Opinion ID: 187509
Heading Depth: 1
Heading Rank: 6

Heading: More Appropriately Determined at the Partnership Level

Text: In arguing that the second requirement is not met, Petaluma urges that the term item should be interpreted narrowly, arguing that it only includes accounting elements such as income, deductions, credit, gain, loss, and basis. As Petaluma concedes, however, the Code does not define item. Moreover, Petaluma's attempt to cabin the meaning of partnership item ignores the statute's plain language authorizing the Secretary to promulgate regulations that flesh out the definition of that term. § 6231(a)(3). The regulations that fulfill that mandate give examples of partnership items that include [t]he partnership's method of accounting, taxable year, and inventory method. Treas. Reg. § 301.6231(a)(3)-1(b). These examples make clear that the meaning of partnership item extends well beyond technical accounting elements. Furthermore, the regulations state that the definition of partnership item includes the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc. Treas. Reg. § 301.6231(a)(3)-1(b). The determination that a valid partnership exists is a sine qua non for determining the amount and characterization of all other partnership items. For example, determining whether there is a valid partnership necessarily controls whether there can be partnership income, partnership gain, partnership losses, and so forth. This regulation establishes that the validity of a partnership is more appropriately determined at the partnership level, thereby meeting the second requirement of the partnership item test. Thus the determination that a partnership is a sham and lacks economic substance is a partnership item because it is a legal determination that underlies the amount and characterization of other partnership items. RJT Investments X, 491 F.3d at 737-38; Keener v. United States, 551 F.3d 1358, 1366 (Fed.Cir.2009) (stating that the nature of a partnership's transactionand, specifically, whether a partnership transaction is a `sham'is a partnership item). Logically, it makes perfect sense to determine whether a partnership is a sham at the partnership level. A partnership cannot be a sham with respect to one partner, but valid with respect to another. In addition, this conclusion is unsurprising given that this court has affirmed the Tax Court's determinations that a partnership should be disregarded for tax purposes on several prior occasions. Andantech L.L.C. v. Comm'r, 331 F.3d 972, 980 (D.C.Cir. 2003); ASA Investerings P'ship v. Comm'r, 201 F.3d 505, 506 (D.C.Cir.2000). Based on § 6233, its implementing regulations, and the regulations elucidating the meaning of partnership item, we hold that the determination that Petaluma was a sham, lacked economic substance, and should be disregarded for tax purposes is a partnership item. Given the Tax Court's jurisdiction under § 6226(f) to determine all partnership items, we conclude that the Tax Court acted within its jurisdiction when it determined that Petaluma was not a valid partnership and should be disregarded for tax purposes.
Petaluma also argues that the Tax Court erred in holding that it had jurisdiction to determine that Petaluma's partners had no outside basis in the disregarded partnership. An outside basis is the value assigned to a partner's investment in his or her partnership interest. See American Boat Co. v. United States, 583 F.3d 471, 474 n. 1 (7th Cir.2009). Under § 6226(f), a court reviewing a petition for readjustment of partnership items only has jurisdiction to determine partnership items. Under TEFRA, every item that is not a partnership item is considered a nonpartnership item. § 6231(a)(4). Items that are affected by one or more partnership items are affected items. § 6231(a)(5). Petaluma argues that outside basis is an affected item, not a partnership item, and therefore the Tax Court had no right to determine that its partners' outside bases were zero. We agree. On appeal the Commissioner concedes that outside basis is not a partnership item in this case. Instead, he asserts that outside basis is an affected item whose elements are mainly or entirely partnership items. He maintains that the Tax Court had jurisdiction to state the obvious conclusion that a partner cannot have any basis in a disregarded partnership. The correctness of this conclusion is immaterial, however, for the question is not whether the Tax Court's determination was correct, but whether the Tax Court had jurisdiction to make that determination at all in this partnership-level proceeding. Here, the partners' outside bases are affected items, not partnership items. Unlike partnership items, affected items are determined not at the partnership level, but at the individual partner level. Once the partnership items have been finalized, the IRS may make a corresponding computational adjustment to each partner's tax liability. 26 U.S.C. § 6230(c)(1)(A)(ii); § 6231(a)(6). When a computational adjustment directly increases a partner's tax liability, the IRS can assess the tax and the partner must bring a refund claim to challenge the computation. § 6230(c)(1). When a computational adjustment's effect indirectly increases a partner's tax liability and necessitates partner-level determinations concerning affected items, however, the IRS must issue a notice of deficiency, and normal deficiency procedures apply. § 6230(a)(2)(A)(i); Desmet v. Comm'r, 581 F.3d 297, 302 (6th Cir.2009) (describing these two assessment procedures). Under § 6226(f), the Tax Court had jurisdiction to determine partnership items, but it did not have jurisdiction to determine affected items. We have already rejected the Tax Court's conclusion that outside basis was a partnership item in this case, and we likewise reject the Commissioner's contention that outside basis, although it is an affected item, could nonetheless be determined in the partnership-level proceeding. The fact that a determination seems obvious or easy does not expand the court's jurisdiction beyond what the statute provides. In other words, it does not matter how low the fruit hangs when one is forbidden to pick it. We hold that the Tax Court had no jurisdiction to determine that Petaluma's partners had no outside basis in the disregarded partnership. Finally, we note that nothing about the concept of outside basis indicates that it is more appropriately determined at the partnership level. If disregarding a partnership leads ineluctably to the conclusion that its partners have no outside basis, that should be just as obvious in partner-level proceedings as it is in partnership-level proceedings. Moreover, with the invalidity of the partnership conclusively established as a partnership-level determination, there is little danger that outside basis will receive inconsistent treatment at the individual partner level.
Petaluma also challenges the Tax Court's jurisdiction over accuracy-related penalties. The FPAA determined that the accuracy-related penalty under Section 6662(a) of the Internal Revenue Code applies to all underpayments of tax attributable to adjustments of partnership items of Petaluma FX Partners, LLC. Petaluma argues that since the Tax Court lacked jurisdiction to determine outside basis, it also lacks jurisdiction to determine that penalties apply with respect to outside basis because those penalties do not relate to an adjustment to a partnership item. We agree. As the Tax Court noted, penalties were formerly determined at the partner level. Petaluma, 2008 WL 4682543, at ; American Boat Co. v. United States, 583 F.3d 471, 478 (7th Cir.2009). In the Taxpayer Relief Act of 1997, Pub.L. No. 105-34, § 1238, 111 Stat. 788, 1026, Congress amended § 6221 and § 6226(f) so that penalties relating to adjustments to partnership items would be determined at the partnership level. American Boat Co., 583 F.3d at 478. Section 6221 now states that the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item ) shall be determined at the partnership level (emphasis added). Likewise, § 6226(f) now provides that a court reviewing a petition for readjustment has jurisdiction to determine . . . the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item  (emphasis added). The Tax Court held that its determination that Petaluma should be disregarded for tax purposes sufficed to give it jurisdiction over accuracy-related penalties. Petaluma, 2008 WL 4682543, at  12. We disagree. True, the determination that Petaluma should be disregarded for tax purposes is a partnership item, but the outside bases of the partners are affected items to be resolved at the partner level. Neither the Tax Court nor the Commissioner on appeal have forwarded any basis for the jurisdiction of the Tax Court over affected items in this proceeding. As it is not clear from the opinion, the record, or the arguments before this court that the penalties asserted by the Commissioner and ordered by the Tax Court could have been computed without partner-level proceedings to determine the affected-items questions concerning outside bases, we are unable to uphold the court's determination of the penalty issues. While it may be that some penalties could have been assessed without partner-level computations, we cannot affirm a decision that has not yet been made. Therefore, we vacate the opinion of the Tax Court on the penalties imposition and computation. It may be that upon remand, a determination can be made for some portion of the penalties, but neither party has briefed that question before us.