A majority of a Tenth Circuit panel ruled, in the case of McNeill v. United States, CA10, No. 15-8095, that the managing partner in a TEFRA partnership was not barred, as a matter of law, from raising a reasonable cause/good faith penalty defense in his individual proceeding. That was despite the fact that the IRS had rejected the defense when raised by the partnership, with Mr. McNeill as the Tax Matters Partner, in the examination of the partnership.
The District Court had dismissed the case, holding that Mr. McNeill was barred from raising this defense by TEFRA. The Court did not use any judicial doctrine to bar this matter (such as res judicata, holding the matter had already been litigated), but rather found that TEFRA itself barred the defense.
As the majority opinion points out:
Instead of passing on the question whether Mr. McNeill could prove reasonable cause and good faith for his tax position, the district court held it was precluded from doing so. Not by operation of the judicial doctrines of claim or issue preclusion. The judicial order dismissing the partnership level case expressly indicated that it was without prejudice and no order in that case ever passed on the reasonable cause/good faith question. Neither the district court in its decision nor the government in its brief before us suggests this was sufficient to trigger claim or issue preclusion principles. Instead, the district court held only that TEFRA itself – as a matter of statute – precludes a managing partner like Mr. McNeill from pursuing at the partner level a reasonable cause/good faith defense where (as here) the IRS in administrative proceedings has rejected the partnership's assertion of reasonable cause/good faith at the partnership level.
The provision the District Court invoked is found at IRC §6230(c)(4) which provides:
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.
The majority points out the last sentence allows a partner to raise partner specific defenses and that judicial precedent has held that this is both a partnership and partner level issue:
The Supreme Court itself has suggested that under TEFRA a partner’s reasonable cause and good faith defense cannot be “conclusively” determined at the partnership level. Woods, 134 S. Ct. at 564 (“[T]he partner may nonetheless have acted in good faith with reasonable cause, . . . see § 6664(c)(1). [This issue cannot] be conclusively determined at the partnership level.”). And the lower court cases the government attempts to rely upon are perhaps even less helpful to its cause. In Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636 (2008), the partnership argued that “the partnership-level trial should resolve conclusively the reasonable cause defenses of each of the individual partners.” Id. at 658. Meanwhile, the government (consistent with its regulations, of course) contended that the reasonable cause/good faith defense is more properly adjudicated at the partner level -- and it prevailed upon the court to agree, 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.” Id. Much the same story played out in Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 548 (5th Cir. 2009), 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.” Id. at 547.
The Court noted that their ruling was a limited one, and certainly hinted that res judicata might have been a better way to address the problem:
In saying this much we do not mean to deny that there's often a strong identity of interests between a managing or tax matters partner and a partnership. Neither do we mean to suggest that issues addressed in partnership level proceedings always may be contested by individual partners in partner level proceedings. So, for example, our case doesn't involve the question whether TEFRA would (or could) permit parties to relitigate matters that the doctrine of issue preclusion might otherwise forbid thanks to their final determination in an earlier judicial proceeding by parties with sufficient commonality of interests to qualify as privies. See Entek GRB, LLC v. Stull Ranches, LLC, 763 F.3d 1252, 1258 (10th Cir. 2014) (discussing use of offensive issue preclusion against parties and their privies). The only question before us is whether, when no party argues that a final judicial ruling exists that triggers judicial preclusion principles, an adverse decision in a TEFRA administrative partnership level proceeding prevents a managing (or tax matters) partner from pursuing a reasonable cause/good faith defense in later partner level proceedings.
The dissenting opinion argued that, in fact, he was not asserting any actual reasonable-cause defense that had not been asserted in the partner level proceedings—and thus, the opinion reasoned the District Court had properly concluded that, as a matter of law, those issues were not up for reconsideration:
I don’t read the third sentence as making the second sentence’s conclusive penalty determinations inconclusive for partner-level defenses in penalty-refund actions. Instead, I read the third sentence as ensuring that partners can always bring partner-level defenses subject to any conclusive determinations being applied in those partner-level proceedings. And many times, partners can prevail at the partner level because none of the FPAA’s conclusive determinations defeat their partner-level defense. For instance, those partners may not have known or done all that the partnership's managing partner knew and did. And even here, if Mr. McNeill had somehow asserted that his own reasonable-cause defense differed from Dulwich’s reasonable-cause defense based on his own conduct and intent, he might still have prevailed despite the conclusive effect TEFRA gives to the FPAA's penalty determinations.
Nor does the TEFRA regulation guarantee all partners an absolute right to assert reasonable-cause defenses in their partner-level refund actions. It does, however, allow partner-level defenses based on reasonable cause if the defenses are personal to the partner and “cannot be determined at the partnership level.” 26 C.F.R. § 301.6221-1(d). Here, because the reasonable cause Mr. McNeill asserted for Dulwich and later for himself are the same, Mr. McNeill's partner-level defense based on his reasonable cause for his tax activity could be and was determined at the Dulwich partnership level.