Where Taxpayer Failed to Report Items on Partnership K-1, IRS Could Assert Negligence Penalty in Partner Level Proceeding

Although the TEFRA Partnership audit rules are now living on borrowed time, cases looking at new issues continue to arise under those rules, and many involve concepts that likely will carry over to the new partnership audit regime.  One such issue arose in the case of Malone v. Commissioner, 148 TC No. 16.

Congress in 1997 modified the TEFRA partnership audit rules to bring certain issues involving penalties applicable to partnership items under the TEFRA rules where the matter had to be decided in a partnership proceeding, and not in proceedings for individual partners.

As the Tax Court commented:

Before 1997 the categorization of accuracy-related penalties as factual affected items was clear. “The additions to tax for negligence and valuation overstatement are affected items requiring factual determinations at the individual partner level”; normal deficiency procedures apply. Crowell v. Commissioner, 102 T.C. 683, 689 (1994) (citing N.C.F. Energy Partners v. Commissioner, 89 T.C. at 745); Crystal Beach Dev. of Destin, Ltd. v. Commissioner, T.C. Memo. 2000-170, 79 T.C.M. (CCH) 2068, 2069 n.2 (2000) (concluding that the Court lacked jurisdiction in a partnership-level proceeding and noting that “we are satisfied that Congress intended for accuracy-related penalties to be treated similarly to additions to tax; i.e., as affected items”). Section 6662(a) and (b)(1) penalties for negligence based on partnership items were and continue to be factual affected items.

Through the 1997 Act, however, Congress modified the Court’s deficiency jurisdiction with respect to certain penalties. Before the 1997 Act, following a partnership-level proceeding, the Commissioner was required to issue a notice of deficiency to each of the partners to assert penalties relating to the adjustment of partnership items. This was inefficient because the predicate for the penalty was often related events that occurred at the partnership level, which would be common to all of the partners. The 1997 Act streamlined this process by bypassing deficiency procedures for penalties attributable to adjustments of partnership items. To effect this change, Congress amended several TEFRA provisions to expand the scope of TEFRA to include “the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item”. Sec. 6221; see also sec. 6226(f) (expanding a court’s jurisdiction in a TEFRA proceeding to include penalties).

In this case, the taxpayers had failed to report items contained on the Schedule K-1 received from the partnership, arguing instead they had disposed of their interest.  They had not filed a notice of inconsistent treatment and the IRS found that they had not disposed of their interest.

The IRS thus adjusted the taxpayer’s return to remove the gain on sale they reported, but added the much larger gains shown on the partnership K-1. The notice of deficiency issued to the taxpayer also asserted the accuracy related penalty under IRC §6662(a), asserting both a substantial understatement of tax and negligence on the part of the taxpayers.

The taxpayers argued that the IRS, following the 1997 changes in the law, could not attempt to assert a §6662(a) penalty against them for items arising from the partnership, as those had to be raised in the partnership’s own TEFRA exam.

But the Tax Court found that Congressional changes only had an impact when there are adjustments made to partnership items—here they had simply failed to report the items that, under the TEFRA partnership rules, they were required to report in the absence of filing a notice of inconsistent treatment.

The Court concluded:

But in this case there are no adjustments to partnership items. There is no dispute that the partnership items reported by MBJ were not adjusted--the Commissioner did not attempt to dispute the items as reported on MBJ’s Form 1065. The Malones argue, however, that the inconsistently reported partnership items on their 2005 Form 1040 were “adjusted” within the meaning of section 6230(a)(2)(A)(i). We disagree.

The adjustments made to the liability reported on the Malones’ 2005 Form 1040 were computational adjustments to their tax liability to take into account the partnership items as originally reported by MBJ. There were no adjustments to partnership items. Accordingly, the section 6230(a)(2)(A)(i) exclusion from deficiency procedures is inapplicable to the section 6662(a) and (b)(1) negligence penalty before the Court in this case.