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Jurisdiction to Dispute Penalties: Partner v. Partnership-Level Proceedings

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The U.S. Supreme Court recently heard oral arguments in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562).  In addition to the heavily-disputed circuit split regarding the gross misstatement penalties, the Court may rule on a complicated jurisdictional question implicated in TEFRA partnership proceedings.  Although neither party nor the lower courts raised the issue, the Court directed the parties, without further detail, to brief and argue whether the district court had jurisdiction under I.R.C. § 6226 to consider the substantial misstatement penalty for an underpayment “attributable to” an overstatement of basis.  Accordingly, the Court may address the issue of whether penalties related to the overstatement of outside basis must be resolved in a partnership proceeding or must be raised in a subsequent partner-level claim.  It is possible that the Supreme Court may resolve the Woods case on jurisdictional grounds, without addressing the substantive circuit split on whether the 40% gross valuation misstatement penalty applies to transactions that lack economic substance, though most believe that it will also address the circuit split on the gross valuation misstatement penalty.

In either event, the fact that the Supreme Court directed the parties to brief and argue the jurisdictional issue is a pointed reminder that the TEFRA partnership audit procedures are outdated and in desperate need of a fix.  In fact, TEFRA jurisdictional issues have generated huge amounts of litigation about partnership tax procedure, often without addressing the underlying merits of a tax dispute.  So the Supreme Court’s guidance in Woods on TEFRA jurisdiction may have far reaching impact and either confirm or cast doubt on a whole series of ad hoc TEFRA procedural decisions over the past ten years.

In Woods, the particular TEFRA partnership procedures at issue involves penalties.  When TEFRA was originally enacted, penalties were not partnership items and had to be resolved in individual partner-level proceedings after the completion of the partnership audit and any resulting tax litigation.  In 1997, congress amended TEFRA to provide that penalties are determined at the partnership level without reclassifying penalties as partnership items.  As a result, significant confusion arose as to whether all or only a portion of the penalty issues (e.g., everything except the reasonable cause defense to penalties as this is specific to an individual partner’s state of mind) can be determined in a partnership proceeding.  Also, significant issues arose as to whether a court has jurisdiction in a partnership  proceeding over penalties if the underlying adjustment resulting in a partner-level underpayment of tax is itself not a partnership item.

Many courts have found that the reasonable cause defense to penalties is jurisdictionally appropriate at the partnership level when the defense involves the conduct and state of mind of the partnership’s managing member or when the defense is not personal to the partners or dependent on their separate returns.  Where the penalties imposed require a determination of non-partnership items, however, courts have found the defense properly raised at the partner level.  Thus, several courts have found no jurisdiction in a partnership-level proceeding when the penalties related to the outside bases of the individual partners because outside bases are generally not partnership items and must determined at the partner level.  It is this last point that the Supreme Court in Woods has focused its jurisdictional analysis on, even though the parties to the case did not raise jurisdictional questions.

After being directed to brief the issue, the taxpayers in Woods rely heavily on Tax Court decisions Jade Trading and Petaluma to argue that the district court lacked jurisdiction to impose the penalty because it relates to a nonpartnership item, i.e., the partner-by-partner determination of the partners’ outside (or tax) bases in the partnership interests.  See Petaluma FX Partners LLC v. Comm’r, 591 F.3d 649, 655-56 (D.C. Cir. 2010), on remand 135 T.C. 366; Jade Trading v. United States, 80 Fed. Cl. 11, 60 (2007), aff’d in part and vacated in part, 598 F.3d 1372 (Fed. Cir. 2010).  In contrast, the government argued that the district court had jurisdiction to impose the penalty because the issue was a partnership item.  Interestingly, the government previously conceded that its argument was wrong.  See Brief for Respondents, United States v. Woods, 133 S. Ct. 1632, 2013 WL 3816999, *21-24 (July 19, 2013) (citing Logan Trust v. Comm’r, No. 12-1148 (D.C. Cir. Oct. 25, 2012) (“We agree that outside basis is an affected item, not a partnership item . . .”)).

Hopefully, the Supreme Court’s jurisdictional decision in Woods clarifies—instead of further confuses—TEFRA jurisdictional rules.  Given the current political environment in Washington, D.C., it is unlikely that congress would take up a statutory fix to TEFRA, much less agree on what that fix should look like.  The current case-by-case, and often conflicting, judicial resolution of TEFRA issues is maddening to lawyers, judges, and especially taxpayers who simply want the merits of their tax cases decided.