Reliance on Tax Attorney & Licensed Appraiser Helps Taxpayer Preserve Deductions & Avoid Penalties

us_tax_courtIn Palmer Ranch v. Commissioner, a TEFRA partnership avoided accuracy-related penalties even though the Tax Court reduced the fair market value of its conservation easement by $3.98 million.

The taxpayer claimed a $23.94 million charitable contribution deduction on its 2006 partnership return. The IRS disallowed $16.97 million of the value under exam. At trial, the parties presented valuation experts who relied upon the comparable sales method to set the before and after value of the property. The taxpayer’s expert valued the land at $307,000 per acre, while the IRS expert came in at at $94,000 per acre. The Tax Court reviewed the four properties used by both experts and compared the property’s then-current use with its highest and best use. The taxpayers’ contended that 360 multifamily dwelling units could be developed on the 82-acre parcel. The IRS disagreed, emphasizing: a failed rezoning history; environmental concerns; limited access to outside roads; and neighborhood opposition. The Court rejected each of these arguments and found that “there is a reasonable probability that [the parcel] could have been successfully rezoned to allow for the development of multifamily dwellings.”

The IRS also argued that the real estate market was softening in 2006. Judge Goeke accepted the idea of a declining real estate market and reduced the taxpayer’s pre-encumbrance appraisal of the land from $25.2 million to $21 million. Using the same “after” value percentage (5% of the unencumbered property) the Court found that the fair market value of the conservation easement was $19.96 million.

Following the framework set forth in the U.S. Supreme Court’s recent decision in United States v. Woods, the Court determined that it had jurisdiction to consider the IRC § 6662 penalties. The Court then accepted the taxpayers’ reasonable cause defense and disallowed the 20% penalty because the taxpayer: retained a tax attorney to advise them on the tax aspects of the easement donation; hired a credible, licensed appraiser, and made a good-faith attempt to determine the easement value.

Read the Tax Court opinion here: Palmer Ranch v. Commissioner, T.C. Memo. 2014-79

Supreme Court Adopts IRS Position on Jurisdiction and Application of Partnership Penalties

Gary Woods and his partner, Billy Joe McCombs, generated substantial tax losses using the COBRA tax shelter. The COBRA shelter used offsetting options to inflate the basis of property distributed by a partnership, which is then contributed and sold to another partnership or pass through entity, resulting in a large tax loss without a corresponding economic loss. Messrs. Woods & McCombs reaped ordinary income losses of $13 million and capital losses of $32 million when they used the COBRA structure to purchase and sell $3.2 million of options.

After the IRS disallowed their losses, Woods filed a refund claim (which was denied) and pursued that claim with a complaint filed in the U.S. District Court. After Woods prevailed on certain issues in the 5th Circuit, the government petitioned the U.S. Supreme Court for certiorari. The case selected by the high court to resolve a split in the circuits. The Fifth, Federal and D.C. Circuits had all found for the taxpayers. Other circuits had adopted the government’s position.

The Supreme Court addressed two questions in an opinion authored by Justice Scalia. The Court first considered whether the district court has jurisdiction under TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) to determine valuation-related penalties at the partnership level. This is important because partnerships are not taxed as entities for Federal income tax purposes. The income and losses determined at the partnership level pass-through to each partner where they are taxed on the partner’s individual or corporate tax return.

One purpose of TEFRA was to allow determinations at the partnership level and prevent the need for multiple proceedings to determine the tax liabilities of items common to all partners in the partnership. The jurisdictional question has been widely litigated and this decision will affect many millions of dollars of pending tax penalties.

The second, related, question was whether the 40% gross valuation overstatement penalty under I.R.C. Sec. 6662 applied when a partnership was found to not have economic substance. A partnership lacking in economic substance ceases to exist for tax purposes.

The Court ruled for the government on both questions. On the first question, the Court held that there was jurisdiction to consider the penalty question at the partnership level. The court essentially adopted the position suggested at oral argument by Deputy Solicitor General Malcolm Stewart that “any question that will necessarily have the same answer for all partners should be presumptively be resolved at the partnership level.” Justice Scalia opined that “deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy: duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.”

Relying on the “plain language” of the penalty the Court also held that the 40% substantial or gross valuation penalty applied to the overstated basis of the partners. “[O]nce the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in the partnership greater than zero.” The Court adopted the observation of Fifth Circuit Judge Prado that “the basis understatement and the transaction’s lack of economic substance are inextricably intertwined” and therefore the penalties were “attributable to” the overstatement of basis that occurred once the partnership ceased to be recognized for tax purposes.

In an final note of interest to tax practitioners, Justice Scalia rejected the taxpayer’s reliance on the “Blue Book” – a publication of the Joint Committee of Taxation often published after the enactment of tax legislation explaining the legislative history of the statute – and clearly stated that this publication is not a relevant source of Congressional intent.

Read the entire opinion here:
U.S. v Woods, 517 U.S. __, No. 12-562 (Dec. 3. 2013).

Tax Court: Premature FPAA on Computational Items Invalid, Jurisdiction Denied

There are few areas of the tax code as complex and potentially confusing as the rules for TEFRA partnership proceedings. Even the most steely-eyed tax pros wince at the details. Nonetheless, TEFRA is at the heart of many of the transactions that the IRS has challenged over the course last decade and the courts are still sifting through the details.

In Rawls Trading, LP v. Commissioner the government sought a stay of proceedings on a Final Partnership Administrative Adjustment (FPAA) issued to one of three partnerships involved in a single tax-advantaged transaction. Respondent argued that the FPAA was issued prematurely and that the court should stay its proceedings until determinations were made on FPAAs issued to the two related partnerships which were party to the transaction. Petitioners argued for a consolidated hearing on all three FPAAs. The Tax Court chose a third path and raised the question of jurisdiction.

The FPAA for the upper tier partnership, which the government wanted stayed, contained only computational adjustments.  All of the adjusted items were held in the lower tier partnerships and the upper tier partnership FPAA only noted the consequences those adjustments on a pass-through basis.  The Court reasoned that if the adjustments on the upper tier partnership were only computational and the FPAA did not contain items that were subject to the Court’s determination in a deficiency proceeding then there was nothing for the court to determine in a deficiency proceeding. The Court made exactly such a finding and determined that the FPAA was invalid as filed. The Court dismissed the FPAA for lack of jurisdiction noting that it could not stay proceedings on an FPAA that did not confer jurisdiction on its own merits.

Yes, there is a little more to it than that, but Judge Vasquez does a better job of navigating the labyrinth of TEFRA to reach that conclusion in his opinion than I can in this short column. Nonetheless, this is an important decision in the field of TEFRA procedure and adds yet another layer of complexity to this already challenging area of the law.

Read the full opinion here:
Rawls, LP v. Commissioner, 138 T.C. No. 12 (2012)

Tax Court: No Partnership Return, No FPAA

The Tax Court continues to define the broad limits of TEFRA. Petitioner argued that the notice of deficiency was invalid because the item at issue was a partnership item and thus a Final Partnership Administrative Adjustment should have been issued. The Court ruled that TEFRA does not apply where the taxpayer has not filed a partnership return and the partnership does not qualify as a partnership under TEFRA. The Court rejected the petitioner’s motion to dismiss for lack of jurisdiction.

Read the opinion here:
Huff v. Commissioner 138 T.C. No. 11 (2012)

Ninth Circuit: No Jurisdiction over Bifurcated TEFRA Partnership Interests

The Ninth Circuit Court of Appeals rules that it does not have jurisdiction over partner’s bifurcated interests (direct and indirect) in a TEFRA partnership.

Commissioner v. JT USA, No. 09-70219 (9th Cir.)