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Taxing Opinion: "Sham" Partnership Challenges IRS Tolling

By Robyn Hagan Cain on September 16, 2011 | Last updated on March 21, 2019

David Morgan is the sole owner of UTA Management, an S Corporation. In 1999, Morgan caused UTA Management's assets to be contributed to UTAM, a newly formed limited partnership. UTA Management owned a 99 percent partnership interest in UTAM. Morgan later agreed to sell the partnership interests of UTA Management and DDM Management, a separate S corporation that Morgan and his family members owned, to an unrelated insurance company.

Before the sale, Morgan entered into a series of transactions, including short sales, to increase UTA Management's outside basis in the UTAM partnership. The transactions resulted in an overall UTAM loss.

Morgan treated the stock sale as the sale of UTA Management’s assets for income tax purposes; the tax consequences were reflected on UTA Management’s 1999 return, filed on April 15, 2000. Morgan filed his 1999 individual return on October 16, 2000, and reported the flow through loss from the sale.

More than six years after the filing of UTAM’s 1999 partnership return, but less than six years from the filing of Morgan’s 1999 individual return, the IRS mailed a notice of final partnership administrative adjustment to DDM Management (UTAM’s “tax matters” partner) pertaining to UTAM’s 1999 tax year.

In the notice, the IRS adjusted the firm’s outside partnership basis to zero, explained that the short-sale transactions “lacked economic substance,” and “constitute[d] an economic sham for federal income tax purposes.” It determined that UTA Management should have reduced its outside basis to account for the offsetting obligations that were transferred to UTAM along with the short-sale proceeds. Further, it found that UTAM was itself a sham, existing solely for tax avoidance purposes. The Tax Court agreed.

The DC Circuit Court of Appeals reviewed the Tax Court’s opinion against its 2003 Andantech, L.L.C. v. Commissioner opinion.

Partnerships do not pay taxes, but they must file annual informational returns. When the IRS disagrees with how a partnership return reports a partnership item, it mails a final notice of final partnership administrative adjustment to the partners.

There is no separate limitations period for the mailing of the notice of final partnership administrative adjustment. But the notice would have no point if the IRS sent it after all of the individual partners’ assessment periods had expired for taxes reflected in the adjustment.

Does the IRS mailing a notice of final partnership administrative adjustment toll an individual partner’s limitation period under I.R.C. §6501?

The D.C. Circuit Court of Appeals found that the six-year limitations period was applicable with regard to the Morgan’s 1999 return and that the assessment period, suspended pursuant to I.R.C. §6229(d), was the partner’s open assessment period under section I.R.C. § 6501.

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