IRS Does Not Bear Burden of Production in Partnership Level Proceedings

(Parker Tax Publishing May 2018)

The Tax Court held that the IRS does not bear the burden of production with respect to penalties in partnership level proceedings and is therefore not required to provide evidence of written supervisory approval under Code Sec. 6751(b)(1). The court reasoned that the burden of production rule in Code Sec. 7491(c) applies only to individual liability for penalties, and concluded that partnership level proceedings do not determine individual liabilities and are not proceedings with respect to individuals. Dynamo Holdings Limited Partnership v. Comm'r, 150 T.C. No. 10 (2018).

Background

Beekman Vista, Inc. (BV) is a U.S. corporation that is wholly owned by a Canadian entity. BV develops property in Florida. Dynamo Holdings Limited Partnership (Dynamo) is a U.S. partnership that also develops property in Florida. BV and Dynamo have at least one direct owner in common and share other indirect beneficial owners.

Transfers of property occurred between BV and Dynamo during 2005-2007. The IRS argued that the transfers were gifts among the beneficial owners. BV and Dynamo treated the transfers as sales paid for with loans that were eventually repaid. The IRS argued that if they were loans, they were for less than fair market value, and that the discounts were constructive distributions subject to withholding taxes.

The IRS audited BV's returns for tax years 2004 through 2008 and Dynamo's partnership returns for 2005-2007. The examination of BV's returns raised the question of whether it had properly withheld taxes under Code Sec. 1442. In February 2012, the IRS issued a notice of deficiency to BV for 2005 and 2006. The IRS determined that the corporation was liable for withholding taxes and for an addition to tax under Code Sec. 6651(a) for failure to file, as well as a penalty under Code Sec. 6656(a) for failure to make deposits. BV petitioned the Tax Court to challenge these determinations. In an amended answer, the IRS asserted an increased deficiency, an increase to the addition to tax under Code Sec. 6651(a)(1), and an increase to the amount of the Code Sec. 6656(a) penalty for each year.

The IRS issued a final partnership administrative adjustment with respect to Dynamo for 2005-2007 in December 2010. In addition to various adjustments to partnership items, the IRS applied accuracy related penalties under Code Sec. 6662(a) for negligence and substantial understatements of tax. Dynamo also petitioned the Tax Court, but neither BV nor Dynamo raised the issue of whether the IRS complied with the supervisory approval requirement in Code Sec. 6751(b). The cases were consolidated and a trial was held in early 2017.

In December 2017, the Tax Court decided Graev v. Comm'r, 149 T.C. No. 23 (2017) (Graev). In that decision, the court held that in cases where the IRS bears the burden of production under Code Sec. 7491(c) with respect to penalties, it must provide evidence of written supervisory approval of the penalties as required by Code Sec. 6751(b)(1). The day after Graev was decided, the Tax Court ordered the IRS to address the effect of Code Sec. 6751(b) in that case and related cases and to provide evidence of supervisory approval.

The IRS filed a response arguing that under Code Sec. 6751(b)(2)(A), supervisory approval is not required for additions to tax under Code Sec. 6651. As for the penalties under Code Secs. 6656(a) and 6662(a), the IRS argued that it did not bear the burden of production because neither BV nor any of Dynamo's partners were individuals. BV and Dynamo responded that the IRS bore the burden of production for the Code Sec. 6656(a) penalty at issue in the BV proceeding and the Code Sec. 6662(a) penalty at issue in the Dynamo proceeding, and argued that the IRS did not meet its burden under Code Sec. 6751(b) because it did not establish that the penalties were approved by immediate supervisors.

The IRS filed a motion to reopen the record, arguing that the Tax Court should allow additional testimony from the supervisors and agents involved to reinforce the evidence of supervisory approval. However, the IRS did not indicate that it would offer evidence of supervisory approval of the increased penalties asserted in its amended answer. BV and Dynamo filed a motion to dismiss as to the Code Sec. 6656 and 6662 penalties, arguing that the IRS did not meet its burden to establish that the supervisors who approved the penalties were immediate supervisors.

Analysis

The Tax Court held that in a partnership level proceeding, the IRS does not bear the burden of production with respect to penalties under Code Sec. 7491(c). It further held that where the IRS does not bear such a burden, the taxpayer may raise the lack of supervisory approval as a defense, but it found that BV and Dynamo did not raise that defense in this case and it was therefore waived. The court denied the IRS's motion to reopen the record and denied the taxpayers' motion to dismiss as to the penalties.

The IRS did not bear the burden of production with respect to the penalties asserted against Dynamo because the court found that under Code Sec. 7491(c), the IRS bears the burden only in proceedings with respect to individual liabilities, and partnership level proceedings do not determine individual liabilities. In a partnership level proceeding, the tax treatment of partnership items, as well as the applicability of any penalties or additions relating to an adjustment to a partnership item, are determined at the partnership level. The court explained that the partners' liability, if any, is determined later at the partner level.

Partnership level proceedings also are not proceedings with respect to individuals, in the court's view, because partnerships themselves are not individuals under the Code. And while individual partners may be parties to a partnership level proceeding, the court found that Code Sec. 7491(c) focuses on the nature of the proceeding, and not the parties.

The court found evidence in the Code that Congress did not intend for Code Sec. 7491(c) to apply to partnership level proceedings and noted practical concerns that would result if the IRS bore the burden of production with respect to penalties in partnership level proceedings. Because partnerships are not individuals, the court would have to determine the burden by looking through to the taxpaying partners, which would be contrary to the intent of partnership level proceedings. Additional complexities would arise with tiered partnerships, in the court's view.

With respect to the increased Code Sec. 6656 penalty asserted against BV in the IRS's amended answer, the court found that the IRS bears the burden of proof on any such increases, and therefore left the issue of whether the IRS met that burden to be resolved on the merits in a separate opinion.

Observation: The court observed that in two of its previous decisions - RERI Holdings I, LLC v. Comm'r, 149 T.C. No. 1 (2017) and Curtis Inv. Co. v. Comm'r, T.C. Memo. 2017-50 (2017) -- the court took for granted that the burden of production was on the IRS. The court concluded that, to the extent those decisions stated that the IRS bears the burden with regard to penalties in partnership level proceedings, it would decline to follow those decisions.

For a discussion of the burden of production, see Parker Tax ¶263,525. For a discussion of procedural requirements in computing penalties, see Parker Tax ¶262,195.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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