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Partnership tax law is complicated for any attorney drafting a partnership agreement. See Drafting Partnership and LLC Agreements: Tax Boilerplate, Allocation, and Liquidation Provisions (explaining in detail how to understand tax provisions in partnership agreements and how to draft effective partnership tax provisions). But attorneys also face complicated issues in handling partnership tax controversies. The recently decided case, Krause v. U.S., 2010 US App LEXIS 21531 (5th Cir, October 12, 2010) (unpublished opinion) demonstrates the pitfalls that a tax attorney can face – even when dealing with his or her own tax controversy.
In Krause, a tax attorney set up a Son of Boss transaction in a partnership, Krause & Associates Advanced Strategies (“KAAS”), in which he and his totally controlled entities were the only general and limited partners. When KAAS suffered a multi-million dollar loss due to the Son of Boss transaction, this loss flowed through directly to Krause. Krause claimed this loss on his 2002 and 2003 federal income tax returns.
The IRS considers the Son of Boss tax shelters to be abusive practices. IRS Notice 2000-44, 2000-2 CB 255. Not surprisingly, the IRS challenged Krause’s loss deductions by issuing a Final Partnership Administrative Adjustment (FPAA) to KAAS’s general partner. The FPAA determined that KAAS was a hoax and existed for the sole purpose of tax avoidance. The FPAA also stated that the adjustments of partnership items for KAAS, which resulted in an underpayment of tax, were due to “(1) substantial understatements of income tax, (2) gross valuation misstatement(s), or (3) negligence or disregarded rules or regulations.” The IRS then issued a Notice of Deficiency that indicated that Krause owed additional taxes due to the FPAA adjustments and also owed an additional $112,466 in penalties and interest for the gross valuation misstatements.
Krause did not contest the FPAA or the Notice of Deficiency. Instead, he paid the full amount of the additional tax, penalties, and interest. Krause then filed a refund claim for the penalties and interest paid. Individual taxpayers often contest IRS adjustments to their individual tax returns in exactly this manner. See Tax Controversies: Audits, Investigations, Trials, Section 3.05. But the IRS never responded to the refund claim. Krause sued.
Unfortunately for Mr. Krause, a refund claim is not the proper method to contest issues raised in an FPAA. See Tax Planning for Partners, Partnerships, and LLCs, Section 15.01; Lexis Tax Advisor -- Federal Topical, Sec. 2D:15.01. To avoid duplicative and piecemeal litigation by multiple partners, TEFRA requires that the IRS adjust partnership-level items only through an FPAA. See IRC Sec. 6223; IRC Sec. 6225; Lexis Tax Advisor -- Federal Code IRC § 6223(a); Lexis Tax Advisor -- Federal Code IRC § 6225(a). For the same reasons, TEFRA also requires that the partnership challenge the FPAA to contest IRS adjustments to partnership-level items. Partnership-level items include penalties, such as those the IRS imposed on Krause. Treas. Reg. Sec. 1.6662-5(h). Since KAAS never challenged the FPAA, it became final. IRC Sec. 6230; Lexis Tax Advisor -- Federal Code IRC § 6230(a); Lexis Tax Advisor -- Federal Code IRC § 6230(c). Because of the finality of the FPAA, the District Court lacked jurisdiction to hear Krause’s case. IRC Sec. 6230(c)(4) and Lexis Tax Advisor -- Federal Code IRC § 6230(c). Krause’s case was dead and he had no further procedural remedies.
Krause again demonstrates that the taxpayer must follow the proper procedures in contesting IRS adjustments. When the IRS issues an FPAA to a partnership, the partnership itself must contest the adjustments made in the FPAA, even when the individual taxpayer and entities totally under the taxpayer’s control are the only general and limited partners in the partnership. Perhaps because of his total control over KAAS and the identity of interests, Krause may have mistakenly thought that he and the partnership were the same entity, and that he had all of the procedural remedies that an individual taxpayer typically has.
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