James Beavers, J.D., LL.M., CPA
TaxTrends
Tax Preparer and Taxpayer Reporting Standards Equalized • Partner Allowed to Make Different Elections for Different Partnership Interests
Background
Prior to May 25, 2007, an income tax return preparer who prepared a tax return for which there was a tax understatement that was due to an undisclosed position was liable for a preparer penalty if there was not a realistic possibility of the position’s being sustained on its merits. If the preparer disclosed the position, the preparer was liable for a penalty only if the position was frivolous. An amendment to Sec. 6694 made by the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), changed the scope of the preparer penalty to apply to all types of tax returns (instead of just income tax returns), increased the amount of the penalties, and heightened the standards of conduct needed for tax return preparers to avoid the imposition of penalties for the preparation of a return for which there is an understatement of tax. Under the SBWOTA version of Sec. 6694, a tax return preparer could be penalized for preparing a return on which there was an understatement of tax liability due to an “unreasonable position” taken on the return. An unreasonable position was defined as a position that a return preparer does not reasonably believe is more likely than not (MLTN) to be sustained on its merits unless the position is disclosed on the return and for which there is a reasonable basis. The imposition of the MLTN standard by SBWOTA was unexpected by both IRS officials and the tax community and was roundly criticized by both. The chief complaint was that the new standard of conduct was higher than the standard imposed on taxpayers, who have always had a “substantial authority” standard applied to their undisclosed positions. This difference in standards created a potential conflict of interest between preparers and their clients because, in some situations, a preparer could be protected from a penalty only by a position’s disclosure by a client who was not required to disclose the position. As Barry Melancon, president and CEO of the AICPA, stated, this conflict “could have chilled the professional advice CPAs might have given taxpayers.” The AICPA’s Tax Division immediately went to work with the IRS to come up with a way to work around this problem with the new rules. As a result, the IRS issued guidance (see REG-129243-07 and Notice 2008-13) that softened the impact of the new standard by allowing preparers to avoid application of the standard in some situations where a preparer provided the taxpayer a properly completed Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, for the position or disclosed certain information to the taxpayer about the position. However, the tax community remained dissatisfied with the new standard and very worried about how the IRS might apply it in practice.
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PROCEDURE & ADMINISTRATION
Tax Preparer and Taxpayer Reporting Standards Equalized
A provision in the 2008 Tax Extenders and AMT Relief Act sets the standard of conduct for preparers to avoid the penalty for understatement of tax due to an undisclosed return position at “substantial authority,” the same standard applied to taxpayers. The controversial “more likely than not” standard has been retroactively repealed. The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.
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TaxTrends
New Legislation Equalizes Standards of Conduct
Recognizing the problems caused by the MLTN standard of conduct for tax return preparers, as part of the 2008 Tax Extenders and AMT Relief Act, P.L. 110-343, Congress lowered the return preparers’ standard of conduct for undisclosed positions to the same “substantial authority” standard applied to taxpayers. In general, under the substantial authority standard, the position taken must have an approximately 40% chance of being sustained on its merits, as opposed to a 50% or more chance as required under the MLTN standard. However, it is higher than the pre-SBWOTA “realistic possibility of success” standard, which required approximately a 33% chance of a position prevailing on the merits. For disclosed positions, the “reasonable basis” standard continues to apply. The preparer standard for Sec. 6662A reportable transactions (i.e., listed transactions and reportable transactions with significant avoidance or evasion purposes) was left at the MLTN level, and the MLTN standard is not lowered for Sec. 6662A reportable transactions even if the transactions are disclosed. The new standard applies to returns prepared after May 25, 2007, the date the standard had been increased to more likely than not by SBWOTA. Note: While Congress has repealed the MLTN standard, the other SBWOTA changes to the preparer penalty provisions, including the increased penalty amounts and the application to preparers of all return types, remain in force. To the extent that the proposed regulations deal with issues other than the MLTN standard, they presumably also still apply. made to equalize the standards rather than if a change would be made. In the meantime, both the IRS and the tax community have wasted a large amount of time and resources dealing with a changed standard that would have done little to help the Service’s enforcement efforts or actually improve tax reporting. The MLTN standard was inserted into the SBWOTA legislation late in the process and remained there despite intense objections by the AICPA and its members. Hopefully in the future the members of both the House Ways and Means Committee and the Senate Finance Committee will do a better job of vetting potential legislation and consulting with the IRS and the tax community to prevent the passage of obviously flawed tax provisions. Tax Extenders and Alternative Minimum Tax Relief Act of 2008, P.L. 110-343, §506
PARTNERS & PARTNERSHIPS
2004, the Service challenged the sale transaction in an audit under the Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248 (TEFRA). In response to the IRS’s letter informing them of its challenge, the Gregorys attempted to make an election under Sec. 6223(e)(2) for their indirect interests—but not their direct interests—to have the relevant partnership items of JT USA treated as nonpartnership items (i.e., they attempted to opt out of the TEFRA proceedings with respect to the indirect interests). In March 2005, the Gregorys filed a petition with the Tax Court, and in November 2006 they moved to strike themselves as indirect partners from the case because they had opted out of the proceedings through the elections they made in 2004. The IRS objected to the Gregorys’ request, arguing that their elections to opt out of the proceedings were ineffective because they did not elect to opt out with respect to all the interests they each held in JT USA.
Partner Allowed to Make Different Elections for Different Partnership Interests
The Tax Court held that taxpayers owning multiple interests in the same partnership were entitled to make different elections under Sec. 6223 for each interest.
The Parties’ Arguments
Sec. 6223(e)(3) states, “The partner shall be a party to the proceeding unless such partner elects . . . to have the partnership items of the partner for the partnership taxable year to which the proceeding relates treated as nonpartnership items.” According to the Service, the word “partner” in Sec. 6223 refers to the person holding any such interest, not to that person in his or her capacity as holder of a particular partnership interest. The IRS argued that the Gregorys were trying to simultaneously opt in and opt out and that such a self-contradictory election must be ineffective. The IRS argued that the Gregorys could opt out only with respect to all the interests they held in JT USA and that their elections were invalid. The Service also argued that allowing separate elections would increase the administrative burden on the IRS and lead to inconsistent results, consequences that were contrary to the purpose of TEFRA. The Gregorys countered that the law allows the same person to make two different elections as long as each election
Background
John and Rita Gregory were pharmacists living near San Diego. John, an off-road motorcycle enthusiast, started selling motorcycle socks at a local dirt track. The business was a success, which led the Gregorys to form a limited partnership, JT USA LP, to conduct the business. Later the Gregorys expanded the business into the sale of paintball accessories just as that sport took off. The Gregorys were so successful selling paintball accessories that in 2000 a paintball manufacturer offered to buy JT USA for $32 million. At the time of the sale, the Gregorys owned both direct and indirect (through an LLC and an S corporation) partnership interests in JT USA. The sale was structured as what the IRS alleged was a “Son of Boss” transaction. In October
Reflections
While the return preparer standard has not been reduced to its previous “realistic possibility” level, at least the problem of there being a higher standard for preparers than for taxpayers has been eliminated. Given the very real and very obvious problem caused by having a higher standard of conduct for preparers than taxpayers, it was more a question of when a change would be
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relates to a different partnership interest. Although they conceded that TEFRA and its regulations do not specifically address the possibility of the same person acting in each of two different capacities, they argued that the Tax Court must fill in this gap in the law in the most reasonable way possible and that the more reasonable way to fill the gap was by construing the term “partner” in Sec. 6223 to refer to a person holding a particular partnership interest, not a person holding any number of partnership interests.
The Tax Court’s Decision
The Tax Court held that the Gregorys were entitled to make different elections for each interest. Because there was no guidance directly on point, in making its decision the Tax Court chose to look at how the regulations, case law, and law outside the Code treated partners that held more than one interest in a partnership in other situations. Looking at the regulations (as they existed at the time of the events involved), the Tax Court noted that in the case of a partner that held a direct and an indirect interest in a partnership, Temp. Regs. Sec. 301.6224(c)-2T(a)(1) stated that the partner was not bound with respect to his or her indirect interest by a settlement agreement entered into with respect to his or her direct interest. The Tax Court also pointed to its case Barbados #6, Ltd., 85 T.C. 900 (1985), in which it held that where a partner was both the tax matters partner (TMP) of a partnership and a notice partner, the fact that the partner was a TMP did not preclude him or her from also acting as a notice partner. In addition, the court found support for treating interests separately in the Revised Uniform Limited Partnership Act, which states that when a partner is both a general and a limited partner of a limited partnership, the partner is subject to the rules for general partners when acting in his or her capacity as a general partner and to the rules for limited partners when acting in his or her capacity as a limited partner. The Tax Court further noted that the wording of the pertinent regulation (Temp. Regs. Sec. 301.6223(e)-2T(c)(1))
itself supported the Gregorys’ argument. It noted that the regulation did not say the election covered all a partner’s partnership interests, but rather spoke in terms of all the partnership items for the year to which the election relates. Given that the regulation was generally understood to apply only to the partnership items of the partner making the election (and not the partnership items of all the partners in the partnership), the Tax Court did not see any reason why a partner that held more than one interest in a partnership should not be able to make different elections for each interest. Finally, the Tax Court also rejected the IRS’s argument regarding administrative burdens and inconsistent results. It agreed that to some degree allowing separate elections would conflict with the purpose of TEFRA but that the election under Sec 6223(e)(2) becomes available only after the Service has failed in its duty to provide proper notice and therefore the TEFRA process has already gone awry. It also noted that the inconsistencies might be inevitable when dealing with complex partnerships because too many factors were involved to treat all partners identically. According to the Tax Court, the fact that in this case the same partners owned both direct and indirect interests did not change this.
Reflections
As the Tax Court points out, under the general principles of partnership law, it is hard to see why separate partnership interests should not be treated separately for election purposes regardless of who owns the interests when the Code and the regulations do not clearly state that they should be treated separately. If this treatment allows some taxpayers to gain an unfair advantage through planning, the better way to solve the problem would be through legislation or regulation, not through the courts. JT USA LP, 131 T.C. No. 7 (2008)
TTA
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