Raghunathan Sarma v. Commissioner of Internal Revenue

USCA11 Case: 21-12303 Date Filed: 08/19/2022 Page: 1 of 23
[PUBLISH]
In the
United States Court of Appeals
For the Eleventh Circuit
____________________
No. 21-12303
____________________
RAGHUNATHAN SARMA & GAILE SARMA,
Petitioners-Appellants,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
____________________
Petition for Review of a Decision of the
U.S.Tax Court
Agency No. 26318-16
____________________
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21-12303 Opinion of the Court 2
Before NEWSOM, MARCUS, Circuit Judges, and MIDDLEBROOKS,*
District Judge.
MIDDLEBROOKS, District Judge:
This appeal involves the tax consequences of Raghunathan
Sarma’s participation in a complex tax avoidance scheme. In 2001,
Sarma expected to realize an $80.9 million capital gain as a result of
selling a portion of his company. The scheme, which involved a set
of tiered partnerships, allowed Sarma to claim a $77.6 million
artificial loss to offset his legitimate capital gains. A federal District
Court found the scheme to be an abusive tax shelter and upheld
the IRS’s disallowance of the benefits of the shelter in a partnership-
level proceeding, and a prior panel of this Court affirmed. Kearney
Partners Fund LLC v. United States, 803 F.3d 1280 (11th Cir. 2015)
(per curiam).
As a result of the partnership-level proceeding, the IRS
issued a notice of deficiency to Petitioners disallowing the $77.6
million loss deduction they reported on their joint tax return.
Petitioners sought review in the U.S. Tax Court, which rejected
their various challenges. After careful review and with the benefit
of oral argument, we affirm.
I
A
Partnerships are not taxpayers; taxable income and losses of
a partnership are passed through to its partners. 26 U.S.C. § 701.
Partnerships do, however, file annual information returns
* Honorable Donald M. Middlebrooks, United States District Judge for the
Southern District of Florida, sitting by designation.
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reporting their tax items, such as gains, losses, deductions and
credits. Id. § 6031(a). Partners are responsible for reporting their
distributive share of the partnership’s tax items on their individual
federal income tax returns. Id. §§ 702, 704.
The Tax Equity and Fiscal Responsibility Act of 1982
(“TEFRA”), the governing scheme in effect during the relevant
period, established uniform audit and litigation procedures for the
resolution of partnership tax items. Pub. L. No. 97-248, 96 Stat.
648. 1 Prior to TEFRA, the IRS could not audit items that were
attributable to the partnership in a single unified proceeding.
United States v. Woods, 571 U.S. 31, 38 (2013). Instead, the IRS had
to adjust partnership-level items individually with each partner
through the normal deficiency proceedings. Id. (citing 26 U.S.C.
§§ 6211–6216 (2006 ed. and Supp. V)). This led to duplicative
proceedings involving the same tax items and inconsistent results
among partners of a given partnership. Id. By enacting TEFRA,
Congress sought to alleviate those problems. Id.TEFRA provides a two-step process for resolving
partnership tax matters. First, “partnership item[s]” are adjusted “at
the partnership level” in a single partnership-level proceeding. 26
U.S.C. § 6221(a), 6231(a)(3). A “partnership item” is “any item
required to be taken into account for the partnership’s taxable
year” if “such item is more appropriately determined at the
partnership level than at the partner level.” Id. § 6231(a)(3).
1
The Bipartisan Budget Act of 2015 repealed TEFRA partnership procedures
for taxable years beginning on or after January 1, 2018. Greenberg v. Comm’r,
10 F.4th 1136, 1144 n.1 (11th Cir. 2021) (citing Pub. L. No. 114-74, § 1101(a),
129 Stat. 584, 625). All citations to the Internal Revenue Code and Treasury
Regulations herein reflect the provisions in effect during the relevant period.
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Conversely, a “nonpartnership item” is “an item which is (or is
treated as) not a partnership item.” Id. § 6231(a)(4). To challenge a
partnership item, the IRS initiates an administrative proceeding
against the partnership. Id. § 6223(a)(1). The IRS then issues a
notice of final partnership administrative adjustment (“FPAA”) to
the partners informing them of the adjustments to partnership
items. Id. § 6223(a)(2). Partners can seek judicial review of the
adjustments to partnership items in a partnership-level proceeding.
Id. § 6226(a), (b)(1).
Then, once partnership-level adjustments are final, the IRS
determines whether the partnership-level adjustments necessitate
any partner-level changes, including to “affected items.” Id. §§
6225, 6231(a)(5). An “affected item” is “any item to the extent such
item is affected by a partnership item.” Id. § 6231(a)(5). If an
adjustment is merely computational and does not require partner-
level factual determinations, the IRS may directly assess the
computational adjustment without issuing a notice of deficiency,
i.e., there is no prepayment right to judicial review. See id.
§§ 6230(a)(1), (c), 6231(a)(6); Treas. Reg. § 301.6231(a)(6)-1(a)(2). If
an adjustment attributable to an affected item requires partner-
level determinations, the IRS must issue an affected item notice of
deficiency to the partner and the normal deficiency procedures
apply, i.e., there is a prepayment right to judicial review. 26 U.S.C.
§ 6230(a)(2)(A)(i); Treas. Reg. § 301.6231(a)(6)-1(a)(3).
Any partnership that filed partnership return during the
relevant time period was subject to TEFRA, unless it qualified as a
“small partnership.” 26 U.S.C. § 6231(a)(1)(A), (B)(i). A small
partnership is a “partnership having 10 or fewer partners each of
whom is an individual . . . , a C corporation, or an estate of a
deceased partner.” Id. § 6231(a)(1)(B)(i). A partnership cannot be a
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small partnership if any partner is a “pass-thru partner,” Treas Reg.
§ 301.6231(a)(1)-1(a)(2), which is an entity through which “other
persons hold an interest,” 26 U.S.C. § 6231(a)(9). The
determination that a partnership is a small partnership is made
“with respect to each partnership taxable year.” Treas. Reg.
§ 301.6231(a)(1)-1(a)(3). Small partnerships are exempt from the
definition of “partnership.” 26 U.S.C. § 6231(a)(1)(B)(i). Meaning,
small partnerships are not subject to TEFRA’s audit and litigation
procedures unless they elect to have TEFRA apply. See id.§ 6231(a)(1)(A)–(B). Tax items of small partnerships must be
challenged at the partner level in deficiency proceedings. See
Arenjay Corp. v. Comm’r, 920 F.2d 269, 270 (5th Cir. 1991).
B
Sarma2 participated in a tax avoidance scheme called
“Family Office Customized partnership” or “FOCus.” Kearney
Partners Fund, LLC v. United States, 803 F.3d 1280, 1283 (11th Cir.
2015) (per curiam). An investment firm called Bricolage Capital,
LLC (“Bricolage”) and the accounting firm KPMG marketed
FOCus to wealthy individuals with recent “large liquidity
event[s].” See id. at 1283. Sarma was one such individual. In 2001,
Sarma expected to realize an $80.9 million capital gain as a result of
selling a division of his company, American Megatrends. Id. at
2
Petitioners were married when they filed joint returns in 2001 through 2004.
Under the Internal Revenue Code, married taxpayers who file joint returns
are treated “as one taxable unit,” allowing them to aggregate their income and
deductions. Vichich v. Comm’r, 146 T.C. 186, 193 (2016).
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1282. Sarma participated in the FOCus scheme to avoid paying the
resulting taxes.
Each FOCus vehicle required the creation of a set of three
tiered partnerships: an upper tier, middle tier and lower tier. Id. at
1283. The partnerships owned a 99% interest in the partnership in
the tier below it, with Bricolage-affiliated entities owning the
remaining 1% of each entity. Id. at 1284. Sarma invested in the
FOCus vehicle comprised of the following partnerships:3
(1) Nebraska Partners Fund, LLC (“Nebraska”), the upper tier,
(2) Lincoln Partners Fund, LLC (“Lincoln”), the middle tier, and
(3) Kearney Partners Fund, LLC (“Kearney”), the lower tier.
FOCus was designed to generate significant artificial losses
to offset legitimate taxable income. An essential component was a
series of offsetting foreign currency exchange forward contracts,
referred to as straddles (“FX straddles”), executed by Kearney
through Credit Suisse First Boston (“Credit Suisse”). 4 The proceeds
from the gain legs of the FX straddles were placed into certificates
of deposit (“CDs”) at Credit Suisse. Kearney reported and realized
3
The entities are in fact limited liability companies, but they are treated as
partnerships for federal income tax purposes. We refer to them as
partnerships.
4
This trading activity was complex, see Kearney Partners Fund, 803 F.3d at
1286–88, and the precise mechanics are not critical to our analysis. Relevant
for our purposes, it involved pairs of transactions which the District Court
called “straddles,” with each transaction in a given pair being a “leg.” Id. at
1286. Whichever leg resulted in a gain was “cash settled” and the gain was
realized, and Credit Suisse used the gain leg to offset the loss leg. Id.
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a $79.1 million gain from the gain legs. 5 The loss legs had not been
closed out and remained unrealized. However, the amounts of
those losses were locked in.
The scheme also required several ownership changes in the
partnerships, which resulted in the partnerships having several
short tax periods within the 2001 calendar year. 6 On December 4,
2001, Sarma acquired a 99% interest in Nebraska. Nebraska already
owned a 99% interest in Lincoln, and Lincoln owned a 99% interest
in Kearney. All three partnerships terminated their tax periods. See
Treas. Reg. § 1.708-1(b)(2). The three partnerships each filed
partnership returns for their respective December 4, 2001 short tax
years, and new partnerships were deemed formed on December 5,
2001. See id. § 1.708-1(b)(4). On December 14, 2001, Sarma
acquired a 99% interest in Lincoln from Nebraska. At this point,
Lincoln became a small partnership. See 26 U.S.C.
§ 6231(a)(1)(B)(i). Lincoln and Kearney terminated their tax periods
5
The ultimate taxpayer-partners at the time, who were affiliated with
Bricolage, reported the gains on their individual tax returns but “washed away
[the gains] through the manipulation of the tax system.” Kearney Partners
Fund, 803 F.3d at 1288 n.13.
6
A partnership terminates “when 50 percent or more of the total interest in
partnership capital and profits is sold or exchanged within a period of 12
consecutive months.” Treas. Reg. § 1.708-1(b)(2). The taxable year for the
partnership closes when the partnership terminates, and a new partnership is
deemed formed. Id. § 1.708-1(b)(3)–(4). Thus, the changes in ownership
described herein resulted in several “short” tax years for the respective
partnerships.
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and filed partnership returns for their respective short tax years
ending December 14, 2001.
On December 19, 2001, Lincoln (a small partnership) sold its
99% interest in Kearney (a TEFRA partnership) for $737,118 to a
Bricolage-affiliated entity. On the date of the sale, Lincoln claimed
an outside basis in Kearney of $79,110,062. “Tax basis is the amount
used as the cost of an asset when computing how much its owner
gained or lost for tax purposes when disposing of it.” Woods, 571
U.S. at 35. Outside basis is “[a] partner’s tax basis in a partnership
interest.” Id. at 35–36. Outside basis increases when the partnership
has a gain and decreases when the partnership has a loss. 26 U.S.C.
§ 705(a). In computing its outside basis in Kearney, Lincoln
increased its outside basis to account for the gain legs from the FX
straddles, but it did not decrease its basis to account for the
unrealized losses from the loss legs. Lincoln reported a $78,392,194
short term capital loss on its partnership return for its December
31, 2001 short tax period. Lincoln allocated $77,608,272 of the
Lincoln loss to Sarma in accordance with his 99% partnership
interest. Sarma, in turn, claimed a deduction for this loss on his
2001 joint tax return, and carried over the remaining portions to
his 2002, 2003 and 2004 returns.
Kearney ended its tax period and filed a partnership return
for its December 19, 2001 short tax year. Lincoln’s final short tax
year in 2001 spanned from December 15, 2001 until December 31,
2001. Lincoln filed partnership returns for 2002, 2003 and 2004 with
Sarma as its 99% partner.
C
The IRS issued nine FPAAs to the partnerships for several
short tax years, including Kearney’s December 19, 2001 tax year. In
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the FPAAs, the IRS determined that the partnerships were an
abusive tax shelter and adjusted partnership items to eliminate the
benefits of the shelter. The IRS did not issue an FPAA to Lincoln
for its December 31, 2001 short tax year, as Lincoln was a small
partnership. However, Sarma held an indirect interest in several
partnerships during the short tax years for which the FPAAs were
issued. See 26 U.S.C. § 6231(a)(9), (10). The partnerships sought
judicial review of the adjustments in the FPAAs in the United States
District Court for the Middle District of Florida.
The District Court presided over a bench trial, at which
Sarma testified. Kearney Partners Fund, LLC v. United States, 2014
WL 905459, *4, *9, *14 (M.D. Fla. March 7, 2014). Thereafter, the
District Court found that “every step of the FOCus series of
transactions”—including the creation of the partnerships, the
purchases and sales of the various partnerships, including the sale
of Kearney, and the FX straddles—was “solely motivated by tax
avoidance.” Id. at *13. Sarma “schemed to create and operate the
partnerships (even before [he] formally purchased them) to serve
as an abusive tax shelter.” Id. at *1. The partnerships and their
transactions “had no economic substance whatsoever.”7 Id. at *1,
*13. The District Court sustained the IRS’ adjustments that
reduced Kearney’s gains and losses from the FX straddles to zero.
On October 13, 2015, a panel of this Court affirmed. Kearney
Partners Fund, 803 F.3d at 1281. The partnership-level proceeding
became final on January 11, 2016.
7
“[A] transaction is not entitled to tax respect if it lacks economic effects or
substance other than the generation of tax benefits, or if the transaction serves
no business purpose.” Winn-Dixie Stores, Inc. v. Comm’r, 254 F.3d 1313, 1316
(11th Cir. 2001) (per curiam).
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D
The partnership-level court lacked jurisdiction to determine
Lincoln’s outside basis in Kearney, and so a partner-level
proceeding was required to make that adjustment. On September
9, 2016, the IRS issued an affected item notice of deficiency to
Petitioners asserting deficiencies for 2001 through 2004 arising out
of Sarma’s involvement in the FOCus shelter (“2016 notice”).
Because Kearney was a sham, the IRS determined that Lincoln had
no basis in Kearney. The IRS disallowed the $77.6 million loss
deduction Petitioners reported and asserted resulting tax
deficiencies. Previously, in 2009 and 2010, the IRS had also issued
notices of deficiency to Petitioners for their 2001 through 2004 tax
years. Petitioners filed a petition in the U.S. Tax Court challenging
the 2016 notice.
Petitioners moved to dismiss for lack of jurisdiction.
Petitioners first argued that the statute of limitations expired prior
to the IRS’s issuance of the 2016 notice. Petitioners additionally
argued that the 2016 notice was an invalid third notice of
deficiency. For reasons that will be more fully explained below, the
resolution of both of these issues hinges on whether Lincoln’s
outside basis in Kearney is an “affected item.” The Tax Court held
that it was, and thus found the notice to be both timely and valid.8
8
The IRS also moved to dismiss on the grounds that the adjustments in the
2016 notice did not require “partner level determinations” under 26 U.S.C.
§ 6230(a) and thus deficiency procedures were not required. The Tax Court
denied the motion, finding that partner-level determinations, and thus
deficiency procedures, were required.
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Respondent moved for summary judgment. Petitioners
argued, in relevant part, that because Kearney was found to be a
sham for tax purposes, Lincoln should be deemed the owner of
Kearney’s assets and Lincoln’s sale of its Kearney interest should be
deemed a sale of Kearney’s assets. The Tax Court granted
summary judgment for Respondent and rejected Petitioners’
deemed ownership theory. It held that Lincoln’s outside basis in
Kearney was zero, reasoning that a partner cannot have any basis
in a sham partnership. See Woods, 571 U.S. at 41–42. Lincoln
therefore had no gain or loss on the Kearney sale, Lincoln was not
entitled to deduct the Lincoln loss, and Petitioners were not
entitled to deduct the $77.6 million pass through loss.
Petitioners raise three issues on appeal. First, whether the
Tax Court erred by finding that the statute of limitations had not
expired prior to the issuance of the 2016 notice. Second, whether
the Tax Court erred by finding that the 2016 notice of deficiency
was a valid multiple notice. Both of these issues rise and fall with a
single determination: whether Lincoln’s outside basis in Kearney
(i.e., a small partnership’s outside basis in a TEFRA partnership) is
an “affected item.” Third, whether the Tax Court erred by failing
to treat Lincoln’s sale of Kearney as a sale of Kearney’s assets. After
careful review, we affirm.
II
We review de novo the Tax Court’s legal conclusions,
including the Tax Court’s interpretation of the Internal Revenue
Code. Greenberg v. Comm’r, 10 F.4th 1136, 1155 (11th Cir. 2021)
(citing Highpoint Tower Tech. Inc. v. Comm’r, 931 F.3d 1050, 1056
(11th Cir. 2019)). We also review the Tax Court’s grant of
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9
summary judgment de novo. Roberts v. Comm’r, 329 F.3d 1224,
1227 (11th Cir. 2003) (per curiam). Summary judgment is
warranted where the record establishes “that ‘there is no genuine
issue as to any material fact and that a decision may be rendered as
a matter of law.’” Baptiste v. Comm’r, 29 F.3d 1533, 1537 (11th Cir.
1994) (quoting Tax Ct. R. 121(b)).
A
The general limitations period for assessing tax or issuing a
notice of deficiency is three years after the taxpayer files his or her
individual return. 26 U.S.C. § 6501(a). There is an exception,
though, for partnership items. See id. § 6501(n)(2) (“For extension
of [the] period in the case of partnership items . . . see section
6229.”). Under § 6229, “the period for assessing any tax imposed by
subtitle A with respect to any person which is attributable to any
partnership item (or affected item) for a partnership taxable year
shall not expire before” three years from the date on which the
partnership return is filed. Id. § 6229(a). Section 6229(a) therefore
“holds open” the § 6501 limitations period for the assessment of tax
attributable to partnership items or affected items. Rhone-Poulenc
Surfactants & Specialties, L.P. v. Comm’r, 114 T.C. 533, 544 (2000).
9
Petitioners moved for reconsideration of the orders denying their motion to
dismiss and granting Respondent’s motion for summary judgment, both of
which the Tax Court denied. We review Tax Court orders denying motions
for reconsideration for abuse of discretion. Huminski v. Comm’r, 679 F. App’x
926, 927 (11th Cir. 2017) (per curiam) (citing Byrd’s Estate v. Comm’r, 388 F.2d
223, 234 (5th Cir. 1967)). Since we find no error in the Tax Court’s orders
denying Petitioners’ motion to dismiss or granting Respondent’s motion for
summary judgment based on a de novo review, we likewise find no abuse of
discretion in denying the motions for reconsideration of those orders.
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The mailing of a timely FPAA suspends the statute of limitations
until the conclusion of the partnership-level proceeding and for one
year thereafter. 26 U.S.C. § 6229(d).
The IRS issued the 2016 notice on September 9, 2016. If the
2016 notice adjusts an affected item, as Respondent argues, the
statute of limitations did not expire until January 11, 2017—one
year after the Kearney proceeding became final. Petitioners,
however, contend that Lincoln’s outside basis in Kearney is not an
affected item, therefore § 6229 does not apply, and the statute of
limitations under § 6501(a) expired no later than February 16, 2013.
The timeliness of the 2016 notice thus depends on whether
Lincoln’s outside basis in its Kearney interest is an affected item.
We hold that it is.
An affected item is “any item to the extent such item is
affected by a partnership item.” 26 U.S.C. § 6231(a)(5). The
determination that a partnership lacks economic substance and is a
sham is a partnership item. Woods, 571 U.S. at 39; Highpoint
Tower Tech., 931 F.3d at 1058. Lincoln’s outside basis in Kearney
is certainly an “item,” and so the operative question is whether
Lincoln’s outside basis in Kearney is “affected by” the District
Court’s determination that Kearney was a sham.
A partner’s outside basis in a partnership interest is generally
an affected item. See Woods, 571 U.S. at 41–42. Here, Lincoln
claimed an inflated outside basis in Kearney based upon the
artificial gains Kearney generated through the sham FX straddles.
The inflated basis allowed Lincoln to claim an artificial loss on its
sale of its Kearney interest. The process of calculating outside basis
“presupposes that the partnership was valid.” RJT Investments X v.
Comm’r, 491 F.3d 732, 736 (8th Cir. 2007). And once a partnership
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is “deemed not to exist for tax purposes, no partner could
legitimately claim an outside basis greater than zero.” Woods, 571
U.S. at 44. The determination that Kearney was a sham factors into
Lincoln’s computation of its gain or loss on the sale of its Kearney
interest. Thus, Lincoln’s outside basis in Kearney is an item affected
by a partnership item.
Nothing in the statutory text compels a different result when
the partner is a small partnership. Small partnerships are not
“partnerships” within the meaning of TEFRA, so they cannot have
“partnership items.” 26 U.S.C. §§ 6231(a)(1), (3). The items of a
small partnership are thus nonpartnership items. Id. § 6231(a)(4).
That designation, however, does not prevent them from also being
“affected item[s],” which are “any item[s]” affected by a partnership
item. Id. § 6231(a)(5) (emphasis added). Because Kearney’s sham
status is a partnership item of Kearney, and because Lincoln’s
outside basis in Kearney is affected by that partnership item,
Lincoln’s outside basis in Kearney can be an affected item.
Treasury Regulation § 301.6231(a)(5)-1(b) supports this plain
reading of the statutory definitions. It provides: “[t]he basis of a
partner’s partnership interest is an affected item to the extent it is
not a partnership item.” Treas. Reg. § 301.6231(a)(5)-1(b). Here,
“[t]he basis of [Lincoln’s] partnership interest [in Kearney] is an
affected item to the extent it is not a partnership item.” It cannot
be a partnership item of Lincoln because Lincoln is statutorily
barred from having partnership items. No party suggests that
Lincoln’s outside basis in Kearney is a partnership item of Kearney.
Since Lincoln’s outside basis in Kearney is not a partnership item,
it is an affected item.
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Petitioners’ argument to the contrary rests on an untenable
analogy to TEFRA partnerships. The analogy works as follows: An
upper-tier TEFRA partnership’s outside basis in a lower-tier
TEFRA partnership could not be an affected item because it would
be a partnership item of the upper-tier partnership. Nonpartnership
“partnership-level” items of a small partnership should receive the
same treatment as partnership items of a TEFRA partnership. It
follows that a small partnership’s outside basis in a TEFRA
partnership would be a “partnership-level” nonpartnership item,
and the IRS should have addressed it at the “Lincoln partnership
level” or the “Lincoln level.” Put simply, this analogy is contrary to
the text and structure of TEFRA.
There is at least a colorable textual argument to support the
proposition that an upper-tier TEFRA partnership’s outside basis in
a lower-tier partnership would be a partnership item of the upper-
tier and not an affected item. 10 See 26 U.S.C. § 6231(a)(3), (a)(5);
Treas. Reg. § 301.6231(a)(5)-1(b). But critically, small partnerships
cannot have “partnership items.” American Milling, LP v.
Commissioner does not help Petitioners for that very reason—it
involved an upper-tier TEFRA partnership’s basis in a lower-tier
TEFRA partnership. See T.C. Memo 2015-192 at *1, *5 (2015). The
textual bar that could arguably prevent an upper-tier TEFRA
partnership’s outside basis in a lower-tier TEFRA partnership from
being an affected item disappears when the upper-tier partnership
is a small partnership.
10
The Parties debate whether an upper-tier TEFRA partnership’s outside basis
in a lower-tier partnership could be an affected item. We need not resolve this
dispute, since Lincoln was not a TEFRA partnership during its December 31,
2001 tax year.
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Nor does TEFRA’s structure evidence Congressional intent
for “partnership level” items of small partnerships to receive like
treatment as partnership items of TEFRA partnerships. TEFRA
does not endeavor to treat uniformly all entities that file returns as
partnerships. Rather it provides for a single unified proceeding to
resolve partnership items of a given “partnership,” as that term is
statutorily defined, for the purpose of uniform application of the
partnership-level items among the partners. See, e.g., JT USA LP v.
Comm’r, 131 T.C. 59, 65 (2008). This concept of “levels” matters
for TEFRA partnerships because separate proceedings exist and
jurisdictional limits apply to the items that can be resolved at each
level. See 26 U.S.C. §§ 6226(f), 6230(a)(2)(A)(i). It is an irrelevant
distinction for small partnerships, which are exempt from having
entity-level items resolved in entity-level proceedings. See
Wadsworth v. Comm’r, T.C. Memo 2007-46, *6 (2007) (“The small
partnership exception permits this Court to review in a[n]
[individual partner’s] deficiency suit items that otherwise would be
subject to partnership-level proceedings.”). Indeed, we find
Petitioners’ advocacy for a comparison to TEFRA’s treatment of
partnership items hard to reconcile with their later contention that
Congress did not intend for small partnerships to be subject to
TEFRA’s audit and litigation rules at all.
As a final matter, the Tax Court did not “open up” Lincoln’s
December 31, 2001 “otherwise closed” tax year, as Petitioners
contend. Br. of Petitioners at 36–38. “Congress anticipated that the
taxable year in which an assessment is made would not always be
the same as the taxable year in which the adjustments are made,”
which the intersection between § 6501 and § 6229 reflects. See
Kligfeld Holdings v. Comm’r, 128 T.C. 192, 202–05 (2007) (holding
that the Internal Revenue Code does not require any “matching”
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of the partnership and partner’s respective taxable years). Section
6229(a) establishes the minimum period in which the IRS must
assess tax attributable to partnership items or affected items against
the ultimate taxpayer, “notwithstanding the period provided for in
§ 6501.” Greenberg, 10 F.4th at 1164 (quoting Rhone-Poulenc, 114
T.C. at 542) (internal quotation marks omitted). Put another way,
“section 6229(a) holds open the § 6501 limitations period as to all
partners for a fixed period of time, thereby providing a minimum
period within which to assess adjustments attributable to
partnership items against all partners.” Rhone-Poulenc, 114 T.C. at
544. Here, that would be Petitioners. Lincoln is a flow-thru entity
that does not itself pay taxes. TEFRA applies “to any person
holding an interest” in a TEFRA partnership during the taxable
year at issue. Treas. Reg. § 301.6233-1(a). Sarma held an indirect
interest in Kearney through Lincoln. See 26 U.S.C. § 6231(a)(10)
(defining “indirect partner”); id. § 6231(a)(9) (defining “pass-thru
partner”). Sarma is a person to whom an adjustment of an affected
item from the partnership-level proceeding can be applied. See id.
§ 6229(a).
The filing of the FPAA, the timeliness of which Petitioners
do not contest, suspended the limitations period for assessment of
tax attributable to affected items until January 11, 2017. The 2016
notice asserts a deficiency that is attributable to an affected item.
Accordingly, the statute of limitations had not expired when the
IRS issued the September 9, 2016 notice of deficiency, as the Tax
Court correctly found.
B
Having found that Lincoln’s outside basis in Kearney is an
affected item, it then follows that the 2016 notice was valid. Section
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6212(c)(1) generally bars the issuance of multiple notices of
deficiency to the same taxpayer for the same tax year. Petitioners
contend that the 2016 notice is invalid in light of the two prior-
issued notices and, thus, that the Tax Court lacked jurisdiction. See
GAP Corp. & Subsidiaries v. Comm’r, 114 T.C. 519, 521 (2000)
(“[The Tax] Court’s jurisdiction to redetermine a deficiency in tax
depends upon a valid notice of deficiency . . . .”).
However, Congress carved out an exception to this general
rule in § 6230(a)(2)(C) for affected item notices of deficiency. See 26
U.S.C. § 6230(a)(2)(A), (C) (“Notwithstanding any other law or rule
of law, any notice or proceeding under subchapter B with respect
to a deficiency [attributable to affected items which require partner
level determinations] shall not preclude or be precluded by any
other notice, proceeding, or determination with respect to a
partner’s tax liability for a taxable year.”); see also Rawls Trading,
L.P. v. Comm’r, 138 T.C. 271, 291 (2012) (describing
§ 6230(a)(2)(C) as an exception to the “no-second-deficiency
notice” rule set forth in § 6212(c)(1)). Because the 2016 notice
adjusts an affected item, it is not subject to the general rule in
§ 6212(c)(1). The exception in § 6230(a)(2)(C) applies, and the Tax
Court correctly found the 2016 notice to be valid.
C
We now turn to Petitioners’ deemed ownership theory.
Petitioners do not challenge the Tax Court’s finding that Lincoln
had no outside basis in Kearney in light of Kearney being a sham.
Rather, Petitioners argue that the Tax Court should have treated
Lincoln’s sale of its Kearney interest as something wholly
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different—a sale of Kearney’s assets. 11 They argue that Kearney, as
a sham partnership, must be treated as an agent or nominee of its
owners. Lincoln should thus be deemed the owner of Kearney’s
assets, and Lincoln’s sale of its Kearney interest deemed an asset
sale. Petitioners contend that the Tax Court needed to resolve
Lincoln’s basis in Kearney’s assets, namely the CDs (which Kearney
purchased with the gains from the FX straddles), and determine the
amount of Lincoln’s loss on the deemed asset sale. Their position
is that Lincoln took a cost basis of $81.8 million in the CDs. Were
that the case, Lincoln would have sold an asset worth $81.8 million
for $717,868—less than one percent of its value—yielding an $81
million loss.
When a partnership is found to be a sham for tax purposes,
the rules governing the income taxation of partners (subchapter K
of chapter 1) do not apply, and the activities of the purported
partnership are treated as engaged in by one or more of the
purported partners. 436 Ltd. v. Comm’r, T.C. Memo 2015-28, *34–
*35 (2015). A sham partnership has no identity separate from its
owners and is treated as an agent or nominee. Tigers Eye Trading,
LLC v. Comm’r, 138 T.C. 67, 96, 99 (2012), aff’d in part, rev’d in
part Logan Tr. v. Comm’r, 626 F. App’x 426 (D.C. Cir. 2015). But
the transactions of a disregarded partnership still need to be
addressed, “to the extent [the reviewing court] ha[s] jurisdiction.”
436 Ltd., T.C. Memo 2015-28 at *35.
If a sham partnership files an informational return, which
Kearney did, the return is treated as though it were filed by an
11
Petitioners suggest that Respondent conceded that Lincoln should be
deemed the owner of the CDs. No such concession was made, as the Tax
Court correctly found.
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entity subject to TEFRA. 26 U.S.C. § 6233; Treas. Reg. § 301.6233-
1. Meaning, TEFRA applies to Kearney, its items, and any person
holding an interest in Kearney for that taxable year. Treas. Reg.
§ 301.6233-1. TEFRA, via § 6226(f), vests the partnership-level
court with jurisdiction to determine the entity’s items that would
have been partnership items, as well as to determine the proper
allocation of any items to the purported partners. Tigers Eye, 138
T.C. at 95. Basis in the CDs would be a partnership item of
Kearney. See Superior Trading, LLC v. Comm’r, 137 T.C. 70, 91
n.20 (2011) (explaining that inside basis of a partnership asset is a
partnership item). In the instant partner-level proceeding, the Tax
Court lacked jurisdiction over Kearney’s partnership items. The
cases on which Petitioners rely do not support deeming the
Kearney sale as an asset sale by Lincoln. Those cases were
partnership-level proceedings in which the purported partnerships
distributed assets with inflated bases to their partners. Tigers Eye,
128 T.C. at 80; New Millennium Trading, LLC v. Comm’r, T.C.
Memo 2017-9, * 32 (2017); 436 Ltd, T.C. Memo 2015-28 at *9.
Kearney did not distribute the CDs to Lincoln. Nor did the District
Court treat Kearney as having distributed the CDs to Lincoln, or
treat Lincoln as the owner of the CDs.
To recharacterize Lincoln’s sale of its Kearney interest as an
asset sale would run afoul of the principle that “a taxpayer is free to
organize his affairs as he chooses, nevertheless, once having done
so, he must accept the tax consequences of his choice, whether
contemplated or not, and may not enjoy the benefit of some other
route he might have chosen to follow but did not.” Meruelo v.
Comm’r, 923 F.3d 938, 945 (11th Cir. 2019) (quoting Comm’r v.
Nat. Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974))
(internal quotation marks omitted). Taxpayers generally must
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accept the tax consequences flowing from “the transaction they
actually execute” (meaning, they are “bound by the ‘form’ of their
transaction”), and they “may not reap the benefit of some other
transaction they might have made” (meaning they cannot “argue
that the ‘substance’ of their transaction triggers different tax
consequences”). Id. (quoting Selfe v. United States, 778 F.2d 769,
773 (11th Cir. 1985)) (internal quotation marks omitted). Lincoln
reported this transaction as a sale of its interest in Kearney on its
December 31, 2001 partnership return. Kearney did not distribute
the CDs to Lincoln, and the District Court did not treat Lincoln as
the owner of the CDs. What it did, rather, was find Kearney to be
a sham and eliminate the tax consequences of the shelter at the
partnership level, thereby enabling the IRS to reduce Lincoln’s
outside basis in Kearney to zero and disallow Petitioners’ $77.6
million loss deduction. That is not the tax consequence Petitioners
contemplated, but it is the tax consequence to which they are
bound.
Petitioners’ reliance on Gregory v. Helvering, 293 U.S. 465(1935), and the substance over form doctrine is misplaced.
Substance over form is an exception to the general rule that courts
respect the form of the transaction, which allows courts “to
determine the true nature of a transaction disguised by formalisms
that exist solely to alter tax liabilities.” Shockley v. Comm’r, 872
F.3d 1235, 1247 (11th Cir. 2017) (quoting John Hancock Life Ins.
Co. (U.S.A.) v. Comm’r, 141 T.C. 1, 57 (2013)) (internal quotation
marks omitted). “Taxpayer[s] can not [sic] argue substance over
form, except when necessary to prevent unjust results.” Adobe
Resources Corp. v. United States, 967 F.2d 152, 156 (5th Cir. 1992)
(citing Spector v. Comm’r, 641 F.2d 376 (5th Cir. Unit A 1981)).
The circumstances must be “exceptional.” Meruelo, 923 F.3d at
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945. There is nothing unjust about holding Petitioners to the form
of the transaction they chose. That is especially so considering that
the form of the transaction—the sale of an interest in a partnership,
albeit one later determined to be a sham—was an integral and pre-
planned part of an abusive tax shelter. The Tax Court did not err
in declining to recharacterize Lincoln’s sale of its Kearney interest.
D
As a final matter, we reject Petitioners’ contention that the
Tax Court failed to address due process concerns because
Petitioners “were never given the opportunity to directly
challenge” the disallowance of the Lincoln loss. Br. of Petitioners
at 14 n.4. Lincoln and Sarma were parties to the Kearney
proceeding—Lincoln as a direct partner of Kearney and Sarma as
an indirect partner of Kearney through Lincoln. See 26 U.S.C. §
6226(c) (partners are treated as parties to partnership-level
proceedings); id. § 6231(a)(2) (defining “partner” as including “any
other person whose income tax liability . . . is determined in whole
or in part by taking into account directly or indirectly partnership
items of the partnership”). Sarma apparently received the
statutorily required notice of the Kearney proceeding and
participated in it. See id. § 6223(h) (providing for notice to indirect
partners through the pass-thru partner). As the Second Circuit has
explained, the expansive definition of “partner” and permitting all
“partners” notice and participation rights ensures that those whose
tax liability is affected by partnership-level proceedings receive due
process. Callaway v. Comm’r, 231 F.3d 106, 110 (2d Cir. 2000).
Petitioners had the opportunity to persuade the District
Court that Kearney was not a sham and that its activities had
economic substance. See Napoliello v. Comm’r, T.C. Memo 2009-
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104, *7 (2009), aff’d 655 F.3d 1060 (9th Cir. 2011) (“TEFRA’s notice
provisions generally safeguard due process rights by providing
partners with notice of the partnership adjustment and an
opportunity to participate in the partnership-level proceeding.”).
Sarma testified at the bench trial and the District Court made
credibility determinations. Kearney Partners Fund, 803 F.3d at
1285. Petitioners then challenged the effects of the partnership-
level adjustments on their own tax items in the instant proceeding.
Petitioners received and availed themselves of notice and the
opportunity to be heard, and we find no due process violations.
* * *
For the foregoing reasons, we AFFIRM.