Filing partnership returns late now subjects the partnership to significant penalties. Under IRC §6103 the partnership is penalized $195 per month per partner, up to a maximum of ten months, for each month or fraction of a month the partnership return is filed after the due date (including extensions actually granted). However, no penalty applies if the partnership can show the failure is due to reasonable cause. [IRC §6698(a)]
In the case of In re: Refco Public Community Pool LP, Banktruptcy Court for the District of Delaware, Case No. 14-11216, 118 AFTR 2d ¶ 2016-5085 the bankruptcy plan administrator challenged the IRS’s claim for late filing penalties of $3,662,000 for the years 2005-2007.
The partnership’s operations are described as follows in the opinion:
The Debtor formed in 2003 as a partnership to track the performance of the Standard & Poor's Managed Futures Index. The Debtor invested substantially all of its assets in SPhinX Managed Futures Fund, SPC (“SMFF”), a Cayman Islands domiciled segregated portfolio company that was part of a group of affiliated companies knows as the SPhinX Group. SMFF used Refco, LLC as its regulated futures commission merchant to execute futures and other trades; and maintained assets in excess of its required margin with Refco Capital Markets, Ltd. In late 2005, the Debtor was placed in extremis when these Refco entities, along with certain affiliates, (“Refco”) filed for bankruptcy, and shortly thereafter, the SPhinX Group, including SMFF, filed for liquidation in the Grand Court of the Cayman Islands.
Things get a bit messy from this point forward. Refco (the entity that SPhinX had assets on deposit with, not the investment partnership that is the one looking for relief in this case) filed for bankruptcy after discovering a large, undisclosed related party receivable. The news about the related party receivable caused investors (including SPhinX Group) to withdraw their funds, and shortly before the bankruptcy SPhinX withdrew $312 million, an amount it was later forced to repay $260 million to Refco LLC’s bankruptcy estate. As well, its assets were frozen by the U.S. Bankruptcy Court and it ended up going into bankruptcy itself.
The partnership in this case (Refco Public Community Pool, LP) attempted to cash out its investments with SPhinX, but instead of cash it received “special situation shares” which were illiquid, which now were the only material assets held by the partnership.
SPhinX put itself into liquidation voluntarily in the Grand Court of the Cayman Islands. Unfortunately the liquidators appointed by the Grand Court found an accounting disaster. As the Bankruptcy Court noted:
Early on in the liquidation proceeding, the Liquidators uncovered serious accounting issues. In 2006, the Liquidators advised the Debtor and other investors in the SPhinX Group that the accounting work performed by Derivatives Portfolio Management LLC (“DPM”), the SPhinX Group's administrator responsible for maintaining the accounting records, was inaccurate and incomplete. Of note, certain DPM prepared spreadsheets that detailed the year-to-date change in net asset values among the SPhinX Group funds (hereinafter, the “NAVINC Files”) contained serious deficiencies. In an affidavit submitted to the Grand Court on June 20, 2007, Mr. Krys discussed a host of significant accounting issues: extensive co-mingling of funds; misstatements of cash; failure to process redemptions; inadequate documentation of transactions within the SPhinX Group; failure to properly allocate shares; two sets of books; and the net asset value calculations not accounting for the Preference Settlement. Due to these issues and others, the Liquidators advised investors that they could not give assurances regarding the accuracy of the net asset value calculations disseminated to investors since 2002. The Liquidators also began including strongly worded disclaimers warning against relying upon or using any financial reports regarding the SPhinX Group.
The SPhinX group itself stopped filing Forms 1065 or providing K-1s to its partners (including Refco Public Community Pool, LP) after 2005. Before making any distributions the liquidators identified 23 issues that had to be resolved, including the allocation of the Preference Settlement among the various SPhinX Group funds and the treatment of the S shares.
The SPhinX’s Group’s failure to file partnership returns was noticed by the IRS and the question of their penalties was dealt with in their bankruptcy. As the Court notes:
In July 2011, the Liquidators filed a motion under Bankruptcy Codesection 505 in its Chapter 15 proceeding seeking a determination that the SPhinX Group owed no penalties for not filing Partnership Returns for the years 2005 to 2007. In a declaration submitted with the motion, Mr. Krys noted that the Liquidators would not be filing Partnership Returns for any year after 2005. He explained that to prepare these returns would cost between $5 and $7 million because an accounting firm would have to reconstruct thousands of records. The IRS and the Liquidators settled the matter and SPhinX Group was absolved from having to file Partnership Returns for the years 2005 to 2007.
So now we turn to the taxpayer in this case (Refco Public Community Pool, LP) which had its own partnership returns to file for these years. But it was faced with significant problems. The only asset it had was an interest that was treated as a partnership for federal tax purposes, but it was not receiving K-1s for that entity. The information it did have on those entities for the years in question was provided to them with warnings that the information should not be used for any purpose, as it was highly unreliable and likely significantly misstated.
The taxpayer’s position was that it could not prepare a Form 1065 for the years in question because it simply lacked any sort of information regarding the income of the entity for reasons wholly outside of its control, and despite attempts by the partnership to obtain some sort of information aside from K-1s that could be relied upon to prepare the returns.
The IRS, however, indicated that its position was this would not be reasonable cause for failing to file a Form 1065 of any sort. As the Court summarized:
…[T]he IRS asserts that the Debtor could have prepared its Partnership Returns without receiving a Schedule K-1 from SMFF. The Debtor cannot establish reasonable cause when it did not seek to obtain the information necessary to file from another source. The IRS contends that if the Debtor made reasonable efforts, it could have easily obtained the NAVINC Files and the unaudited Sphinx Funds Positions Liquidation Summary, as of December 31, 2006, and the unaudited Sphinx Funds Receipts & Disbursements Statement for the period June 30, 2006 to December 31, 2007, (together, the “Summary Financial Data”). The IRS argues that this information would have been sufficient to prepare the Debtor's Partnership Returns.
The taxpayer agrees that it could have used that information. But it knew the information was both unreliable and inaccurate. And even if that wasn’t a problem, there were additional issues:
The Debtor also asserts that it could not use the Summary Financial Data to prepare its Partnership Returns because this information does not calculate the income of the separate funds—a critical piece of information when preparing Form 1065. Additionally, the Debtor contends that the Liquidation Issues created substantial uncertainties regarding the Debtor's investment in SMFF. The Debtor argues that two of these issues—the allocation of the Preference Settlement and the scope of rights attaching to the S Shares—created such uncertainty it could not prepare its Partnership Returns.
The Court sided with the partnership in this matter—nearly all of its assets consisted of investments on which the only information that could be obtained was clearly wildly unreliable. The Court notes that:
As an accrual method taxpayer, the Debtor cannot recognize income until “all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.” , Treas. Reg. §§ 1.451-1(a), (c)(1)(ii). With SMFF not providing Partnership Returns after 2005, the above-noted events prevented the Debtor from determining whether it had a fixed right to receive income from SMFF. The documents available from SMFF were the NAVINC Files and the Summary Financial Data, but this information was fraught with errors; and with respect to the Summary Financial Data in particular, entirely unhelpful because it only provided information on “receipts” and “proceeds” received, not “income.” Thus, the Court concludes that the Debtor's failure to file its Partnership Returns arose from events beyond its control.
In this case the Court also used the jurat to justify the failure to file given the knowledge of the various problems with the available information, noting:
Based on this knowledge, a reasonable person would likely be concerned with signing the jurat clause at the bottom of Form 1065, which provides in relevant part, that “[u]nder penalties of perjury, I declare that I have examined this return ... and to the best of my knowledge and belief, it is true, correct, and complete.” To the best of the Debtor's knowledge, the information it had to prepare the Partnership Returns was inaccurate.
The Bankruptcy Court concluded that the taxpayer had reasonable cause for failure to file the returns in question and denied the IRS’s attempt to file a claim for the penalties.
It’s important to note that while this case is interesting, it serves primarily to suggest it might be possible in extreme situations to escape the late filing penalty due to lack of information wholly outside the taxpayer’s control. Note that this case has a number of unique features, including having all of the assets invested in the problem investment, a liquidator that had found (and communicated to the taxpayer) numerous issues with the accounting records of the investment the partnership held that caused the liquidator to indicate the information should not be used and the fact that the Bankruptcy Court was certainly aware that allowing this claim for the IRS would take money out of the pockets of other innocent parties.
If a taxpayer’s case is not this extreme (which will be true in the vast majority of cases), it’s unlikely the taxpayer will prevail. The lack of perfect information by itself is not sufficient to excuse filing, nor even would it likely be true that merely having some partnership assets invested in this manner would excuse the late filing—a Court would conclude that the partnership return overall numbers could be reasonably estimated even if they clearly weren’t “perfect.” And it’s important not to forget that this case was decided in Bankruptcy Court in Delaware—not a venue that the vast majority of clients would be able to ask to decide on the matter in their case.
But the decision does at least open the “possibility” of a jurat defense to nonfiling if the facts are severe enough and the partnership took numerous steps to attempt to obtain adequate information.