Dead statutes have a long life span in the tax world.

They have a long life span because cases involving prior tax years percolate through the judicial system long after the relevant statute has been amended or repealed. Perhaps the best example is the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the regime that Congress created in the 1980s to streamline partnership audits. In 2015, Congress passed the Balanced Budget Act of 2015, which created a whole new regime for partnership audits. Meanwhile, courts continue to decide unresolved questions under the old one.

Under TEFRA, audits proceeded in two phases: First, there was a partnership level proceeding, that adjusted “partnership items.” United States v. Woods, 571 U.S. 31, 39 (2013). When it concluded the audit at the partnership level, the IRS issued a final partnership administrative adjustment, and the partners had the opportunity to seek judicial review at that time. Id. Proceedings then shifted to the partner level, where adjustments could be made to an individual partner’s return. Some of those adjustments at the partner level were subject to judicial review, and others were not. Id.

Recently, the Ninth Circuit ruled that a statute of limitations challenge to the final partnership administrative adjustment that was the result of the partnership level proceeding was itself a partnership item that had to be addressed during the partnership level proceedings. As a consequence, a partner who sought to raise the issue in a partner-level proceeding was too late. Bedrosian v. Comm’r, No. 18-70066, 2019 U.S. App. LEXIS 30138, *11-*12 (9th Cir. Oct. 8, 2019).

John and Judith Bedrosian invested in a partnership called Stone Canyon Partnership in 1999; by the time their case reached the Court of Appeals twenty years later, the partnership was considered “a tax-shelter scheme.” Id. at *4. The case involved deductions they claimed on their 1999 and 2000 tax returns. Id.

The IRS started a partnership level proceeding in 2005 to allow some of the deductions that the Bedrosians claimed. Along the way, it did some things wrong:

  • It ended the partnership level proceeding too quickly, issuing the final partnership administrative adjustment in 62 days despite a statutory 120 day waiting period, although it did provide the Bedrosians with a notice advising that they could convert their partnership items to individual items at that time;
  • It immediately initiated a deficiency proceeding against them individually to enforce the partnership-level determination. Id. at *6.

While the IRS apparently overreached, the Bedrosians made a few mistakes of their own. They didn’t seek judicial review of the final partnership administrative adjustment. They also did not file the election statement that would have converted their partnership items to individual items. Instead, they filed a petition with the Tax Court in response to the individual deficiency notice that they received. Id.

The path that they chose proved to be a disaster. The Tax Court ruled that it lacked jurisdiction over their petition because they should have raised the statute of limitations by seeking judicial review of the final partnership administrative adjustment instead. Id. at *7. No partner filed a timely challenge to the final partnership administrative adjustment, but the tax matters partner attempted to do so, arguing that it could file late because the notice of the final partnership administrative adjustment was sent to the wrong address. The Tax Court rejected that argument too. Id.

The Bedrosians filed an initial appeal in their individual Tax Court case, but that was dismissed for lack of jurisdiction. Id. When they returned to the Tax Court, they filed a motion for summary judgment, arguing that the disallowance of their deductions was too late. Id. at *8. The Tax Court denied their motion and dismissed their petition, ruling that they should have raised the limitations issue in an appeal of the final partnership administrative adjustment. Id.

The Bedrosians fared no better on appeal.

First, the Ninth Circuit held that the statute of limitations was itself a partnership item. That meant they were precluded from raising it later.

Second, it ruled that they had not properly converted their partnership items to non-partnership items.

Third, it refused to explore their contention that the IRS acted in bad faith when it issued a notice of deficiency to them.

On the first issue, the Bedrosian’s argument was that the final partnership administrative adjustment was invalid because the statute had expired. Id. at *10. In response, the government argued that the whole question of whether the partnership proceeding was timely was itself a partnership item. As the Ninth Circuit explained, “TEFRA offers a rather tautological definition of partnership items: A partnership item is any item that the Secretary of the Treasury decides is ‘more appropriately determined at the partnership level than at the partner level.’” Id. at *10-*11 (quoting I.R.C. § 6231(a)(3) (2015)). The Court also observed that the corresponding regulation reaches broadly to all items affecting the partners’ share of tax items, and related factual and legal determinations. Id. at *11.

Given the breadth of the regulation, the argument that the statute of limitations is a “partnership item” seems pretty solid in a vacuum because it affects all of the partners. And while the issue was technically open in the Ninth Circuit, the Bedrosians had an uphill fight: “Every other circuit court to consider this issue has held that the FPAA statute of limitations is a partnership item that must be litigated in a partnership level proceeding.” Bedrosian, 2019 U.S. App. LEXIS 30138 at *11. In fact, six different circuits had already adopted that position. The Ninth Circuit decided to follow suit, and the Bedrosians lost. Id. at *11-*12.

The second issue requires some explanation. Because the IRS had issued the final partnership administrative adjustment without adequate notice, the Bedrosians had a statutory remedy. As the Ninth Circuit explained: “Here, the IRS concedes that the Bedrosians were entitled to convert their items under § 6223(e)(3)(B) because the IRS issued the Stone Canyon FPAA prematurely, well before the expiration of TEFRA’s 120-day waiting period.” Bedrosian, 2019 U.S. App. LEXIS 30138 at *12-*13.

While the Bedrosians had a remedy, they also had a problem: They failed to actually fill out the election form. They tried to paper over that problem by arguing that they “substantially complied” by filing their Tax Court petition. Id. at *13-*14. It was a creative argument, but it did not work:

They argue that, by challenging the disallowance of partnership deductions in their deficiency proceeding, they sufficiently demonstrated their desire to convert their partnership items to non-partnership items. Substantial compliance, however, demands more. To be deemed to have substantially complied . . . , a taxpayer must, at a minimum, have provided a “clear expression” of the “intention to elect.” The Bedrosians’ petition in this case contained no such clear expression of their intention to elect. In fact, the petition said nothing about making an election or a conversion, nor did the petition mention § 6223(e)(3). Further, the Bedrosians’ petition was filed in the Tax Court; election statements must be filed in a designated IRS office. And the Bedrosians filed their petition long after the 45-day deadline to file a statement of election.

Bedrosian, 2019 U.S. App. LEXIS 30138, *13-*14 (citations omitted).

The final issue was their contention that the IRS acted in bad faith in commencing deficiency proceedings. This issue is almost always a loser because courts do not look behind the notice of deficiency to examine motive; the taxpayer either shows the IRS is wrong about the proposed assessment or the taxpayer loses. The Ninth Circuit followed this rule, which is hardly a surprise. Id. at *15.

In sum, the Ninth Circuit added another nuance to TEFRA, even though it has been repealed. Along the way, it also offered up a helpful reminder that IRS audits are complicated and the failure to pay close attention can have unpleasant consequences. While the Bedrosians may appear to have been treated unfairly, they had an opportunity to preserve their rights, but did not do so. That left their lawyers without much to work with.

  •  
  •  
  •  
  •  
  •  
  •