In Russian Recovery Fund, Ltd., 108 AFTR2d ¶2011-5494, the Court of Federal Claims ruled that the Internal Revenue Service may proceed with a collection action against a partner in a lower-tier partnership or “indirect partner” provided such partner’s return was filed within three years of the issuance of a final partnership administrative adjustment (FPAA) to the upper-tier partnership with respect to partnership level items that were adjusted. The tax items finally resolved in the FPAA to the upper-tier partnership directly impacted on the tax liability of the lower-tier partner. The Court further held that the Internal Revenue Service was not allowed to proceed with collection action against an “indirect partner” who filed his individual return more than three years before the issuance of the final partnership administrative adjustment.
In accordance with the entity level audit rules enacted into law as part of the Tax Equity and Fiscal Responsibility Act (“TEFRA”), 26 U.S.C. §§ 6221–6233 (2006), the case filed in this action is a petition for readjustment of partnership items brought under 26 U.S.C. § 6226(a) by Russian Recovery Advisors, LLC (“RRA”) as the tax matters partner for Russian Recovery Fund, LTD (“RRF”). Plaintiffs allege, inter alia, that the Internal Revenue Service's (“IRS”) issuance of a FPAA for the tax year ending December 31, 2000, was untimely and therefore invalid, and that the representative partners' 2000 and 2001 tax years are closed for adjustment and assessment. The Court of Federal Claims had previously held in this case it was improper for an FPAA to adjust an individual partner’s amount at-risk based on its distributive share of non-recourse partnership liabilities and that the remedy for improper adjustment of a non-partnership item set forth in an FPAA does not invalidate the FPAA. See Russian Recovery Fund Ltd. v. United States, 81 Fed. Cl. 793 (2008).
Entity Audit Rules under TEFRA
As announced by TEFRA, under the partnership audit rules, the tax treatment of any partnership item, including the applicability of any penalty, addition to tax or additional amount which relates to an adjustment to a partnership item, is generally determined at the partnership level. §6221. Where the Internal Revenue Services wants to adjust any “partnership items,” it must notify the individual partners through issuing an FPAA. §6226. See also §§6229, 6501. For period of 90 days after the FPAA is issued, the tax matters partner of the entity level partnership (or LLC) has the exclusive right to file a petition for readjustment of the partnership items in the Tax Court, the Court of Federal Claims, or a U.S. District Court. §6226(a). After this 90 exclusivity period expires, the other partners (members) are granted an additional period of 60 days to file a petition for readjustment. §6226(b)(1). Any partner (member) whose individual tax liability might be affected by the outcome of the litigation of partnership items may participate in the proceeding. §6224. The Internal Revenue Service may assess additional tax liability against individual partners within one year of the final conclusion of the partnership's tax determination. §6229(d). A partner may challenge the tax liability so determined by paying the assessment and filing a refund suit in the Court of Federal Claims for example. The partner is prohibited from brining an action for a refund attributable to partnership items. See §7422(h).
Statutes of Limitation: Assessment of Income Tax
It is universally acknowledged that the general statutory period of limitations for the assessment of income tax may not be made more than three years after the later of the date the tax return was filed or the due date of the tax return. §6501(a). Subject to exceptions and special rules, similarly the period for assessing tax attributable to a partnership item (or affected item), for a partnership tax year won't expire before the date that is three years after the later of: (1) the date the partnership return was filed, or (2) the last day for filing the return for that year (without regard to extensions). §6229(a).
As the tax matters partner for the Russian Recovery Fund, LTD (“RRF”), Russian Recovery Advisors, LLC. (“RRA”), filed a petition with the U.S. Court of Federal Claims for readjustment of partnership items per §6226(a). It challenged the IRS on the basis that the FPAA that the Service issued on 10/15/2005 for the tax year ending 12/31/2000 was issued beyond the permitted statute of limitations and was invalid as it affected an indirect partner who had filed a return more than three years before the FPAA. Accordingly, the Court of Federal Claims previously held it improper for an FPAA to adjust an individual partner's amount at-risk in its distributive share of nonrecourse partnership liabilities as part of such FPAA. A deposit issue was also involved. See §6226(e). RRF was a limited partnership of ten partners that specialized in distressed asset transactions. Two of its partners were RRA and FFIP, LP (FFIP).
RRF filed its 2000 income tax return on Aug. 14, 2001. In the 2000 tax year, RRF allocated $46,424,782 of net section 988 (foreign currency) losses to FFIP. On Oct. 14, 2005, the Service issued an FPAA to RRF for the 2000 tax year, proposing adjustments to RRF partnership items. In the 2000 FPAA, IRS proposed to characterize this $46,424,782 disallowed the entire claimed losses which were allocated to FFIP.
FFIP, a partner of RRF, and also a pass thru entity, filed its own 2000 partnership tax return on or before August 16, 2001. After netting the losses it received from RRF with its own losses, FFIP reported $4,205,838 in losses for the 2000 tax year and $25,272,185 in losses for the 2001 tax year. The original $46.4 million in foreign currency section 988 losses that were allocated from RRF make up a large portion of both of these loss figures.
Nancy Zimmerman was an indirect partner of RRF through FFIP. She filed her 2001 return on Oct. 15, 2002, which was less than three years before the FPAA was issued. She filed her 200 income tax return more than 3 years before the issuance of the 2000 FPAA to RRF. James DiBiase was an indirect partner of RRF through FFIP. He filed his 2001 and 2000 returns more than three years before the FPAA.
On May 10, 2005, FFIP, through its TMP, entered into an extension agreement with the IRS on Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Partnership. The extension effectively allowed the Service to assess additional federal income tax attributable to the partnership items of FFIP against any partner for the period ending December 31, 2001 through August 31, 2006. Beginning in 2005, the Service audited FFIP's 2001 partnership return including a detailed review of RRF's net section 988 losses reported on FFIP's 2001 tax return. The IRS completed the review of FFIP's 2001 partnership return and issued a “no adjustments” letter to FFIP. This extension allowed IRS to assess any federal income tax attributable to the partnership items of FFIP against any partner for the period(s) ended Dec. 31, 2001 at any time on or before Aug. 31, 2006.
Conclusions of the Court
After setting forth a detailed analysis of the facts and the law on each issue that was the subject of cross motions for summary judgment, the Court of Federal Claims reached several conclusions.
- Statute of Limitations Affirmative Defense Raised by Indirect Partners. The IRS asserted that RRA, as TMP to RRF, lacked standing to assert the statute of limitations defense on behalf of indirect partners. The Court of Federal Claims held that §6226 permits partners other than the tax matters partner to raise the statute of limitation defense and yet such in no way prevents the TMP from raising the defense of their behalf. See, e.g., AD Global Fund, LLC. v. United States, 481 F.3d 1351 (Fed. Cir 2007); Blak Invs. v. Comm'r, 133 T.C. 431 (2009). It is noted in the Court’s analysis that when a partner attempts to raise the statute of limitations defense at a partner level proceeding, it is foreclosed because the defense must be raised in the partnership level proceeding. Prati v. United States, 603 F.3d 1301, 1307 (Fed. Cir. 2010); Chimblo v. Comm'r , 177 F.3d 119, 125 [83 AFTR 2d 99-2610] (2nd Cir. 1998).
In Keener v. United States, 551 F.3d 1358 (Fed. Cir. 2009), the Federal Circuit held that the subject of a statute of limitations defense is appropriately viewed as a partnership item and handled in a partnership proceeding as opposed to a partner-level proceeding. Section 6221 provides that “[e]xcept as otherwise provided in this subchapter, the tax treatment of any partnership item ... shall be determined at the partnership level.” 26 U.S.C. § 6221 (2006). The Court of Federal Claims read Keener and section 6221 together to mean that it is necessary for a statute of limitations defense, as a partnership item, to be raised in the partnership-level proceeding. See §6226(d)(1)(B). Thus, while the statute allows partners other than the tax matters partner to raise a statute of limitations defense, it does not prevent the tax matters partner from raising the defense on their behalf.
- One Year Rule Under Section 6229(d). RRA contended that due to the running of the statutes of limitation under §§6229 and 6501, summary judgment should be granted to the petitioners since the FPAA in this case was issued more than 3 years after RRF filed its 2000 return FPAA. In accordance with §6229(d) the statute of limitation for assessing RRF’s (indirect partner) 2001 return for “any tax imposed . . . which is attributable to any partnership item (or affected item) for a partnership taxable year,” was suspended until one year after the Court's final decision. The RRA argued that the Service could only have assessed the losses on RRA’s 2001 return by issuing an FPAA to FFIP for the 2001 tax year. The Service argued that such losses must be adjusted at their source, RRF, not at FFIP, a second-tier partnership. The Court said that IRS could have issued an FPAA to FFIP, but to adjust the losses, an FPAA had to be issued at their source (RRF). The issuance of the FPAA to RRF had the effect of disallowing the foreign currency section 988 losses in 2000. The Court then held that the losses reflected on Nancy Zimmerman’s 2001 individual return were “attributable to” the disallowed RRF 2000 losses.
- Assessment Against Lower Tier Partner Permitted.
The Court therefore concluded that RRF loss adjustments arising from the 2005 FPAA could result in the assessment of income taxes as to Zimmerman’s tax liability for 2001. Under §6229(d), the issuance of the FPAA to RRF on October 14, 2005 suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. Simply put, this means that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was still open for assessment. Plaintiffs argue that the IRS could only have assessed the losses on Ms. Zimmerman's 2001 return by issuing an FPAA to FFIP for the 2001 tax year. Defendant responds that the losses must be adjusted at their source, RRF, not at FFIP, a second tier partnership. The question, therefore, is whether after FFIP carried the losses forward into 2001, they ceased to be RRF partnership items and moved beyond the reach of an RRF partnership proceeding.
The Service is permitted to issued multiple FPAAs in tiered partnerships. Since RRF was the source of the losses reported and allocated to FFIP, also a pass through entity, the issuance of an FPAA to the lower tier partnership, i.e., FFIP, would be inappropriate for disallowing the RRF losses. See Sente Investment Club Partnership v. Commissioner, 95 T.C. 243 (1990); Kligfield Holdings v. Commissioner, 128 T.C. 192, 202 (2007)(FPAA issued to adjust partnership items in a closed year in order to assess a deficiency in a partner's later year return). See also §6231(a)(6). from the source down to the indirect partners in order to consider whether individual partners owe any tax. Under TEFRA, losses must be disallowed at their point of origin.
The Court found the Plaintiffs' argument for the issuance of multiple FPAAs unconvincing. The IRS could have issued an FPAA to FFIP, but to adjust the §988 losses, an FPAA had to be issued at their source, which was RRF. The issuance of the FPAA to RRF had the effect of disallowing the section 988 losses in 2000. The issuance of the FPAA to RRF on October 14, 2005, suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. This meant that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was, in the view of the Court, still open for assessment (but under the facts of the case, not for Ms. Zimmerman’s 2000 tax return). It does not matter if the disallowed losses are also FFIP partnership items in 2001 because that fact does not prevent the FPAA from disallowing the losses at the RRF origination point and then assessing Ms. Zimmerman's 2001 tax return through a computational adjustment. The Court held that the FPAA issued to RRF in 2000 validly suspended the limitation period for assessing Ms. Zimmerman's 2001 individual tax return relating to partnership tax items involving the upper-tiered partnership.