnership. 4 

3. substantial Understatement of Income Tax 

The accuracy-related penalty also applies to underpayments 

attributable to a "substantial understatement" of income tax. 155 

An understatement generally means the excess of the amount of tax 

required to be shown on a return over the amount of tax which is 

shown on the return. 156 A "substantial understatement" is 

defined as an understatement that exceeds the greater of 10 

percent of the tax required to be shown on the return or $5,000. 

In the case of a corporation (other than an s corporation or a 

personal holding comr.any), the test is applied by substituting $10,000 for $5,000. 1 7 As applied to a partner in a partnership, 

the determination of whether an understatement exists and whether 

that understatement is substantial is based on the partner's 

individual or corporate overall tax liability, rather than on the 

taxable income generated by the partnership. 

The amount of the understatement is reduced by the portion 

thereof attributable to (1) the tax treatment of an item as to 

which there is or was substantial authority, or (2) any item with 

respect to which there was adequate disclosure of the relevant 

facts on the return or in a statement attached to the return. 158 

For this purpose, disclosure of the tax treatment of ~artnership 

items is generally made on the partnership's return. 1 9 The test 

relating to adequate disclosure does not apply to a tax shelter 

investment. The term "tax shelter" includes a partnership or 

other entity whose principal purpose is the avoidance or evasion 

154As discussed above, it would be necessary to provide some 

type of relief to a partner who receives an erroneous 1099-K in 

certain cases. 

155I.R.C. § 6662 (b) (2). 

156I.R. c. § 6662 (d) (2). 

157I.R.C. § 6662(d)(l). 

158I.R. c. § 6662 (d) (2) (B). 

159Treas. Reg. § 1.6661-4(e). Because the statute has not 

been changed on this point, the regulation probably reflects 

current law. A partner may also make adequate disclosure with 

respect to a partnership item by attaching a statement to his or 

her return. 
80 

of federal income tax. In the tax shelter context, the taxpayer 

must demonstrate that (1) substantial authority exists or existed 

for the position taken on the return, and (2) the taxpayer 

reasonably believed that the position taken on ~s or her return 

was more likely than not the correct position. 1 The determination of whether a partnership item is related to a tax shelter 

is based ~p the principal purpose of the partnership, not the 

partner. 1 With respect to tax shelters, the actions taken by 

the partnership will be deemed to have been taken by the partner 

and will be considered in deciding whether the partner reasonably 

believes that the tax treatment of an item is more likely than 

not the proper tax treatment. 162 

Under section 6664(c)(1), no accuracy-related penalty will 

be imposed with respect to any portion of an underpayment if it 

is shown that there was reasonable cause for such portion and 

that the taxpayer acted in good faith. In the case of an understatement related to a partnership item, the good faith (or lack 

thereof) of the partnership generally will be imputed to the 

partner. 163 

Most of the issues relating to the imposition of the 

accuracy-related penalty related to substantial understatements 

are resolved at the partnership level. In particular, the 

partnership makes the determination as to whether a reporting 

position is supported by substantial authority. Nevertheless, 

the penalty currently is applied separately with respect to each 

partner. In view of the administrative difficulties this treatment creates with respect to widely held partnerships, the 

penalty for substantial understatements (like the other relevant 

parts of the accuracy-related penalty) should be treated as a 

160I.R.C. § 6662(d) (2) (C). 

161Treas. Reg.§ 1.6661-S(a) (1) and (2). 

162Treas. Reg.§ 1.6661-S(e). In general, a taxpayer may 

establish reasonable belief if (1) the taxpayer analyzes the 

relevant facts and authorities and reasonably concludes that 

there is a greater than 50 percent likelihood that the tax 

treatment will be upheld in litigation if challenged; or (2) the 

taxpayer in good faith relies on the opinion of a professional 

tax advisor, provided the opinion is based on the tax advisor's 

analysis of the pertinent facts and authorities and unambiguously 

states that the tax advisor concludes that the tax treatment of 

an item will be upheld if challenged. Treas. Reg. 

§ 1. 6661-5 (d). 

163Treas. Reg.§ 1.6661-6(b). Any good faith imputed to a 

partner as described above may be refuted by other factors 

showing the partner's lack of good faith. Id. 
81 

partnership item for partners of widely held partnerships, and 

the partnership should in effect be treated as a taxpaying 

entity. 

Under either the Partnership Collection Proposal or the 

other approaches, the penalty would be collected from the partnershf~ and treated as a nondeductible expense by the · partners. 4 Determinations with respect to the reasonable cause 

exception (and imposition of the penalty with respect to tax 

shelters) would be made at the partnership level. For purposes 

of applying the penalty to widely held partnerships, an 

"understatement" would be defined as the net adjustment to 

partnership income or deductions, multiplied by the highest 

marginal rate under section 1 or section 11. The test applied 

with respect to corporations in section 6662(d)(l)(B) (substituting $10,000 for $5,000 as the threshold level for an 

understatement to be deemed substantial) would be used to 

determinr whether the partnership would be subject to the 

penalty. 65 

4. Substantial Valuation overstatement 

The accuracy-related penalty includes an addition to tax for 

underpayments of tax attributable to valuation overstatements. 166 

A valuation overstatement is deemed to occur if the value of any 

property or its adjusted basis claimed on any return is 200 

percent or more of the amount determined to be the correct 

amount. 167 The valuation overstatement penalty does not apply 

unless the underpayment of tax attributable to the valuation 

overstatement exceeds $5,000 ($10,000 in the case of a 

164Alternatively, under the partner collection method, the 

penalty could continue to be payable by partners, although the 

applicability of the penalty would be determined at the 

partnership level. 

165secause the penalty would be imposed at the partnership 

level, income and deductions from a widely held partnership would 

not be taken into account in determining a partner's separate 

liability for the penalty based on other investments. 

166Like other portions of the accuracy-related penalty, the 

addition to tax for substantial valuation overstatements equals 

20 percent of the underpayment. 

167under section 6662(h), the rate of the general accuracy 

penalty is doubled (to 40 percent) in the case of gross valuation 

misstatements. As relevant to widely held partnerships, a gross 

valuation misstatement is a valuation overstatement claimed on a 

return that is 400 percent or more of the amount determined to be 

the correct amount. 
82 

corporati?~ other than an s corporation or a personal holding 

company). 8 A valuation overstatement by a partnership flows 

through to the returns of the individual partners. Thus, an 

underpayment of tax on an individual partner's return resulting 

from a valuation overstatement by a partnership is treated as an 

underpayment of tax attributable to a valuation overstatement. 

As is generally the case with respect to the accuracy-related 

penalty, no penalty will be imposed if it is shown that there was 

a reasonable cause for the underpayment attributable to the 

valuation or adjusted basis ct~imed on the return and that such 

claim was made in good faith. 9 

The applicability of the accuracy-related penalty with 

respect to valuation overstatements should be determined at the 

partnership level with respect to widely held partnerships and 

the penalty imposed on the partnership. Individual partners are 

unlikely to have had any involvement in valuing partnership 

property. Therefore, the valuation penalty should be a partnership item. Under this approach, for purposes of applying the 

penalty to a widely held partnership, the term "underpayment" 

would be defined to include the net adjustment to partnership 

income and deduction attributable to a substantial valuation 

overstatement by the partnership multiplied by the maximum tax 

rate (either the individual or corporate rate). The underpayment 

of tax attributable to substantial valuation overstatements would 

be subject to the $10,000 threshold generally applicable to 

corporations under section 6662(e)(2). The partnership would be 

treated as the taxpayer for purposes of determining whether the 

reasonable cause exception of section 6664(c) should apply. 

c. Fraud Penalty 

Under section 6663, if any portion of an underpayment is due 

to fraud, a penalty is imposed equal to 75 percent of such 

portion. The accuracy-related penalty is not to apply to any 

portion of an underpayment on which the fraud penalty is imposed. 

Like the accuracy-related penalty, the fraud penalty should be 

assessed at the partnership level and collected from the 

partnership. 

168I.R.C. § 6662 (e). 

169I.R.C. § 6664(c). 
SECTION VII. SCOPE OF THE PROPOSALS--DEFINITION OF A WIDELY HELP 

PARTNERSHIP 

The definition of a widely held partnership should satisfy three criteria. First, it should cover partnerships with 

numerous partners, because it is these partnerships that present 

the most serious administrative difficulties under current law. 

Second, it should provide a bright line, so that partnerships and 

the Service will be able to determine with certainty whether any 

given partnership is subject to the simplified reporting and 

current assessment system. Third, the definition of a widely 

held partnership should exclude service partnerships such as 

accounting or law firms. In a service partnership, each partner 

is likely to be an active member of the business, making full 

entity treatment less appropriate. 70 

The following definition should satisfy these criteria. A 

widely held partnership is any r:artnership (i) with 250 or more 

partners during a taxable year 1 1 , and (ii) in which interests 

are required to be registered under federal or state laws 

regulating securities or have been sold under an exemption from 

registration requiring the filing of a notice with a federal or 

state agency regulating the offering or sale of securities. 172 

In determining the number of its partners during a taxable 

year, a partnership will be entitled to rely on the number of 

partners properly reported to the partnership by nominees under 

170Although all publicly traded partnerships will presumably 

be treated as widely held partnerships, the uncertainty inherent 

in the definition of a publicly traded partnership under section 

7704 makes it unsuitable as a threshold test for application of 

the proposals made herein. Moreover, there is a sizable 

population of partnerships that have numerous partners but are 

not publicly traded partnerships under section 7704. 

171Pursuant to section 60ll(e) of the Code, the Service may 

not require the filing of information returns by electronic or 

magnetic media unless the filer is required to file at least 250 

of the particular information return. Therefore, this appears to 

be an appropriate bench mark for required participation in the 

simplified reporting system. 

172This definition is similar to that under the House 

Proposal, except that it is restricted to relatively large 

partnerships. We believe the scope of the definition under the 

House proposal was considerably broader than necessary. 
84 

section 603l(c). 173 Any partnership that actually has 250 or 

more partners in a taxable year will be subject to audit under 

the current assessment procedure, as well as any partnership that 

reports under the simplified system. 174 

Partnerships with less than 250 partners may wish to enter 

the simplified system. This would be acceptable as long as the 

system is restricted to partnerships that have a relatively large 

number of partners. The fewer the number of partners, the easier 

it would be to take advantage of any variations in the calculation of taxable income resulting from the simplified system. 

Therefore, partnerships with at least 100 partners should be 

allowed to elect into the system. 

A partnership that becomes subject to the simplified system, 

either because it is a widely held partnership or because it 

elects in, will be required to remain in the system unless it 

receives permission of the Commissioner to be removed. It is 

expected that such permission would be granted only in rare 

cases, such as where a partnership suffered a severe diminution 

in size. It may also be necessary to consider aggregation rules 

for situations where series of partnerships are structured to 

avoid the 250 partner limitation. 

173A nominee holding a partnership interest on behalf of 

another person during a partnership's taxable year is required to 

furnish the partnership with the name, address, and taxpayer 

identification number of the owner within one month of the close 

of the taxable year. Temp. Treas. Reg. § 1.603l(c)-1T. 

174A partnership might be subject to the widely held 

partnership audit system and not the simplified reporting system 

for a given year. This would occur if, for example, at the time 

a partnership mailed Form 1099-Ks to its partners, it did not 

have information indicating that it had at least 250 partners due 

to lapses in nominee reporting. If it is subsequently determined 

that the partnership had 250 or more partners in that year, the 

partnership would be subject to the widely held partnership audit 

system, but would not be required to file an amended return and 

transmit Form 1099-Ks to its partners. It might be necessary to 

provide a rule for situations in which the Service inadvertently 

applies the wrong audit and assessment procedure under these 

circumstances. Consideration should be given to whether any 

other problems would result from a partnership being subject in a 

single taxable year to the widely held partnership audit system 

and not to the simplified reporting system. 
SECTION VIII. EFFECTIVE DATE CONSIDERATIONS 

Effective date considerations differ somewhat for the 

current assessment system and the simplified reporting system. 

The simplified reporting system should probably apply to all 

widely held partnerships as soon as practicable after the passage 

of implementing legislation, taking into account the time 

necessary for partnerships to develop new accounting and 

reporting procedures. 

There are a number of possible approaches to implementing 

the proposed audit and assessment system for widely held partnerships. First, the new rules could be made effective only for 

partnerships formed after a certain date. This would permit 

partnerships to take the new rules into account in structuring 

their partnership agreements. However, it would delay the true 

effective date of the provision for many years. Such a delay may 

be unacceptable in view of the Service's current difficulties in 

administering widely held partnerships. Alternatively, the audit 

and assessment system could be made applicable to audits 

commenced after a given date. While this would make the rules 

quickly applicable, it would place significant pressure on 

determining the exact date an audit is commenced. It also might 

be viewed as unfair to impose a new system on partnerships that 

have not had any time to prepare for it. Therefore, the best 

approach would be to make the prr~osal effective for taxable 

years ending after a given date. 5 The date selected should 

allow partnerships enough lead time to amend their partnership 

agreements should they choose to do so. 

The simplified reporting system and the revised audit 

procedures could be effective in differing taxable years, as the 

implementation of either is not dependent on the other. However, 

if the necessary lead time for the simplified reporting system is 

comparable to that needed under the audit and assessment system, 

both should be made applicable in the same taxable year. 

175The reference to taxable years ending after rather than 

before a given date is preferred due to occasional uncertainty 

concerning the date a partnership's .taxable year commences. 
APPENDIX I 

Proposals for Amendments to TEFRA Rules 

The unified audit and litigation provisions that were 

enacted with respect to partnerships as part of the Tax Equity 

and Fiscal Responsibility Act of 1982 (TEFRA) and extended to S 

corporations by the Subchapter s Revision Act of 1982, represented a radical change in the way that audits and litigation 

relating to these entities and their investors were conducted. 

As can be expected with respect to any change of this magnitude, the transition has been difficult and the procedures have not 

always worked in practice the way that they were envisioned. 

However, we are in favor of retaining these provisions, at least 

with respect to partnerships that would not be subject to the new 

procedures recommended by this study. On the other hand, based 

upon our experience in administering these provisions, we 

recommend that certain changes be made. A summary of the TEFRA 

rules is provided in Appendix II. 

1. Boundary Issues 

A substantial problem area exists with respect to whether 

the TEFRA partnership.procedures or the regular deficiency procedures apply to a particular taxable year, a particular 

taxpayer, or a particular adjustment. This determination can be 

very technical and difficult to make, and the consequences of an 

incorrect choice can be severe because if the Service applies the 

wrong procedure, the statute of limitations applicable to the 

correct procedure may have expired by the time that the problem 

is discovered. The situations giving rise to this problem are 

generally described as presenting "boundary issues." 

One example of a boundary issue arises in the context of the 

small partnership exception contained in section 6231(a)(1) (B). 

Pursuant to that section, the partnership audit provisions do not 

apply to a partnership that has 10 or fewer partners, each of 

whom is a natural person (other than a nonresident alien) or an 

estate, and each partner's share of each partnership item is the 

same as that partner's share of every other partnership item. 

Several pitfalls exist in applying this provision. Specifically, 

if an incorre.ct determination is made regarding whether there 

were ever more than 10 partners in the partnership at any one 

time during the year, or whether a person is a nonresident alien, 

or whether any special allocations were made during the year, the 

service may inadvertently apply the wrong procedures. 

similarly, boundary issues may be encountered as a result of 

the operation of the special enforcement provisions of section 

6231(c). For example, Temp. Treas. Reg. 

§§ 301.6231(a)(7)-1T(l)(4) and 301.6231(c)-7T(a) provide that 

upon the filing of a petition naming a partner as a debtor in a 

bankruptcy proceeding, that partner's partnership items are 

converted to nonpartnership items, and if the debtor was the tax 
2 

matters partner (TMP), such status terminates. These rules are 

necessary because of the automatic stay provision contained in 11 

u.s.c. § 362. However, problems arise because the Service is not 

automatically notified of every bankruptcy filing. When the 

Service is unaware that a partner is in bankruptcy, the Service 

may mistakenly treat the debtor as a party to a partnership 

proceeding and allow the statute of limitations with respect to 

the partner's nonpartnership items to expire. In such a case, a 

statutory notice of deficiency adjusting the converted partnership items will be barred, even though the Service could have 

timely issued such a notice if the Service had been aware of the 

bankruptcy filing. Likewise, if unbeknownst to the Service the 

TMP goes into bankruptcy, the Service may issue a notice of final 

partnership administrative adjustment (FPAA) to the bankrupt TMP, 

which may be determined to be invalid because the debtor's status 

as TMP was automatically terminated by the filing of the 

bankruptcy petition. 

Another boundary issue arises in the context of tiered 

partnerships. In particular, if the source (operating) partnership is non-TEFRA and the tier (investor) partnership is 

TEFRA, or vice versa, it is unclear whether the TEFRA procedures 

or the deficiency procedures should be applied. The Service has 

taken the position that it is the source partnership's status 

that controls with respect to any adjustments relating to items 

flowing from the source partnership. However, to the extent that 

the tier partnership generates income or expense items attributable to its own activities, any adjustment to those items must 

be made at the tier level. When dealing with multiple tier 

situations, such determinations are very difficult and mistakes 

are bound to be made. As a result, many of these adjustments may 

be in jeopardy if it is subsequently determined that the wrong 

procedures were applied. To alleviate this problem, the interplay between the TEFRA and deficiency procedures in the context 

of tiered partnerships should be clarified. 

As the above discussion illustrates, boundary issues present 

hidden traps and create substantial administrative difficulties 

for the Service, which must frequently decide at its peril 

whether to apply the TEFRA procedures or the deficiency procedures and run the risk that if it chooses incorrectly, the 

adjustments may be barred. Since the revenue loss may be substantial, we recommend that legislation be enacted which would 

mitigate the effect of boundary issues. One approach would be to 

resolve each boundary issue separately. If that is not feasible, 

another approach would be to provide that if the Service erroneously makes a determination regarding the proper procedure to 

apply and timely issues the appropriate notice in accordance with 

that determination, i.e., a statutory notice or a notice of FPAA, 

then the statute of limitations for assessment will not expire 

before 1 year after a court determines that the wrong procedure 

was followed and that determination becomes final. A legislative 
3 

proposal along these lines is attached. One potential benefit to 

this latter approach is that it will cover all boundary issues, 

even those that have not yet been identified. As a result, this 

approach should eliminate the need to seek additional legislation 

concerning boundary issues in the future, if new boundary issues 

are identified. 

Additionally, we have two proposals concerning the small 

partnership exception that should reduce the number of partnerships that are subject to the unified, entity-level procedures 

and eliminate some of the boundary issues discussed above: 

A. The "natural person (other than a nonresident alien) or 

an estate" requirement should be eliminated from section 

6231(a) (1) (B) (i) (I) and replaced with a "no pass-thru entity" 

requirement. Under this proposal, a partnership with 10 or fewer 

partners that has a subchapter c corporation as a partner would 

still qualify for the small partnership exception, but a partnership having an S corporation, a trust, another partnership 

(tier), or a nominee as a partner would not be eligible for the 

exception. 

B. The same share requirement contained in section 

6231(a) (1)(B)(i) (II) should be eliminated. When dealing with a 

partnership that has 10 or fewer partners, we do not believe that 

the mere existence of a special allocation causes sufficient 

problems to warrant subjecting the entire partnership to the 

TEFRA procedures. It should be recognized, however, that if this 

proposal is adopted, a potential for inconsistent treatment of 

partners may be created if a reallocation of items becomes 

necessary. 

2. Treatment of Partnership Items in Deficiency Proceedings 

In Munro v. Commissioner, 92 T.C. 71 (1989), the Tax Court 

upheld the validity of a statutory notice that disallowed net 

losses from TEFRA partnerships before computing the deficiency 

amount, but ruled that it was impermissible for the Service to 

disallow the partnership losses in the statutory notice even if 

this was done. solely for computational purposes and was not 

intended to be a substitute for issuing a notice of final 

partnership administrative adjustment (FPAA) as required by 

section 6225. The court held that the partnership items (whether 

income, loss, deduction or credits) included on a taxpayer's 

return should be completely ignored in determining whether a 

deficiency exists that is attributable to nonpartnership items. 

Hence, under Munro, the Service may not assume the correctness of 

its proposed adjustments to partnership items for computational 

purposes in determining a deficiency, and taxpayers may not 

offset net partnership losses against their taxable income for 

purposes of deficiency proceedings. 
4 

Prior to the Munro case, it was the Service's practice to 

treat all partnership items as if they were correctly reported 

for purposes of the deficiency proceeding; under Munro, the 

partnership items are eliminated from the taxpayer's return. 

However, in Munro situations, where the taxpayer is oversheltered, i.e., losses entirely offset the taxpayer's income, 

this procedure would not have permitted any adjustment to the 

nonpartnership items. It was these unusual facts that led to the 

Munro opinion. 

In most of the cases that are either currently in litigation 

or under audit, net losses from TEFRA entities are claimed and 

used to only partially offset income from non-TEFRA sources. 

Since under normal circumstances the TEFRA proceeding progresses 

more slowly than the deficiency proceeding, computing the 

deficiency under Munro will result in a greater deficiency being 

asserted in the deficiency proceeding than would have been 

asserted under the Service's practice prior to the Munro opinion. 

Consequently, under Munro, the taxpayer will not get the benefit 

of the partnership losses until the losses are determined to be 

allowable in a TEFRA proceeding, even though the factual scenario 

that gave rise to the Munro opinion is relatively unusual. 

While we believe that the Tax Court's opinion is technically 

correct in that the deficiency procedures and the TEFRA procedures were intended to be totally separate, the solution proposed 

by the Tax Court is unworkable as a practical matter. In the 

typical case, computing the tax liability without reference to 

partnership items will have the same effect as though those 

partnership items were disallowed. If the partnership items were 

losses, the effect will be a greatly increased deficiency for the 

nonpartnership items. If, when the partnership proceeding is 

completed, the partner is ultimately allowed any part of the 

losses, the partner will receive part of the increased deficiency 

back in the form of an overpayment. However, in the interim, the 

partner will have been subject to assessment and collection of a 

deficiency inflated by items still in dispute in the partnership 

proceeding. In essence, implementation of Munro in the typical 

case means loss of a prepayment forum for TEFRA partnership 

adjustments •. As a policy matter, we view this result as an 

inappropriate and unintended consequence of implementing Munro. 

In light of the above, and other problems which have been 

identified with respect to the implementation of Munro, we 

strongly endorse the legislative proposal that has been worked 

out with the staffs of the Joint Committee and House Legislative 

Counsel. In essence, this proposal would enable the Service to 

continue using its prior practice for most cases but provides a 

special rule covering oversheltered situations such as existed in 

Munro. With respect to the oversheltered cases, the proposal 

provides that partnership items shall be disregarded in determining whether a deficiency exists for purposes of the deficiency 
5 

proceeding and any adjustment in that proceeding shall be taken 

into account in determining the amount of any computational 

adjustment following the completion of the partnership 

proceeding. A copy of this proposal is attached. 

3, Relationship Between the Limitations Periods Provided 

By Sections 6229 and 6501 

Section 6501 provides a limitations period with respect to 

any tax imposed by title 26. This period is determined with 

reference to the filing of the taxpayer's return. Section 6229 

provides a limitations period with respect to any tax imposed by 

subtitle A that is attributable to any partnership item or 

affected item. This period is determined with reference to the 

filing of the partnership's return. Under the existing statutory 

scheme, it is unclear whether these two sections create separate 

statutes of limitations, i.e., section 6501 applies with respect 

to nonpartnership items and section 6229 applies with respect to 

partnership and affected items, or whether section 6229 simply 

extends the limitations period with respect to partnership and 

affected items in situations where the section 6501 period has 

otherwise expired, Since both of these interpretations are 

supportable under current law but each approach presents conceptual difficulties, legislation clarifying this area should be 

enacted. In addition, the issue of whether an extension of the 

statute of limitations that is obtained pursuant to section 

6501(c) (4) and does not make specific reference to partnership 

items applies to partnership items that subsequently convert to 

nonpartnership items, should also be addressed. 

4, Suspension of the Statute of Limitations During the 

Pendency of Bankruptcy Proceedings 

As discussed with respect to the boundary issues, a 

partner's partnership items convert to nonpartnership items upon 

the filing of a petition naming the partner as a debtor in a 

bankruptcy proceeding. Section 6229(f) provides that the period 

for assessing tax with respect to items that convert to nonpartnership items shall not expire before the date which is 1 year 

after the date that the items become nonpartnership items. 

Section 6503(i) provides for the suspension of the limitations 

period during the pendency of a bankruptcy proceeding. However, 

this provision only applies to the limitations periods provided 

in sections 6501 and 6502. Since the limitations period 

pertaining to converted items is governed by section 6229(f) 

rather than section 6501, the suspension of the limitations 

period provided by section 6503(i) will not apply with respect to 

partnership items that convert to nonpartnership items by reason 

of the filing of a petition naming the partner as a debtor in a 

bankruptcy proceeding. As a result, the limitations period will 

continue to run during the pendency of the bankruptcy proceeding, 

notwithstanding that the Service is prohibited from making an 
6 

assessment against the debtor because of the automatic stay 

imposed by section 362(a) of the Bankruptcy Code. Moreover, 

under certain circumstances it is possible for the normal 3 year 

limitations period to be shortened to 1 year or for the 

limitations period to arguably expire prior to the filing of the 

return for a given year. Consequently, either a provision 

similar to section 6503(i) should be enacted to cover the 

limitations period provided in section 6229(f) or section 6503(i) 

should be amended to extend the suspension provision to the 

section 6229(f) period. The suspension provision should also be 

extended to the limitations period provided in sections 6229(a) 

and 6229(d) relating to the time for making a computational 

adjustment following default or judicial review of a notice of 

final partnership administrative adjustment (FPAA). 

5. Exclusion of Partial settlements From the 1 Year 

Assessment Period 

Section 6231(b)(1)(C) provides that the partnership items of 

a partner for a partnership taxable year shall become nonpartnership items as of the date the Service enters into a settlement 

agreement with the partner with respect to such items. As discussed previously, under section 6229(f), the limitations period 

for assessing any tax attributable to converted items shall not 

expire before the date which is 1 year after the date on which 

the items become nonpartnership items. This rule creates a 

problem in situations where a settlement agreement is entered 

into with respect to some but not all of the issues in the case. 

The reason for this is that a 1 year assessment period will apply 

with respect to the settled items whereas the remaining items 

will be governed by the normal assessment period under section 

6229(a). If issues are settled at several different stages of 

the proceeding, the problem can become severe. 

The fractured statute problem can be illustrated by the 

following example: 

Assume that five issues are raised in connection with the 

examination of the 1984 return for the ABC Partnership. While 

the case is still being handled by the Examination function, the 

Service and all partners enter into a specific matters closing 

agreement whereby all parties agree that a deduction was erroneously claimed. The case then goes to Appeals where the Service 

concedes the second issue. After the case is docketed but before 

the trial, the parties settle the third adjustment. Pursuant to 

a court order, the parties file a Stipulation of Settled Issues 

with the court evidencing their agreement with respect to the 

third adjustment. The remaining two issues are tried but the 

partnership concedes the fourth issue on brief. The last issue 

is decided by the court. 
7 

Under the above scenario, the partners in the ABC 

Partnership will be subject to five different limitations 

periods for assessment with respect to their investment in the 

ABC partnership for the 1984 taxable year. Making five separate 

computations with respect to each partner for a single taxable 

year is extremely burdensome and creates a drain on the Service's 

limited resources. Moreover, the fractured statute poses a 

significant tracking problem for the service, which may result in 

many, if not most, of the assessments not being made within the 

relevant time period. On the other hand, if the assessments are 

timely made, the partners in the ABC Partnership may become 

angered or confused when they receive multiple notices of 

assessment with respect to the same taxable year. 

In light of the above, it is recommended that even though 

partnership items covered by a settlement agreement will convert 

to nonpartnership items, if the agreement constitutes only a 

partial settlement, it should not trigger a 1 year assessment 

period. Instead, legislation should be enacted to provide that 

the 1 year assessment period will not begin to run until all 

issues in the case are disposed of. As applied to the above 

example, this would not occur until the decision of the court 

became final. One possible way to accomplish this may be to 

provide that for purposes of the statute of limitations on 

assessment, a settlement must be comprehensive, i.e., if a 

settlement is limited to selected items, it will not be treated 

as a settlement, and hence, it will not commence a 1 year 

assessment period with respect to those settled items. On the 

contrary, the assessment period with respect to the settled items 

will be governed by section 6229(a). Thus, the assessment period 

with respect to the settled items will be the same as the 

assessment period for the items that have not been settled. 

6. Forum For Contesting the Applicability of the Increased 

Rate of Interest Under Section 6621(cl 

Section 6621(c) provides for an increased rate of interest 

with respect to any substantial underpayment attributable to tax 

motivated transactions. Jurisdiction to determine the applicability of section 6621(c) was granted to the Tax Court in 

section 6621(c)(4), but said jurisdiction is limited to those 

proceedings in which the Tax court also has jurisdiction over the 

deficiency to which the increased rate of interest relates. When 

the issue arises in connection with an investment in a TEFRA 

partnership, the applicability of section 6621(c) is treated as 

an affected item that requires partner-level determinations. As 

a result, under section 6230(a) (2), the application of section 

6621(c) must be determined in separate proceedings at the partner 

level following the completion of the partnership-level 

proceeding. Unfortunately, since in an affected item proceeding 

the Tax Court does not have jurisdiction over the underlying 

deficiency, the Tax Court similarly lacks jurisdiction to 

' 
8 

determine the applicability of section 6621(c) in such a 

proceeding. Likewise, a partner cannot contest the applicability 

of section 6621(c) in a section 6230(c) refund suit because such 

actions are essentially limited to computational disputes. 

Consequently, it is recommended that a judicial forum be provided 

for partners to challenge the imposition of the increased rate of 

interest under section 6621(c) relating to deficiencies attributable to their investment in a TEFRA partnership. It is noted, 

however, that if proposal 13 regarding the determination of 

penalties and the increased rate of interest at the partnership 

level is adopted, no further action with respect to this proposal 

will be necessary since a forum under section 6230{c) will be 

provided. 

7. Forum For Raising Innocent Spouse Defense 

Under section 6013(e), an innocent spouse may be relieved of 

liability for tax, penalties and interest if certain conditions 

are met. However, existing law does not provide the spouse of a 

partner in a TEFRA partnership with a judicial forum to raise the 

innocent spouse defense with respect to any tax or interest that 

relates to an investment in a TEFRA partnership. Since the 

innocent spouse defense requires substantive determinations, a 

refund suit under section 6230(c) would not be permissible. 

Similarly, since innocent spouse is an affirmative defense that 

will only be raised by a taxpayer, the taxpayer will only be able 

to assert the defense in the Tax Court if the Service issues an 

affected items statutory notice to the taxpayer. If such a 

notice is not issued to the taxpayer, there does not appear to be 

a judicial forum available in which to raise the innocent spouse 

defense. Accordingly, it is recommended that a judicial forum be 

provided for a spouse of a partner in a TEFRA partnership to 

raise the innocent spouse defense insofar as it relates to a 

liability that is attributable to an investment in the TEFRA 

partnership. 

a. suspension of the Statute of Limitations Upon the 

Filing of an Untimely Petition 

In a deficiency case, section 6503(a) provides in pertinent 

part that if a proceeding in respect of the deficiency is placed 

on the docket of the Tax Court, the period of limitations on 

assessment and collection shall be suspended until the decision 

of the Tax Court becomes final, and for 60 days thereafter. The 

counterpart to this provision with respect to TEFRA cases is 

contained in section 6229(d). That section provides in pertinent 

part that the period of limitations shall be suspended for the 

period during which an action may be brought under section 6226 

and, if an action is brought during such period, until the 

decision of the court becomes final, and for 1 year thereafter. 

As a result of this difference in language, the running of the 

statute of limitations in a TEFRA case will only be tolled by the 

·-
9 

filing of a timely petition whereas in a deficiency case, the 

statute of limitations is tolled by the filing of any petition, 

regardless of whether the petition is timely. Consequently, if 

an untimely petition is filed in a TEFRA case, the statute of 

limitations can expire while the case is still pending before the 

court. To prevent this from occurring, the Service must make 

assessments against all of the investors during the pendency of 

the action and if the action is in the Tax Court, presumably 

abate such assessments if the court ultimately determines that 

the petition was timely. Hence, the statute creates a trap for 

the unwary and necessitates an inefficient use of resources on 

the part of the Service. Accordingly, section 6229(d) should be 

amended to make the suspension provision concerning the filing of 

petitions in TEFRA cases consistent with the rule under section 

6503(a) pertaining to deficiency cases. 

9. Administrative Adiustment Requests CBAAl 

A. Refund Suits Under Section 6228 

Section 6230(a)(2)(A)(ii) provides that deficiency 

procedures apply to items which have become nonpartnership items. 

An exception to this rule is provided with respect to items that 

convert by reason of a settlement agreement. Pursuant to section 

6231(b) (1) (B), a partner's partnership items become nonpartnership items upon the filing of a suit under section 6228(b). 

Since items that convert pursuant to section 6231(b) (1) (B) will 

already be the subject of a judicial proceeding, the deficiency 

procedures should not apply. Accordingly, this situation should 

be excluded from the rule under section 6230(a) (2)(A) (ii). 

B. Extension of Time Within Which to File an RAA 

Section 6227(a) provides that a partner may file a request 

for an administrative adjustment of partnership items within 3 

years after the later of the date of the filing of the partnership return or the last day for filing the partnership return 

(determined without regard to extensions), but before the Service 

mails a notice of FPAA to the TMP. Section 6511(c) provides that 

if an agreement is entered into under section 6501(c)(4) to 

extend the period for assessment, the period for filing a claim 

for credit or refund or for making a credit or refund if no claim 

is filed, shall not expire prior to 6 months after the expiration 

of the period within which an assessment may be made pursuant to 

the agreement under section 6501(c)(4). It is recommended that a 

provision similar to section 6511(c) be enacted with respect to 

the filing of an RAA where an agreement extending the statute of 

limitations relating to partnership and affected items is entered 

into under section 6229(b). 
10 

c. Allowance of Credits or Refunds After the Expiration of 

the Time For Filing an RAA 

The rules pertaining to credits or refunds attributable to 

partnership items and affected items are set forth in sections 

6227, 6230(c) and 6230(d). These rules are fairly complex. As a 

result, there is confusion regarding the allowance of credits or 

refunds where no RAA has been filed and the time for doing so has 

expired, but the statute of limitations under section 6229 is 

still open or the time for filing a claim or suit under section 

6230(c) has not yet expired. This situation frequently occurs 

when the TMP extends the statute of limitations under section 

6229 and after the time for filing an RAA has expired, a partner 

makes an advance payment of tax to stop the running of interest. 

Under these circumstances, it appears as if a partner should be 

able to obtain a credit or refund, but it is unclear from the 

statute whether the making of such a credit or refund would be 

permissible. Consequently, it is recommended that this point be 

clarified. 

D. RAAs Filed By the Tax Matters Partner in Overpayment 

Situations 

Section 6227(b) (1) provides that if the TMP files an RAA on 

behalf of the partnership and requests substituted return 

treatment, the Service may treat the changes shown on the request 

as corrections of mathematical or clerical errors appearing on 

the partnership return. If an RAA filed by the TMP on behalf of 

the partnership is not treated as a substituted return, under 

section 6227(b) (2) the Service may, without conducting any 

proceeding, allow or make to all partners the credits or refunds 

arising from the requested adjustments; conduct a partnership 

proceeding; or take no action on the request. In light of the 

above, it appears as if substituted return treatment is only 

available where additional tax is due; if the requested 

adjustments would give rise to a credit or refund for the 

partners, the RAA must be handled under section 6227(b)(2). It 

is unclear, however, whether in an overpayment situation the 

partners' right to a credit or refund is protected by the filing 

of an RAA by the TMP, or whether the partners must file separate 

RAAs in order to preserve their respective rights to file a 

refund suit under section 6228. Section 6228(a)(4) seems to 

indicate that the partners are protected if the request is not 

allowed and the TMP files suit, since the partners will be 

treated as parties to the action and they are entitled to 

participate. On the other hand, it appears as if the partners 

will not be protected if the TMP fails to timely file a suit 

since only the TMP is permitted to file a petition with respect 

to an RAA filed under section 6227(b). Accordingly, it is 

recommended that the partners be provided with an additional 

period of time within which to file a petition regarding the RAA, 

in the event that the TMP fails to file such a petition. This 
11 

would be similar to the provisions under section 6226 concerning 

the filing of a petition with respect to a notice of FPAA. Such 

a rule would be beneficial both to the partners and the Service 

because it would eliminate the need for the partners to file 

separate RAAs and the Service would not have to expend its 

limited resources processing those requests. 

10. Application of Section 6223(e) in the Context of a 

Tiered Partnership 

If the Service fails to provide a notice of the beginning of 

an administrative proceeding (NBAP) or a notice of final partnership administrative adjustment (FPAA) to a partner who is 

entitled to such notice, section 6223(e) permits the partner to 

make certain elections. In a tiered partnership, the pass-thru 

partner (tier) will normally be a notice partner. Under current 

law, it is unclear whether the section 6223(e) election may be 

made by the pass-thru partner and would be binding on the 

indirect partners (the investors in the tier) or whether the 

indirect partners are entitled to make separate elections. 

Additionally, if both the tier and an indirect partner make 

elections, it is unclear which election should be given effect. 

Thus, legislation clarifying these points would be helpful. In 

this regard, it is noted that sections 6224(c) (1) and 6224(c) (3) 

provide rules concerning the effect of settlement agreements 

entered into by a pass-thru partner or the tax matters partner 

(TMP) on indirect partners and nonnotice partners, respectively. Similar rules pertaining to section 6223(e) elections may be 

appropriate. 

11. Application of the TEFRA Partnership Provisions to a 

Partner Who is a Member of a Consolidated Group 

When a partner in a TEFRA partnership is a member of a 

consolidated group, several problems arise if the partner is not 

the common parent of the members of the consolidated group. The 

primary reason for this is that Treas. Reg. S 1.1502-77 provides 

that the common parent is the sole agent for each subsidiary in 

the group with respect to all matters relating to the tax 

liability for the consolidated return year, and that no subsidiary shall have the authority to act for or to represent 

itself in any such matter. On the other hand, the TEFRA 

partnership provisions grant many rights to the tax matters 

partner (TMP), such as the authority to extend the statute of 

limitations on behalf of all partners and to enter into a 

settlement agreement that may bind certain other partners. In 

this regard, it is noted that the other members of the consolidated group are treated as partners under section 6231(a) (2)(B) 

because their income tax liability will be determined in part by taking into account indirectly partnership items of the TEFRA 

partnership. Hence, in light of these conflicting provisions, it 

is unclear whether the actions taken. by the TMP will be binding 
12 

on the consolidated group. Some guidance concerning the proper 

application of the TEFRA partnership provisions in this context 

would be helpful. 

12. Dismissal of Premature Petitions 

Section 6226 sets forth the rules concerning judicial review 

of notices of final partnership administrative adjustment (FPAA). 

Pursuant to section 6226(a), the tax matters partner (TMP) is 

given the exclusive right to file a petition for a readjustment 

of partnership items within the 90-day period after the issuance 

of the notice of FPAA. Pursuant to section 6226(b) (1), if the 

TMP does not file a petition within the 90-day period, notice 

partners are permitted to file a petition within the 60-day 

period after the close of the 90-day period. If more than one 

petition is filed under section 6226(b), that section sets forth 

ordering rules for determining which action goes forward and 

provides in paragraph (4) for the dismissal of all other actions. 

Section 6226(h) provides that if an action is dismissed other 

than under subsection (b) (4), the dismissal shall be treated as a 

determination that the notice of FPAA is correct. This provision 

creates a problem in cases where a petition is filed within the 

90-day period by a person who is not the TMP. since such a 

petition is filed under section 6226(a) rather than under section 

6226(b), the dismissal is technically not pursuant to section 

6226(b) (4). Hence, pursuant to section 6226(h), the dismissal of 

the premature petition would have the effect of upholding the 

notice of FPAA. such a result is inappropriate. Consequently, 

it is recommended that legislation be enacted to correct this 

inequity, which clearly was not intended. 

13. Determination of Penalties at the Partnership Level 

Section 6231(a)(3) limits the definition of partnership 

items to those items required to be taken into account under any 

provision of subtitle A. since penalties are contained in 

subtitle F, they cannot be partnership items. Instead, penalties 

are treated as affected items that require partner-level 

determinations. As a result, under section 6230(a)(2), penalties 

may only be asserted against a partner through the application of 

the deficiency procedures following the completion of the 

partnership-level proceeding. These penalty only cases create an 

undue burden for the Service and have the potential of significantly increasing the Tax Court's inventory. Moreover, the 

requirement of conducting a separate proceeding with each partner 

greatly· increases the likelihood of disparate treatment. Hence, 

the major goals of the TEFRA partnership provisions, namely 

administrative and judicial economy and consistent treatment of 

partners, are not being accomplished with respect to penalties 

that are attributable to an investment in a TEFRA partnership. 

Accordingly, it is recommended that penalties be determined at 

the partnership level and imposed against the partners as a 
13 

computational adjustment. However, it is also recommended that 

section 6230(c) be amended to provide the partners with a refund 

forum to raise any partner-level defenses that they may have with 

respect to the imposition of the penalty. This proposal should 

also be made applicable to the increased rate of interest under 

section 6621(c). 

14. Repeal of the Unified Procedures For s corporations 

The Subchapter s Revision Act of 1982 added sections 6241-

6245 to the Code. These provisions generally made the unified 

audit and litigation procedures for partnerships applicable to 

s corporations. Notwithstanding the repeal of General Utilities 

as part of the Tax Reform Act of 1986, which has made the use of 

s corporations more popular, the Service is in favor of repealing 

the unified procedures for S corporations. Historically, 

s corporations have not generally been used as a vehicle to 

market abusive tax shelters and the Service did not experience 

any significant difficulties in auditing s corporations or 

litigating at the shareholder level. Furthermore, for 

S corporation taxable years the return for which is due on or 

after January 30, 1987 (determined without regard to extensions), 

Temp. Treas. Reg.§ 301.6241-1T(c)(2) provides for a small 

s corporation exception for s corporations with five or fewer 

shareholders, and it is our understanding that the vast majority 

of both existing and newly formed S corporations qualify for that 

exception. Hence, it appears as if the repeal of the unified 

procedures for s corporations is justified. 
14 

Section 6229 PERIOD OF LIMITATIONS FOR MAKING ASSESSMENTS. 

* * * 

(h) Special Rule When Secretary Erroneously Applies 

Deficiency Procedures.- If the Secretary erroneously determines 

that subchapter c of this chapter does not apply to a partnership 

taxable year and consistent with that determination timely mails 

a notice of deficiency to a partner pursuant to sections 6212 and 

6501, which includes adjustments to partnership items (or 

affected items) of the partnership, the period of limitations 

provided in this section shall not expire before the date which 

is 1 year after the date that the determination of a court that 

the incorrect procedure was followed becomes final. 

Section 6501 LIMITATIONS ON ASSESSMENT AND COLLECTION. 

* * * 

Redesignate existing subsection (o) as (p) and insert the 

following: 

(o) Special Rule When Secretary Erroneously Makes 

Administrative Adjustment.- If the Secretary erroneously 

determines that subchapter C of chapter 63 applies to a 

partnership taxable year and consistent with that determination 

timely mails a notice of final partnership administrative 

adjustment to the tax matters partner with respect to that 

taxable year pursuant to sections 6223 and 6229, the period of 

limitations for assessing any tax which is attributable to the 

partnership items (or affected items) of the partnership shall 

not expire before the date which is 1 year after the date that 

the determination of a court that the incorrect procedure was 

followed becomes final. 
15 

Section 6230 ADDITIONAL ADMINISTRATIVE PROVISIONS. 

(a) coordination With Deficiency Proceedings.-

* * * 

(3) TREATMENT OF PARTNERSHIP ITEMS IN DEFICIENCY 

PROCEEDINGS.--

(A) IN GENERAL.--In determining whether there is a 

deficiency for purposes of subchapter B, except as provided in 

paragraph (2)(A), adjustments to partnership items may be made 

only as provided in this subchapter. 

(B) SPECIAL RULES,--

(i) IN GENERAL.--In any case in which the 

taxpayer's return shows a loss or no taxable income and shows a 

net loss from partnership items, solely for purposes of 

proceedings conducted under subchapter B, partnership items shall 

be disregarded in determining whether there is a deficiency. Any 

adjustment in such proceedings shall be taken into account in 

determining the amount of any computational adjustment. 

(ii) EXCEPTION FOR CERTAIN ITEMS.--Clause (i) 

shall not apply to any partnership item the treatment of which 

has been finally determined under this subchapter. 

EFFECTIVE DATE--This amendment shall take effect as if such 

amendment had been included in the amendments made by section 402 

of the Tax Equity and Fiscal Responsibility Act of 1982. 
APPENDIX II 

Description of TEFRA Rules 

Prior to the enactment of unified partnership audit rules by 

the Tax Equity and Fiscal Responsibility Act of 1982, adjustments 

to items of income, gain, loss, deduction and credits relating to 

a partnership had to be made in separate proceedings with the 

respective partners. Similarly, settlements and judicial determinations were only binding on those partners that were parties 

to the agreement or judicial proceeding. This system was not an 

efficient means of auditing tax shelters and other large partnerships, because each partner was entitled to separate administrative and judirial review of partnership items that were common 

to all partners. The TEFRA partnership audit rules consolidate 

the administrative and judicial review of all partnership items 

at the partnership level. Congress, noting the potential conflict between investors and tax shelter promoters, balanced the 

consolidated audit provisions with considerable protections for 

individual partners. 

The TEFRA partnership audit rules apply to all 

partnerships, except for partnerships with ten or fewer partners 

where each partners' share of any partnership item is the same as 

his share of every other item (~, there are no special 

allocations) and each partner is a natural person (other than a 

nonresident alien) or an estate. 2 The tax treatment of all 

partnership items is determined at the partnership level. 3 

Generally, all partners must treat items on their individual 

returns consistently with the treatment of those items on the 

partnership return unless they notify the Service of an 

1see General Explanation of the Revenue Provisions of the 

Tax Equity and Fiscal Responsibility Act of 1982, at 267-68 

(hereinafter referred to as "TEFRA General Explanation"). 

2I.R.C. § 623l(a) (1) (B). All partners of a partnership for 

the partnership taxable year under audit generally are subject to 

the TEFRA partnership audit rules. However, under certain 

circumstances, the inclusion of a partner in a unified proceeding 

would interfere with efficient enforcement of the tax law. 

I.R.C. § 623l(c). When special enforcement considerations exist 

with respect to a partner, that partner's partnership items will 

be treated as nonpartnership items and the partner is removed 

from the partnership proceeding. Examples of special enforcement 

situations include the filing of a bankruptcy petition naming a 

partner as the debtor or the criminal investigation of a partner. ~.; Temp. Treas. Reg. §§ 301.623l(c)-4T through BT. 

3r.R.C. § 6221. 
2 

inconsistent treatment. 4 If a partner takes an inconsistent 

position on his or her return and does not provide notice of the 

inconsistency, the Service may immediately assess any deficiency 

necessary to make the partner's treatment consistent with the 

partnership return. Such an ~ssessment would normally also 

include a negligence penalty. 

The central figure in a TEFRA partnership proceeding is the 

tax matters partner ("TMP"). The TMP is a representative of the 

partnership who serves as a liaison between the partnership, the 

Service and the court, with respect to the unified audit and 

litigation proceedings regarding the tax treatment of partnership 

items attributable to the partnership. As such, the TMP serves 

as the focal point for service of all notices, documents and 

orders on the partnership, and concomitantly has many rights and 

duties both at the administrative stage of the proceeding and in 

the course of litigation. The TMP is the general partner designated by the partnership to serve as the TMP or, if there is no 

such designation, the general partner having the largeft profits 

interest as of the close of the taxable year involved. If the 

Service determines that is impracticable to apply the largest 

profits interest fUle, the Service may select any partner to 

serve as the TMP. 

Each partner is entitled ti participate in all aspects of 

the administrative proceedings. If the Service decides to 

initiate a partnership audit, it must furnish both a notice of 

the Beginning of an Administrative Proceeding and a notice of 

Final Partnership A~ministrative Adjustment to all partners 

entitled to notice. In partnerships with more than 100 

partners, only identified partners with a one percent or greater 

interest in partnership profits, and designated members of 

4 I.R.C. § 6222(a) and (b). 

5 I.R.C. § 6222(c) and (d). See I.R.C. S 6662(b)(l). 

6I.R.C. § 623l(a)(7); Temp. Treas. Reg. 

§ 301.623l(a)(7)-1T. 

~; See Rev. Proc. 88-16, 1988-1 C.B. 691. 

8 I.R.C. § 6224(a), 

9I.R.c. § 6223(a). Those partners entitled to receive 

notice from the service are generally referred to as "notice 

partners." The partners who are not entitled to receive notice 

from the Service are referred to as ''non-notice partners." 
3 

"notice groups, 1110 are entitled to notice from the Service. 11 

All other partners are r~ be kept informed of the partnership proceedings by the TMP. 

The TEFRA partnership audit rules provide the TMP with the 

power to make certain decisions on behalf of the partnership. 

The period for assessing any tax with respect to any partner that 

is attributable to any partnership item (or any item affected by 

a partnership item) does not expire before the date that is three 

years after the later of the due date determined with?¥t extension or actual filing date of the partnership return. The TMP 

has the authority to extend that period with respect to all 

partners. 14 The TMP also has the authority to enter into a 

settlement agreement that binds all non-notice partners, 

although any partner may, by notifying the Servfce, refuse to be 

bound by any agreement entered into by the TMP. 5 The TMP may 

file an administrative adjustment request (the functional 

equivalent of an fmended return or claim for refund) on behalf of 

the partnership. 1 The TMP may also select the forum for litigation by filing a petition, during the first 90 days following the 

mailing of the notice of Final Partnership Administrative 

Adjustment, with either the Tax court, the Claims court, or the 

United States district court for the district in which the 

partnership has its principal place of business. 17 

Partners other than the TMP are provided with significant 

protections under the TEFRA partnership audit rules. Notice 

partners have the authority to petition for judicial review from 

a notice of Final Partnership Administrative Adjustment during 

the 60 days following the 90-day period after the mailing of a 

Notice of Final Partnership Administrative Adjustment to the TMP 

(assuming the TMP fails to file a petition during the 90-day 

10A "notice group" is a group of partners having in the 

aggregate a five percent or more interest in partnership profits 

who designate one member to receive notice on behalf of the 

group. I.R.C. § 6223(b)(2). 

11 I.R.C. § 6223(b). 

12 I.R.C. § 6223(g); Temp. Treas. Reg. § 301.6223(g)-1T. 

13 I.R.C. § 6229(a). 

14 I.R.c. § 6229 (b) (1) (B). 

15 I.R.C. § 6224 (c) (3) (B). 

16 I.R.C. § 6227(b). 

17 I. R. C. § 6226(a). 
4 

period). 18 If any partner files a petition in the Tax Court, a 

district court or the Claims Court, any partner in the ifrtnership may file an election to participate in the action. If the 

TMP fails to execute a consent to extend the statute of limitations, the Service must obtain a consent individually from each 

partner or issue a notice of Final Partnership Administrative 

Adjustment to the TMP i~ order to suspend the running of the 

statute of limitations. 0 An administrative adjustment re~est 

may be filed individually by a partner other than the TMP. 1 In 

addition, any partner may reach a settlement of his or her own 

case individually with the Service, and may file a2fequest not to 

be bound by any agreement entered into by the TMP. Partners 

may individually waive their rights under t~~ TEFRA partnership 

audit 2fles or any restrictions placed on the Service by those 

rules. 

Any settlement agreement entered into between the service 

and one or more partners, is binding on the parties to the 

agreement in the absence of fraud, malfeasance or misrepresentation of fact. 24 The TMP cannot bind notice partners. As 

noted above, an agreement entered into by the TMP is binding on 

non-notice partners (~, those partners with less than a one 

percent profits interest in partnerships with over 100 partners) 

only if the TMP expressly states in the agreement that it binds 

the other partners, and the agreement between the Service and the 

TMP will not bind any partner who has filed a statement with the 

Service restricting the TMP's authority to settle on his or her 

behalf. 25 If the Service enters into a settlement agreement with 

18 I.R.C. s 6226(b). 

19 I.R.C. §§ 6224(a); 6226(c) (2); Tax Court Rule 245(b). 

20 I. R. C. s 6229 (b) (1) (A) and (d) • · 

21 I.R.C. s 6227(c). 

22 I.R.C. § 6224 (c) (1) and (c) (J) (B). 

23 . I. R. C. § 6224(b). 

24A partner holding an interest through one or more passthrough partners is bound by a settlement agreement entered into 

by a pass-through partner, unless the indirect partner has been 

identified to the Service. I.R.C. S 6224(c)(l). 

25But see Tax Court Rule 248. Under that rule, if the case 

is docketed in the Tax Court and certain conditions are met, the 

court may enter a decision consistent with a settlement entered 

into with some of the partners, that would be binding on all 

parties to the action, notwithstanding that there may be notice 
5 

respect to partnership items for a particular taxable year, the 

Service generally is obligated (o offer consistent terms to any 

other partner who so requests. 2 The partner's right to re~est 

consistent treatment is subject to certain time limitations. 27 

In general, a change in tax liability of a part£er to 

properly reflect the treatment of a partnership item 8 is made 

through a "computational adjustment." After a final determination 

has been reached with respect to a partnership proceeding, the 

Service allocates the final adjustment among the partners and 

computes their revised tax liability based on return information 

in its possession. A computational adjustment may include a 

change in tax liability that reflects a change in an affected 

item if that change is necessary to properly reflect the treatment of a partnership item. 29 However, changes in a partner's 

tax liability with respect to affected items which require 

partner-level determinations are not included in a computational 

partners, or non-notice partners who filed statements prohibiting 

the TMP from entering into settlements on their behalf, who did 

not enter into a settlement agreement with the Service. 

26 I.R.c. § 6224(c}(2). The service's obligation to offer 

consistent terms only applies if the items subject to the 

original agreement were partnership items with respect to the 

settling partner at the time of the original agreement. Temp. 

Treas. Reg.§ 30l.6224(c)-3T(b)(l). Furthermore, the items must 

be partnership items of the requesting partner at the time of the 

request. Thus, for example, the requesting partner must not have 

previously settled these items with the Service or had the items 

converted to nonpartnership items by reason of a special 

enforcement situation such as the partner's bankruptcy). Temp. 

Treas. Reg.§ 301.6224(c)-3T(b)(2). 

27 I.R.C. § 6224(c}(2). See Temp. Treas. Reg. 

§ 301.6224(c)-3T(c) (3). 

28The term "partnership item" means any item required to be 

taken into account with respect to a partnership taxable year 

under subtitle A of the Code to the extent that regulations 

provide it is more appropriately determined at the partnership 

level than at the partner level. I.R.C. § 623l(a) (3). See 

Treas. Reg.§ 30l.623l(a)(3)-l. Partnership income, loss, 

deduction, or credit are common examples of partnership items. 

29The term "affected item" means any item to the extent it 

is affected by a partnership item. I.R.C. S 623l(a)(5). A 

change in a partner's allowable medical expense deduction due to 

the effect of a partnership item on the adjusted gross income 

threshold is an example of an affected item. 
----------------------------

6 

adjustment, but rather require the issuance of a statut~~y notice 

of deficiency prior to assessment of the tax liability. 

Any partner, or the TMP acting on behalf of }he partnership, 

may file an "Administrative Adjustment Request. 113 In general, 

an Administrative Adjustment Request has the same effect under 

the TEFRA partnership audit rules as either an amended partnership or partner return or a claim for refund with respect to the 

partnership or the partner. An Administrative Adjustment Request 

may be filed with respect to partnership items for a partnership 

taxable year (1) within the three year period after the later of 

the filing date of the partnership return for that year or the 

last day for filing such return (determined without regard to 

extensions), but must be filed before (2) the mailing to the TMP 

of a notice of Fin~l Partnership Administrative Adjustment for 

such taxable year. 2 

The TMP may file an Administrative Adjustment Request with 

respect to the treatment of partnership items on the original 

partnership return. If the TMP asks that the treatment shown on 

the request be substituted for the treatment of partnership items 

on the original partnership return, the Service may treat the 

changes shown on the request as corrections of mathematical or 

clerical errors on the partnership return. 33 If the TMP files an 

Administrative Adjustment Request on behalf of.the partnership 

which is not treated as a substituted return, the Service may, 

with respect to all or part of the requested adjustments: (1) 

compute the appropriate tax as to partners and issue refunds; (2) 

30I.R.C. § 6230(a) (2) (A) (i). A partner-level penalty based 

on an erroneous partnership deduction is an example of an 

affected item that is asserted through a statutory notice of 

deficiency. 

31 I.R.C. § 6227. 

32 I.R.C. § 6227(a). 

33I.R.C. § 6227(b) (1). If the Service treats the 

Administrative Adjustment Request as a correction of mathematical 

or clerical errors appearing on the partnership return, the 

Service may proceed to assessment of the tax against partners 

without carrying on a unified proceeding. See I.R.C. 

§§ 6230(b)(l) and 6225. However, if any partner timely objects, 

the correction cannot be made with respect to that partner 

without conducting a partnership-level proceeding. I.R.C. 

§ 6230(b) (2). 
7 

conduct ~ unified partnership proceeding; or (3) not act on the 

request. 4 

If any partner individually files an Administrative 

Adjustment Request, the Service may: (1) process the request in 

the same manner as a claim for refund with respect to items that 

are not partnership items; (2) assess any additional tax 

resulting from the request; (3) mail to the partner a notice that 

all partnership items of the partner for the partnership taxable 

year to which such request relates shall be treated as 

34If the Service fails to act on an Administrative 

Adjustment Request made on behalf of the partnership, the TMP may 

file a petition for judicial review of the request. I.R.C. 

S 6228(a) (1). Such a petition can be filed only after the 

expiration of six months from the date of the filing of the 

Administrative Adjustment Request and before two years have 

elapsed from the filing date. I.R.C. S 6228(a) (2)(A). However, 

no petition may be filed after the Service has issued a notice of 

the Beginning of an Administrative Proceeding (unless after 

issuance of such notice the Service fails to issue notice of a 

Final Partnership Administrative Adjustment, in which case the 

partner may file a petition within the six-month period following 

the expiration of the applicable statute of limitations). I.R.C. 

S 6228(a)(2)(B) and (C). These limitation periods may be 

extended by agreement of the parties. I.R.C. 6228(a)(2) (D). 

Generally, a court in which a petition is filed will only have 

jurisdiction over items covered by the Administrative Adjustment 

Request that were not allowed by the Service and over items 

raised by the Service as offsets to the requested adjustments. 

I.R.C. § 6228(a) (5). 
8 

nonpartnership items; 35 or (4) conduct a unified partnership 

proceeding with respect to the items covered in the request. 36 

35If the partner is mailed a notice that all of his or her 

partnership items for the partnership taxable year to which an 

administrative adjustment request relates will be treated as 

nonpartnership items, the Administrative Adjustment Request is 

treated as a claim for credit or refund of an overpayment 

attributable to nonpartnership items and the partner may bring a 

refund action under section 7422 with respect to such claim 

within two years of the mailing of such notice. I.R.c. 

§ 6228(b)(l). If the Service fails to grant the request in whole 

or in part and does not issue a notice converting the partner's 

partnership items to nonpartnership items, the partner may 

initiate a refund action within the period starting six months 

following the filing of the request and ending two years after 

such filing. I.R.C. § 6228(b)(2) (B). Upon the commencement of 

such an action, the partner's partnership items are treated as 

nonpartnership items. I.R.c. § 623l(b) (l)(B). No refund actions 

may be brought in a federal district court or the Claims court 

with regard to partnership items except as provided above or as 

provided in section 6230(c) (relating to computational adjustment disputes). I.R.c. § 7422(h). 

36 I.R.C. § 6227(c),