On September 6, 2016, the United States Court of Appeals for the Tenth Circuit revered a district court and held that the managing partner of a partnership was not precluded from raising a partner-level good faith and reasonable cause defense to penalties resulting from a TEFRA partnership audit.5 The district court had ruled that it was precluded from considering the manager partner’s defense because the TEFRA statute precludes a managing partner from pursuing at the partner level a reasonable cause/good faith defense where the IRS has rejected the partnership’s assertion of reasonable cause/good faith at the partnership level. Although the Tenth Circuit reversed the District Court, the decision was not unanimous.
Upon retirement as a utility company executive, taxpayer McNeill expected to receive an $18 million payment. In an effort to reduce any tax on the payout, McNeill created a series of partnerships, based on advice of tax counsel, who purchased underwater debt instruments for little money. McNeill was the managing partner of the relevant partnership and owned over 90% of the partnership. McNeill later sold the debt instruments and claimed a $20 million loss, which offset his $18 million in income received upon retirement. McNeill obtained opinion letters from various accounting and law firms concluding that the transaction would withstand IRS scrutiny. The IRS conducted a TEFRA audit of the partnership, concluded that McNeill’s true basis in the debt was the modest amount he contributed to the partnership and denied the loss. The IRS also imposed penalties and interest. Under TEFRA, McNeill as the tax matters partner sought judicial review of the IRS’s partnership level determination, but the matter was dismissed by the district court and McNeill never sought to reinstate it.
The IRS thereafter issued a deficiency to McNeill and determined that McNeill’s share of the partnership liability was $7.75 million. McNeill paid the liability and sued for a partial refund, arguing that he should be excused from penalties and associated interest because he had “reasonable cause” and he filed his tax return in “good faith.” 6 McNeill’s bases for his defense were the opinions he received from his accountants and lawyers that the transaction was legitimate.7
District Court Ruling
The district court declined to decide the merits of McNeill’s partner level defense. The district court concluded that the TEFRA statute precluded it from reviewing McNeill’s defense because McNeill was a managing partner and the IRS had rejected the partnership’s assertion of reasonable cause at the partnership level.
On appeal, the Tenth Circuit reversed and concluded that the district court had misread the TEFRA statute. The relevant portion of TEFRA states:
No review of substantive issues.--For purposes of any claim or suit under this subsection, the treatment of partnership items on the partnership return, under the settlement, under the final partnership administrative adjustment, or under the decision of the court (whichever is appropriate) shall be conclusive. In addition, the determination under the final partnership administrative adjustment or under the decision of the court (whichever is appropriate) concerning the applicability of any penalty . . . which relates to an adjustment to a partnership item shall also be conclusive. Notwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.8
Analysis of Section 6230
The Circuit Court applied a plain reading to the statute and said that a partner, including “any” partner may raise a partner level defense to challenge the amount of the tax adjustment. According to the circuit court “Congress pretty clearly seemed to contemplate a regime in which any partner may assert any ‘partner level defenses’ that may apply.” 9 But the Government argued that it is inappropriate to allow the managing partner to pursue a good faith defense at the partner level when the partnership already raised a good faith defense because often it’s the managing partner’s good faith that is tested and evaluated at the partnership level. But the Circuit Court rejected the Government’s argument, stating that “[n]othing in the last sentence of the statute carves out managing partners and prevents them alone from taking advantage of its terms.” 10 The court noted that “if Congress had wished to single out managing partners for special treatment, it could have done so—as it has done for other types of partners in other settings. See, e.g., section 6231(a) (defining tax matters partner, notice partner, pass-thru partner, etc.)” 11
The Circuit Court’s conclusion that section 6230 does not carve out the managing partner was further supported by the government’s own implementing regulations. Treasury regulation 301.6221-1(c) expressly indicates that section 6664(c)(1)’s reasonable cause/good faith defense is not a “partnerships item” but something more appropriately determined at the partner level. The court also noted that while the government’s argument would yield a more efficient process, “any claim of efficiency” cannot substitute for “the statute’s text and structure.” 12
The court also found that judicial precedent disfavored a reading of section 6230 that carved- out managing partners. In Woods, the Supreme Court suggested that under TEFRA a partner’s reasonable cause and good faith defenses cannot be “conclusively’ determined at the partnership level.13 And the lower court cases provided little support for the government. In Stobie Creek Investments, LLC v. United States,14 the partnership argued that “the partnership-level trial should resolve conclusively the reasonable cause defenses of each of the individual partners.” 15 Meanwhile, in Stobie Creek the government (consistent with the regulations) argued that the reasonable cause/good faith defense is more properly adjudicated at the partner level—and the court agreed, for the court proceeded to hold that TEFRA “explicitly disallows adjudication of partner-level defenses” like reasonable cause/good faith “in a partnership-level proceeding.” 16 Much the same story played out in Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States, 17 where the government again argued that the reasonable cause/good faith defense “is a partner-level defense that can only be asserted in separate refund proceedings.” 18 Accordingly, the circuit court reversed and remanded the matter to the district court to consider the merits of McNeill’s reasonable cause and good faith defense to penalties.
Judge Phillips dissented and voted to affirm the district court’s decision. The dissent rested on the fact that McNeill’s defense based on reasonable cause was already evaluated at the partnership level, because the partnership-level defense was based on McNeill’s conduct and state of mind. Judge Phillips said that he saw “nothing in 26 U.S.C. § 6230(c)(4) announcing a rule that all partner-level defenses automatically fully escape the effects and underpinnings of FPAAs’ partnership-level determinations of penalties and interest.” 19
The importance of McNeill may be diminished in light of recent legislation regarding future partnership audits. Congress recently revised the program for auditing partnerships to permit the IRS to recoup taxes from the partnership itself rather through the individual partners.20