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.
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 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.
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 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)
The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.
