Am. Milling, LP v. Comm'r

MARVEL, Judge: Respondent issued a notice of final partnership administrative adjustment (FPAA) pursuant to section 6223¹ to UN Limited, the tax matters partner (TMP) of American Milling, LP (American Milling), for 2000, *193 2001, 2002, and 2003 (Milling FPAA). Respondent made adjustments to the income, expense, and deduction items that American Milling reported on its 2000, 2001, 2002, and 2003 Federal income tax returns. Petitioner, its TMP, timely filed a petition contesting respondent's adjustments. When the petition was filed American Milling had its principal place of business in Illinois. This matter is before the Court on petitioner's motion to dismiss for lack of jurisdiction.

In 1998 David Jump engaged in a series of transactions constituting a Son-of-BOSS tax shelter.^2*201 To this end, Mr. Jump formed two single-member limited *194 liability companies: Gateway Grain, LLC (Gateway Grain), and Omaha Pump Co., LLC*200 (Omaha Pump).³ Gateway Grain and Omaha Pump engaged in short sales of U.S. Treasury notes resulting in proceeds in excess of $30 million. They then transferred the short sale proceeds and the related obligation to close the transactions to American Boat Co., LLC (American Boat).⁴ Around the same time American Milling transferred 18 tugboats to American Boat. Under section 723, American Boat took bases in the tugboats (inside basis) equal to American Milling's bases in the tugboats before the contribution. Likewise, under section 722, American Milling's initial basis in its American Boat partnership interest (outside basis) was equal to its bases in the tugboats before the contribution.

American Boat asserted that the contribution of the short sale proceeds increased the contributing partners' outside basis by more than $30 million, but the obligation to close the short sales was not a liability for purposes of section *195 752 and therefore had no effect on outside basis. The result was a large, artificial increase in outside basis.

On December 31, 1998, after closing the short sale*202 transactions, Mr. Jump and the Jump Trust (through Gateway Grain and Omaha Pump) transferred their American Boat partnership interests to American Milling. Consequently, under section 708(b)(1), American Boat's partnership status terminated,⁵ triggering a deemed distribution of American Boat's assets. See, e.g., Palm Canyon X Invs., LLC v. Commissioner, T.C. Memo. 2009-288; Rev. Rul. 99-6, 1999-1 C.B. 432. American Milling claimed a basis in the assets of American Boat (i.e., the tugboats) equal to the legitimate bases of the tugboats plus the inflated basis claimed from the short sale proceeds.

American Boat filed a Form 1065, U.S. Partnership Return of Income, for 1998. Respondent issued an FPAA to American Milling, the TMP of American Boat, for 1998 (American Boat FPAA). In the American Boat FPAA respondent determined, among other things, that American Boat was a sham partnership, the *196 Son-of-BOSS transactions lacked economic substance, American Boat should be disregarded for tax purposes, and the short sale obligations*203 were liabilities for purposes of section 752. Respondent made adjustments to American Boat's ordinary income, capital contributions, outside basis, portfolio income, and investment income.

American Milling contested the adjustments in the American Boat FPAA in the U.S. District Court for the Southern District of Illinois. Am. Boat Co., LLC v. United States, No. 3:06-CV-00788-GPM-CJP (S.D. Ill. Nov. 20, 2008), aff'd, 583 F.3d 471 (7th Cir. 2009). In doing so American Milling made a jurisdictional deposit equal to the amount of tax due pursuant to section 6226(e)(1).^6*204 Because American Milling was a passthrough entity, respondent calculated the amount of *197 the deposit by determining the increase in income tax for the ultimate taxpayer--in this case Mr. Jump. Respondent included in this calculation all adjustments flowing from the American Boat FPAA for 2000 through 2003 including, among other things, the disallowance of American Milling's deduction for legal fees for 2000 that flowed through to Mr. Jump. American Milling, through Mr. Jump, paid $1,260,544 as a jurisdictional deposit.⁷

The District Court held a three-day bench trial in the American Boat case. At trial the Government introduced evidence regarding the inflated bases that American Boat had claimed in the tugboats and American Boat's legitimate bases in the tugboats. The Government also introduced evidence of the inflated depreciation deductions that American Milling had claimed with respect to the tugboats for 2000 through 2003 and the inflated capital loss that American Milling had*205 claimed on the sale of some of the tugboats. These inflated depreciation deductions and inflated capital losses mirror the adjustments respondent made in the Milling FPAA.

On the third day of trial the Government moved for judgment as a matter of law on the following three issues: (1) that the short sale obligations were *198 liabilities for purpose of section 752; (2) that the Son-of-BOSS transactions lacked economic substance; and (3) that the Son-of-BOSS transactions lacked a business purpose. The District Court, ruling from the bench pursuant to rule 52 of the Federal Rules of Civil Procedure, granted the Government's motion for judgment as a matter of law with respect to the first two issues.^8*207 The District Court denied the Government's motion with respect to business purpose. At the conclusion of trial the District Court found that American Boat had reasonable cause for inflating the bases of the tugboats and therefore no section 6662(a)*199 accuracy-related penalty applied. The District Court did not make a specific finding that American Boat was a sham and did not determine American Boat's legitimate bases in the tugboats.⁹ Furthermore, although respondent determined in the American Boat FPAA that American Milling's outside basis in American Boat was a partnership*206 item of American Boat,¹⁰the District Court did not make a specific finding with respect to American Milling's outside basis in American Boat.

Respondent did not directly assess against Mr. Jump any tax deficiency for 1998 resulting from the American Boat proceeding.¹¹ Instead, on January 18, 2013, respondent mailed the Milling FPAA to petitioner. Respondent determined *200 that American Milling had:*208 (1) claimed inflated depreciation deductions for 2000 through 2003 because of inflated bases in the tugboats; (2) claimed an inflated capital loss for 2002 resulting from the sale of some of the tugboats; and (3) erroneously claimed a deduction for 2000 of $300,000 for legal fees incurred in connection with the Son-of-BOSS transactions.

The Milling FPAA includes both numerical adjustments, which are set forth in a schedule of adjustments, and the narrative explanation of items. The explanation of items is captioned "Affected Item Notice Final Partnership Administrative Adjustments".^12*210 It states that as a result of the partnership item determinations made in the American Boat FPAA and the District Court case "all contributions, distributions, and any other transactions that American Milling * * * purportedly engaged in with American Boat * * * are disregarded for federal income tax purposes. The results of the [American Boat] partnership item *201 determinations include but*209 are not limited to reducing the basis of assets distributed to American Milling * * * by American Boat * * * by $31,255,986". The explanation of items further states that the Milling FPAA adjusts American Milling's claimed depreciation deductions and capital loss by reducing the bases of the tugboats by $31,255,986. Finally, the explanation of items states that American Milling's deduction of $300,000 for legal fees is disallowed because American Milling "has not established that such expenses were incurred or, if incurred, allowable under any provision of the * * * [Code]".

Partnerships do not pay Federal income tax, seesec. 701, but they are required to file annual information returns reporting their partners' distributive shares of income, gain, loss, deductions, and credits, seesec. 6031. Under the unified partnership audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648, the tax treatment of any partnership item generally must be determined at the partnership level. Sec. 6221. TEFRA is a series of special tax and audit provisions that apply in all partnership proceedings (with exceptions not relevant here). Seesec. 6231(a)(1). The goal of TEFRA is to have a single point of *202 adjustment for all partnership items at the partnership level. See Kligfeld Holdings v. Commissioner, 128 T.C. 192, 200 (2007). TEFRA, however, limits our jurisdiction at the partnership level to partnership items. Sec. 6226(f).¹³

A partnership item is "any item required to be taken into account for the partnership's taxable year*211 under any provision of subtitle A [Income Taxes] to the extent [the] regulations * * * provide that, for purposes of this subtitle, such item is more appropriately determined at the partnership level than at the partner level." Sec. 6231(a)(3). The critical element is that the partnership is required to make the determination. Sec. 301.6231(a)(3)-1(c)(1), Proced. & Admin. Regs. But the failure of the partnership to actually make the determination does not prevent an item from being a partnership item. Id. A "nonpartnership item" is an "item which is (or is treated as) not a partnership item", sec. 6231(a)(4), and an "affected item" is a nonpartnership item that is affected by the determination of a partnership item, sec. 6231(a)(5).

Petitioner contends that we lack jurisdiction to determine the partnership items of American Milling that respondent adjusted in the Milling FPAA because *203 the Milling FPAA is a "reproduction" of the American Boat FPAA and therefore violates the rule prohibiting respondent from issuing a second FPAA, seesec. 6223(f). Alternatively, petitioner contends that we lack jurisdiction over the Milling FPAA because: (1) all adjustments in the Milling FPAA are computational adjustments flowing from the American Boat*212 FPAA and there are no affected items requiring factual determinations at the American Milling level, and (2) respondent did not have authority to issue the Milling FPAA because neither the Code nor the regulations authorize the issuance of an affected items FPAA.¹⁴

Under section 6223(f), "[i]f the Secretary mails a[n] * * * [FPAA] for a partnership taxable year with respect to a partner, the Secretary may not mail another * * * [FPAA] to such partner with respect to the same taxable year of the same partnership in the absence of a showing of fraud, malfeasance, or *204 misrepresentation of a material fact." Petitioner contends in substance that the Milling FPAA is a duplicate of the American Boat FPAA. Specifically, petitioner contends that the adjustments to the bases of the tugboats*213 and the disallowance of the deduction for legal fees were made in the American Boat FPAA and finally determined in the District Court proceeding. Petitioner relies in part on our Opinion in Wise Guys Holdings, LLC v. Commissioner, 140 T.C. 193 (2013).

In Wise Guys, the Commissioner issued a valid FPAA to a partnership and thereafter issued a second FPAA for the same year to the same partnership. Id. at 194-195. We noted that the second FPAA did not set forth any partnership-level adjustment or determination that was not listed in the first FPAA and appeared to have been issued as the result of an administrative error. Citing section 6223(f), we held that the Commissioner was precluded from mailing a second FPAA to the same partnership for the same year absent a showing of fraud, malfeasance, or misrepresentation of a material fact. Because the first FPAA was valid and the Commissioner did not assert that the second FPAA was issued on account of fraud, malfeasance, or misrepresentation of fact, we concluded that the second FPAA was invalid. Id. at 199-200.

*205 Petitioner contends that when we invalidated the second FPAA in Wise Guys we "did not require the two FPAA's to be identical, but instead recognized that the key factor in determining whether an FPAA was invalid pursuant to **214 * * [section 6223(f)] was whether the adjustments and determinations of the two FPAA's were identical." Petitioner mischaracterizes our analysis in Wise Guys. We invalidated the second FPAA in Wise Guys because it was issued to the same partnership for the same taxable year and there was no showing of fraud, malfeasance, or misrepresentation of fact. The similarity of the content of the two FPAAs was not essential to our holding in Wise Guys. Instead, it simply aided our finding that the second FPAA was "more [likely] the result of a mistake or a lack of communication on the part of * * * [respondent] than of fraud, malfeasance, or a misrepresentation of a material fact." Wise Guys Holdings, LLC v. Commissioner, 140 T.C. at 199-200. Here, by contrast, respondent issued the Milling FPAA to the TMP of American Milling--not to the TMP of American Boat--for years distinct from those at issue in the American Boat FPAA. Wise Guys is distinguishable because it involved a second FPAA issued to the same taxpayer for the same tax year.

Petitioner also contends that the Milling FPAA is a duplicate of the American Boat FPAA because (1) the adjustments in the Milling FPAA "are *206 identical" to the adjustments in the American Boat FPAA, and (2) respondent examined the partnership*215 returns of American Milling as part of the District Court proceeding.^15*216 Petitioner's argument is difficult to understand given that even a cursory examination of the two FPAAs reveals that they make materially different adjustments to items of income and expense. The American Boat FPAA adjusts the ordinary income, capital contributions, outside basis, portfolio income, and investment income that American Boat reported on its Form 1065 for 1998. In contrast, the Milling FPAA adjusts the depreciation, capital loss, and legal fees deductions that American Milling claimed on its Forms 1065 for 2000 through 2003. None of the adjustments in the Milling FPAA is identical to an adjustment in the American Boat FPAA--even if some of the adjustments in the Milling FPAA are related to the adjustments in the American Boat FPAA.

*207 In addition, respondent's examination of American Milling's Forms 1065 for 2000 through 2003 as part of the District Court proceeding does not mean that the partnership items of American Milling were at issue in the District Court proceeding. Instead, respondent examined American Milling's Forms 1065 for 2000 through 2003 for purposes of calculating the TEFRA jurisdictional deposit under section 6226(e)(1) and establishing the sham nature of the Son-of-BOSS transactions.

Mr. Jump was an indirect partner in American Boat, seesec. 6231(a)(9) and (10), and respondent calculated the TEFRA jurisdictional deposit by including all adjustments flowing from the American Boat FPAA to Mr. Jump's returns, seesec. 301.6226(e)-1, Proced. & Admin. Regs.; part III supra pp. 5-6. These adjustments resulted in part from an examination of American Milling's returns for 2000 through 2003, and respondent's calculation of Mr. Jump's increased tax liabilities flowed from that examination. Indeed, respondent's*217 calculations of the resulting tax due included the disallowed legal fees deduction, inflated depreciation deductions, and increased capital loss appearing on the Milling FPAA. Petitioner contends that because the adjustments to American Milling's returns were introduced into evidence during the District Court proceeding and *208 were included in calculating the TEFRA jurisdictional deposit, the District Court "made final" these adjustments. We disagree.

Under section 6226(f), the District Court's jurisdiction in American Boat extended only to "all partnership items of * * * [American Boat] for the partnership taxable year to which * * * [the American Boat FPAA] relates, the proper allocation of such items among the partners, and the applicability of any penalty * * * which relates to an adjustment to a partnership item". The District Court did not have jurisdiction to determine the partnership items of American Milling that respondent adjusted in the Milling FPAA, which are adjustments for a different entity and for tax years different from those at issue in American Boat. Moreover, even if the District Court had made affirmative findings regarding American Milling's outside basis in American Boat or*218 American Boat's inside bases in the tugboats for 1998,¹⁶ those determinations would not be conclusive regarding American Milling's bases in the tugboats for 2000 through 2003. See infra p. 21. Accordingly, we reject petitioner's contentions that the Milling FPAA *209 is an improper second FPAA or that it is a duplicate of the American Boat FPAA and therefore invalid under section 6223(f).

Petitioner contends that the adjustments in the Milling FPAA "are nothing more than computational adjustments * * * [that] do not require a partner level determination." We disagree.

Section 6231(a)(6) defines computational adjustments as "the change in the tax liability of a partner which properly reflects the treatment*219 * * * of a partnership item."^17*220 Thus, a computational adjustment is the consequence to the partner of a determination, whether administrative or judicial, regarding a partnership item.¹⁸ Under section 6230(a)(1), "computational adjustments are *210 viewed as representing the 'deficiency impact' of the proper tax treatment of the underlying partnership items." Rawls Trading, L.P. v. Commissioner, 138 T.C. 271, 287 (2012). When computational adjustments flow from an affected item that requires a partner-level factual determination, section 6230(a)(2) affords the partner a prepayment forum to challenge the Commissioner's partner-level determinations. In the absence of any affected items requiring partner-level determination, the partner cannot dispute the Commissioner's computational adjustments in deficiency mode. Instead, the partner's remedy is limited to a claim for refund and refund litigation if the claim is denied. Seesec. 6230(a)(1), (c)(4).

Petitioner contends that respondent's description of the adjustments in the Milling FPAA makes clear that the adjustments are merely computational because respondent expressly states that the adjustments to basis, depreciation, and loss are the result of the basis adjustments in the American Boat FPAA. However, respondent's description of the adjustments in the Milling FPAA simply notifies American Milling of the reason for the adjustments. It does not preclude the need *211 for factual determinations to determine*221 American Milling's correct bases in the tugboats and related depreciation deductions and capital loss amount.

Respondent contends that the adjustments in the Milling FPAA are both partnership items of American Milling and affected items flowing from the American Boat FPAA. He contends that American Milling's basis in American Boat and its bases in the tugboats received from American Boat are partnership items of American Milling because they are required to be taken into account for determining American Milling's income and loss. Seesec. 301.6231(a)(3)-1(a)(1), Proced. & Admin. Regs. Specifically, respondent contends that the depreciation expenses and loss from the sale of certain tugboats "wear two hats" because they are partnership items of American Milling but were derived in part from American Boat.

The usual rule is that an asset distributed by a partnership to one of its partners has a basis equal to the partnership's basis in that asset. Sec. 732(a). But, under section 732(b), the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest equals the partner's adjusted basis in the partnership, reduced by any money distributed in the same transaction. Accordingly,*222 when American Boat liquidated, American Milling's *212 bases in the tugboats under section 732(b) were determined by reference to its outside basis in American Boat.¹⁹

The District Court did not determine American Milling's outside basis in American Boat as of December 31, 1998, the taxable year at issue in the American Boat proceeding. Moreover, even if the District Court had asserted jurisdiction to determine American Milling's outside basis, such a determination would not conclusively determine American Milling's bases in the tugboats for 2000 through 2003. Indeed, determining the legitimate bases of the tugboats and the resulting depreciation deductions and capital losses requires us to make specific factual findings at the American Milling level. For example, American Milling could have incurred capital improvement costs following the liquidating distribution that increased its bases in the tugboats. Determining that American Milling did not*223 incur such costs is also a partnership-level determination. See, e.g., Greenwald v. Commissioner, 142 T.C. 308, 315 (2014); see also Domulewicz v. Commissioner, 129 T.C. 11, 20 (2007) ("Neither the Code nor the regulations thereunder require that partner-level determinations actually result in a substantive change to a *213 determination made at the partnership level."), aff'd in part, remanded in part sub nom. Desmet v. Commissioner, 581 F.3d 297 (6th Cir. 2009).

Finally, petitioner concedes that the adjustments to depreciation, capital loss, and legal fees in the Milling FPAA are correct. To the extent petitioner argues on brief that the adjustments in the Milling FPAA are improper and do not confer jurisdiction on us because they are not disputed or contested items, we reject that contention. Petitioner may not remove from our jurisdiction the determinations in the Milling FPAA and the explanation of items by conceding the adjustments therein. See, e.g., LTV Corp. v. Commissioner, 64 T.C. 589, 591 (1975).

We conclude that the adjustments to depreciation, capital loss, and legal fees deductions in the Milling FPAA are partnership items of American Milling, and we have subject matter jurisdiction in this case. We have considered the remaining arguments made by the parties and, to the extent not discussed above, conclude those arguments are irrelevant, moot, or without merit.

To reflect*224 the foregoing,

An appropriate order will be issued.