Opinion ID: 71496
Heading Depth: 1
Heading Rank: 9

Heading: Jurisdiction to Determine a Sham Transaction

Text: The Tax Court has held that it does not have jurisdiction in a partnership-level proceeding to determine whether the adjustments made on [a FPAA] are attributable to a tax motivated transaction pursuant to section 6621(c). Affiliated Equip. Leasing II v. Comm'r of Internal Revenue, 97 T.C. 575, 576-78, 1991 WL 241149 (1991) (citing White v. Comm'r of Internal Revenue, 95 T.C. 209, 212, 1990 WL 125093 (1990)); see also N.C.F. Energy Partners, 89 T.C. 741 at 744, 1987 WL 45298. This is because section 6621(c) interest is not a `partnership item' and is not within the Court's scope of review in a partnership level proceeding, but is rather an affected item which requires a partner-level determination. White, 95 T.C. at 212 (citing N.C.F. Energy Partners, 89 T.C. at 745). The Second and Fourth Circuits agree that interest assessed against a partner under Section 6621(c) is not a partnership item. Field v. United States, 328 F.3d 58, 60 (2d Cir.2003); Zfass v. Comm'r of Internal Revenue, 118 F.3d 184, 192 (4th Cir.1997). In Field, the Second Circuit stated that enhanced interest under Section 6621(c) is an affected item that turns on factual determinations made at the partner level. 328 F.3d at 60; see also McGann v. United States, 76 Fed.Cl. 745, 757 (Fed.Cl.2007) (assessment of enhanced interest for tax motivated transactions is not a partnership item, but an affected item). In recent cases, courts have held that the Tax Court does have jurisdiction to make factual findings concerning whether the partnership's transactions were designed merely to secure tax benefits. River City Ranches # 1 Ltd. v. Comm'r of Internal Revenue, 401 F.3d 1136, 1143 (9th Cir.2005); see also Keener v. United States, 76 Fed.Cl. 455, 469 (2007); Prati, 81 Fed.Cl. at 439. The Ninth Circuit in River City Ranches did not characterize Section 6621(c) interest as a partnership item or an affected item. The court held that the nature of the partnership's transactions (i.e., whether the transactions were tax-motivated) is a `partnership item.' 401 F.3d at 1143. The Tax Code defines partnership item as any item required to be taken into account for the partnership's taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that, for purposes of [subtitle F], such item is more appropriately determined at the partnership level than at the partner level. 26 U.S.C. § 6231(a)(3). The court in River City Ranches reasoned: The character of the partnership's transactions does relate back to subtitle A, because it determines the individual partners' personal income taxesa subtitle A matter. A partnership's tax items affect not the (non-existent) income tax of the partnerships, but the income tax of the partners. A partnership's tax items, which determine the partner's taxes, are litigated in partnership proceedingsnot in the individual partner's cases. Id. at 1144 (internal citations omitted). These cases recognize that a determination of sham transaction, properly made at the partnership level, affects the individual partner's income tax liability at the partner level. In Keener, the court concluded that Section 6621(c) interest is an affected item with a partnership-item component and a nonpartnership-item component. 76 Fed. Cl. at 469. The nature of a partnership's transactionswhether they are a shamis the partnership item component of assessing Section 6621(c) interest. Id. Whether a transaction was a sham must be resolved first in a partnership-level proceeding, before any consideration can be given in a refund action to whether the interest should have been imposed on the individual partner. Id. Section 6621(c) applies to tax-motivated transactions other than sham transactions, including any loss disallowed by reason of Section 465(a). 26 U.S.C. § 6621(c)(3)(ii). Section 465 was added to the Tax Code to combat tax shelters caused by nonrecourse financing and other situations in which taxpayers were effectively immunized from loss. See Comm'r of Internal Revenue v. Tufts, 461 U.S. 300, 309 n. 7, 103 S.Ct. 1826, 75 L.Ed.2d 863 (1983). Under Section 465(a), any loss from an activity covered by the section shall be allowed only to the extent ... the taxpayer is at risk. 26 U.S.C. § 465(a)(1). A taxpayer is considered to be at risk for the amount of cash contributed and for certain amounts borrowed for the activity. Id. § 465(b). A taxpayer is generally not at risk for amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements. Id. § 465(b)(4). The Keener court drew a parallel between a sham transaction and Section 465(a). Application of the at-risk provisions of Section 465(a) is an affected item. See Ginsburg v. Comm'r of Internal Revenue, 127 T.C. 75, 2006 WL 2506573 (2006); Greenberg Bros P'ship # 4 v. Comm'r of Internal Revenue, 111 T.C. 198, 202, (1998). Issues concerning items such as the nonrecourse character of partnership notes are to be resolved in a partnership-level proceeding, with those determinations then being binding on the partners in any refund litigation that would ensue. Keener, 76 Fed.Cl. at 467 (citing Greenberg Bros. P'ship, 111 T.C. at 202). The sham-transaction determination is appropriately made at the partnership level, in a unified proceeding, and not at the individual-partner level. In Keener and River City Ranches, the courts distinguished between the actual assessment of interest under Section 6621(c) by the IRS, which requires that the partner's tax underpayment was greater than $1,000, and the factual determination of whether a partnership was engaged in sham transactions. The decisions characterizing Section 6621(c) interest as an affected item that must be resolved at the partner level did not consider whether Section 6621(c) has a partnership-item component that requires findings at the partnership level. The court in Keener stated that these cases go astray ... in assuming that because interest is not itself a partnership item, a court is not required to resolve issues concerning the nature of the partnership's transactions in a unified partnership proceeding. Id. In Ertz v. Comm'r of Internal Revenue, 2007 WL 174133 (U.S. Tax Court Jan. 24, 2007), the Tax Court applied River City Ranches to hold that it lacked jurisdiction in a partner-level proceeding to determine whether a transaction was tax-motivated under Section 6621(c). The taxpayer-partner in Ertz resided in Idaho and the appeal from the Tax Court's decision was to the Ninth Circuit. The Tax Court followed the rule that it is bound to follow a Court of Appeals decision which is squarely [on] point where appeal from [the] decision lies to that Court of Appeals and that court alone. Golsen v. Comm'r of Internal Revenue, 54 T.C. 742, 756, 1970 WL 2191 (1970), aff'd 445 F.2d 985 (10th Cir. 1971), cert. denied, 404 U.S. 940, 92 S.Ct. 284, 30 L.Ed.2d 254 (1971). Under the Ninth Circuit precedent, the Tax Court held that jurisdiction to determine whether a transaction was tax-motivated under Section 6621(c) was only present in a partnership-level proceeding. The River City Ranches rule regarding Tax Court jurisdiction is consistent with the Ninth Circuit's approach to sham transaction in the partnership context. The determination of an existing profit motive is made at the partnership level and does not address the subjective intent of the particular partner in question. Hill v. Commissioner, 204 F.3d 1214, 1218 (9th Cir.2000). Upon finding that a partnership transaction was a sham, as long as the partner's underpayment was $1,000 or greater, the IRS may impose interest under Section 6621(c) irrespective of the taxpayer-partner's subjective intent. See id. at 1220. The Duffies argue that in the Fifth Circuit, a sham-transaction determination requires a finding that the individual partner lacked a profit motive. In partnership cases decided before Compaq and Copeland, the Fifth Circuit affirmed Tax Court decisions that the IRS properly imposed interest at the Section 6621(c) enhanced rate. See Chamberlain v. Comm'r of Internal Revenue, 66 F.3d 729, 732 (5th Cir. 1995); Lukens v. Comm'r of Internal Revenue, 945 F.2d 92 (5th Cir.1991); Durrett v. Comm'r of Internal Revenue, 71 F.3d 515 (5th Cir.1996). In these cases, the Tax Court had found that the individual partner lacked a profit motive, despite testimony to the contrary. Chamberlain, 66 F.3d at 732; Lukens, 945 F.2d at 99-100; Durrett, 71 F.3d at 517. The Fifth Circuit affirmed the imposition of interest at the Section 6621(c) rate in these cases because the Tax Court's factual finding that the individual partners lacked a profit motive was not clearly erroneous. The Fifth Circuit has not decided which of the two tests followed in the circuit courts is the appropriate test for sham transaction. Copeland, 290 F.3d at 337-38. In Transcapital Leasing Associates 1990-II LP v. United States, 246 Fed. Appx. 266 (5th Cir.2007), the court stated it was unnecessary to adopt either variant of the sham transaction doctrine because the transaction lacked a genuine business purpose and was economically insubstantial. The court also expressed no opinion on whether the [profit motive] analysis of an alleged sham transaction ... focuses on the subjective motivation of the taxpayer partner or the flow-through partnership entity. Id. In Chamberlain, Lukens, and Durrett, the Fifth Circuit merely affirmed the result reached in the Tax Court, based in part on the fact that the Tax Court's finding that the individuals lacked a profit motive was not clearly erroneous. Contrary to the Duffies' assertion, the Fifth Circuit does not require a finding that an individual partner lacked a profit motive to impose interest at the enhanced rate under Section 6621(c). While the individual taxpayer's subjective business purpose or profit motive may be relevant to the sham-transaction inquiry, lack of profit motive is not required to impose interest at the enhanced rate. See Thomas, 166 F.3d at 833; Karr, 924 F.2d at 1026; see also Cherin v. Commissioner, 89 T.C. 986, 993, 1987 WL 45771 (1987) (the Tax Court has never held that the mere presence of an individual's profit objective will require [it] to recognize for tax purposes a transaction which lacks economic substance); Bohrer v. Commissioner, 945 F.2d 344, 348 n. 5 (10th Cir.1991) (noting that either lack of profit motive or lack of economic substance can render a transaction a sham). In weighing the relevant factors to determine whether a partnership transaction is a shameconomic substance and business purposea court is not required to determine whether the individual partner lacked a profit motive in deciding that enhanced interest applies. The Duffies concede that under Tax Court Rule 248(b) and the language of the IRS's Motion for Entry of Decisions, they are bound by the Tax Court's determination of partnership items. In its Motion for Entry of Decisions, the IRS took the position that enhanced interest under Section 6621(c) was an affected item, not a partnership item, which is a judicial admission binding on the IRS. See Martinez v. Bally's La., Inc., 244 F.3d 474, 476 (5th Cir.2001) (holding [a] judicial admission is a formal concession in the pleadings or stipulations by a party or counsel that is binding on the party making them.). Although enhanced interest under Section 6621(c) is an affected item, it has a partnership item component and a nonpartnership-item component. Keener, 76 Fed. Cl at 469. The nonpartnership-item component of Section 6621(c) interest is whether the taxpayer's underpayment was substantial$1,000 or greaterand whether it was attributable to a transaction previously determined at the partnership level to be tax-motivated. The Tax Court does not have jurisdiction to make this nonpartnership determination in a partnership-level proceeding. The Tax Court did not determine whether any underpayment by the Duffies was substantial or whether such underpayment was attributable to Texas Farm Venturers's disallowed farming expenses. The Tax Court did determineand had jurisdiction to do sothat the partnership's transactions resulting in the adjustments were a sham. This determination of the partnership-item component of Section 6621(c) interest is properly made at the partnership level. Making the sham-transaction determination at the partner level could lead to inconsistent results. TEFRA was intended to channel partnership items into a unified procedure for resolution; determining whether the partnership's activities were sham transactions in a partnership-level proceeding is consistent with that purpose. The Tax Court had jurisdiction to determine whether the Texas Farm Venturers transactions were sham transactions.