The Tax Court held that because the IRS did not make any adjustments to partnership items, penalties the IRS asserted against the taxpayer did not fall within the exception from deficiency procedures for penalties related to adjustments to partnership items.
During 2005, Bernard Malone was a partner of MBJ Mortgage Services America Ltd. (MBJ), a partnership that is subject to the TEFRA audit procedures. On its 2005 Form 1065, U.S. Return of Partnership Income, MBJ reported installment sales of partnership assets and reported as Malone's distributive share from those sales $3,200,748 of ordinary income and $3,547,326 of net long-term capital gain.
On his return for 2005, Malone failed to report his distributive share from those sales but reported $4,526,897 of long-term capital gain from the sale of his partnership interest in MBJ. Malone did not file a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, or otherwise notify the IRS that he was taking a position inconsistent with that reported by MBJ.
The IRS issued Malone a notice of deficiency in which it adjusted Malone's return to include the partnership items reported by MBJ that he omitted, and disallowed the reported net long-term capital gain because Malone did not sell his partnership interest in 2005. Malone filed a petition in Tax Court challenging the IRS's determination. In its amended answer to Malone's petition, the IRS asserted a Sec. 6662(a) penalty on the alternative grounds of a substantial understatement of income tax and negligence. In an amendment to its amended answer, the IRS clarified that it was asserting the penalty only on account of Malone's failure to report his distributive share of partnership items flowing from MBJ and not on account of the treatment of any of the other adjustments included in the notice of deficiency.
Malone moved to dismiss the penalty from the case, asserting that the Tax Court lacked jurisdiction over a penalty relating to his inconsistent reporting, based on Sec. 6230(a)(2)(A)(i), which provides that deficiency procedures do not apply to "penalties, additions to tax, and additional amounts that relate to adjustments to partnership items."
The Tax Court's decision
The Tax Court held that in Malone's case, the Sec. 6662(a) penalty was subject to deficiency procedures and denied his motion to dismiss for lack of jurisdiction. The court found that the penalties did not fall under the exception to deficiency procedures in Sec. 6230(a)(2)(A)(i) because the IRS did not make any adjustments to partnership items.
In determining whether the deficiency procedures applied, the Tax Court first determined whether the Sec. 6662(a) penalty was a partnership item, which would be determined in TEFRA proceedings at the partnership level. Because the Sec. 6662(a) penalties are in Subtitle F of the Code, and partnership items are limited to items arising under Subtitle A, the court found that Malone's penalty was not a partnership item (and therefore was a nonpartnership item).
Malone argued in his motion that if the penalty was found to be an affected item, it would likely not be subject to deficiency procedures. Under Sec. 6231, an affected item is "any item to the extent such item is affected by a partnership item." Affected items can be computational affected items, which can be determined mathematically and are not subject to deficiency procedures, or factual affected items, which require factual determination at the partner level and thus are subject to deficiency procedures. The court determined that "under the unique facts of the case," the deficiency procedures applied even if the penalty was an affected item.
The Tax Court explained that before 1997, the categorization of accuracy-related penalties as factual affected items was clear. As factual affected items, the penalties required factual determinations at the individual partner level, and thus normal deficiency procedures applied to the penalties. However, in the Taxpayer Relief Act of 1997, P.L. 105-34, Congress modified the Tax Court's deficiency jurisdiction for certain penalties. It amended Sec. 6230(a)(2)(A)(i) to exclude from deficiency proceedings "penalties, additions to tax, and additional amounts that relate to adjustments to partnership items." The court found that under this provision, regardless of the characterization of the Sec. 6662(a) penalty, unless the IRS had made adjustments to a partnership item, the penalty was not excepted from deficiency procedures.
Malone argued that the inconsistently reported partnership items on his 2005 Form 1040 were "adjusted" within the meaning of Sec. 6230(a)(2)(A)(i). The Tax Court disagreed, finding that the adjustments made to the liability reported on his 2005 Form 1040 were tax liability computational adjustments to take into account the partnership items as originally reported by MBJ, and there were no adjustments to partnership items. Because there were no adjustments to partnership items, the court found that deficiency procedures applied to the determination, which gave the court jurisdiction to decide whether the penalty applied.
According to the legislative history, Sec. 6230(a)(2)(A)(i) was enacted to move the determination of a penalty related to the conduct of the partnership to partnership-level proceedings, thereby reducing the administrative burden on the IRS of applying these penalties at the partner level through deficiency procedures. Here, Malone attempted to avoid penalties by standing that provision on its head and using it to move the determination of penalties based solely on a partner's conduct to partnership-level proceedings. The Tax Court rightly thwarted that attempt by recognizing that where there are no adjustments to partnership items, the taxpayer cannot hide behind the Sec. 6230(a)(2)(A)(i) exclusion.
Malone, 148 T.C. No. 16 (2017)