T.C. Memo. 2005-174
UNITED STATES TAX COURT
OLSEN-SMITH, LTD., SMITH-OLSEN, PLC,
TAX MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22081-03. Filed July 18, 2005.
L is a general partnership the direct partners of
which are three limited liability companies (LLCs). P
amended its petition in this TEFRA partnership-level
proceeding to allege that L’s net earnings from self-
employment (NESE) were zero instead of $627,736 as
reported or $696,807 as determined by R. P argues that
L has no “NESE”, as defined in sec. 1402(a), I.R.C.,
because neither L nor any of its partners has a partner
or member who is an individual. R moves to strike P’s
allegation, asserting that the Court lacks jurisdiction
in this proceeding to decide whether L has an indirect
partner who is an individual.
Held: Because a determination of the ownership of
a passthrough entity that is a direct partner in a
partnership may involve information not usually
maintained by the partnership, a determination of the
members of the LLCs (and thus indirect partners of L)
is a nonpartnership item that the Court is not allowed
to decide in this TEFRA partnership-level proceeding.
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Brad S. Ostroff and Martha Combellick Patrick (specially
recognized), for petitioner.
Anne W. Durning, for respondent.
MEMORANDUM OPINION
LARO, Judge: This case is a partnership-level proceeding
subject to the unified audit and litigation procedures of the Tax
Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L.
97-248, sec. 401, 96 Stat. 628. Smith-Olsen, PLC (Smith/Olsen),
the tax matters partner of Olsen-Smith, LTD (LTD), petitioned the
Court to readjust partnership items relating to a Notice of Final
Partnership Administrative Adjustment (FPAA) issued by the
Commissioner as to LTD’s 1999 taxable year. LTD is a general
partnership the partners of which are three passthrough entities
known as limited liability companies (LLCs). In relevant part,
the FPAA determined that LTD’s net earnings from self-employment
(NESE) totaled $696,807, instead of $627,736 as reported, on
account of a $69,071 increase that the Commissioner made to LTD’s
ordinary income.
Following concessions, we must decide whether we have
jurisdiction to decide the single substantive issue remaining in
dispute. Specifically, petitioner in an amendment to petition
alleged that LTD had no NESE because neither LTD nor any of its
partners had a partner or member who was an individual.
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Petitioner argues that the Court’s identity of LTD’s “actual
partners” is a partnership item that is more appropriately made
in this TEFRA partnership-level proceeding than in a
partner-level proceeding because that identification may affect
the allocation of LTD’s income or loss to its partners.
Respondent moves the Court to strike petitioner’s allegation,
arguing that the Court lacks jurisdiction in a TEFRA partnership-
level proceeding to decide whether LTD had an indirect partner
who was an individual. We agree with respondent and shall grant
his motion.
Background1
LTD is a general partnership formed in 1987. Its business
is the practice of law. Its principal place of business was in
Phoenix, Arizona, when the petition commencing this proceeding
was filed with the Court.
During 1999, LTD had three equal direct partners:
Smith/Olsen, Smith & Associates, PLC (Smith/Associates), and
Rossie & Associates, PLC (Rossie/Associates). Smith/Olsen was an
Arizona professional LLC (APLLC) whose members were a complex
trust named 1992 WHO Trust (1-percent owner) and a grantor trust
named SKO-96 Trust (99-percent owner). The grantor of SKO-96
1
The recitations in this Opinion are obtained from the
parties’ stipulations of fact and the exhibits submitted
therewith. We set forth these recitations solely for the purpose
of deciding respondent’s motion.
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Trust was Alfred J. Olsen (Olsen). Smith/Associates was an APLLC
whose members were a complex trust named 1992 WLK Trust
(1-percent owner) and a grantor trust named MBK-96 Trust
(99-percent owner). The grantor of MBK-96 Trust was Susan K.
Smith (Smith), Olsen’s wife. Rossie/Associates was an APLLC with
a single member, a grantor trust named JJR-97 Trust. The grantor
of JJR-97 Trust was James J. Rossie, Jr. (Rossie). Olsen, Smith,
and Rossie (collectively, the three individuals) were all
attorneys who during 1999 worked for and received salaries from
LTD. During that year, the three individuals also received
compensation from LTD in the form of fringe benefits.
LTD filed a 1999 Form 1065, U.S. Partnership Return of
Income (1999 return), that reported that LTD realized $627,736 of
ordinary income during that year and that all of this income was
NESE. The 1999 return also reported that LTD’s partners were
Smith/Olsen, Smith/Associates, and Rossie/Associates, but did not
provide any details as to the members of the LLCs. In relevant
part, the Commissioner determined in the FPAA that LTD’s NESE
totaled $696,807 on account of a $69,071 increase that respondent
made to LTD’s ordinary income. The Commissioner has since
conceded a portion of the $69,071 increase in ordinary income
(and NESE).
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Discussion
The TEFRA partnership-level procedures prescribed in
sections 6221 through 6234 require that all challenges to
adjustments of partnership items be made in a single unified
proceeding.2 Under these procedures, “the tax treatment of any
partnership item (and the applicability of any penalty, addition
to tax, or additional amount which relates to an adjustment to a
partnership item) shall be determined at the partnership level.”
Sec. 6221. The Commissioner generally must wait until a
partnership-level proceeding is over to assess a liability
attributable to a partnership item. See sec. 6225(a); Maxwell v.
Commissioner, 87 T.C. 783, 788 (1986). The Commissioner
generally must follow the deficiency procedures before assessing
a deficiency relating to a nonpartnership item such as an
affected item. See sec. 6230(a)(2); see also sec. 6231(a)(4)
(defines a “nonpartnership item” as an item which is (or is
treated as) not a partnership item); sec. 6231(a)(5) (defines an
“affected item” as any item to the extent the item is affected by
a partnership item).
The Court’s jurisdiction over a TEFRA partnership-level
proceeding is invoked when the tax matters partner or other
eligible partner timely files a petition with the Court seeking a
2
Unless otherwise indicated, section references are to the
applicable versions of the Internal Revenue Code, and Rule
references are to the Tax Court Rules of Practice and Procedure.
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readjustment of partnership items adjusted in a valid FPAA. See
sec. 6226; Rule 240(c); see also Meserve Drilling Partners v.
Commissioner, T.C. Memo. 1996-72, affd. 152 F.3d 1181 (9th Cir.
1998). The Court has jurisdiction in such a proceeding to
determine partnership items to which the FPAA relates, the proper
allocation of those items among the partners, and the
applicability of any penalty, addition to tax, or additional
amount relating to an adjustment to a partnership item. See sec.
6226(f). We decide herein whether LTD’s reporting on its 1999
return of its ordinary income as NESE fits within this
jurisdiction or, more specifically, whether that reporting is a
partnership item. The term “NESE” denotes:
the gross income derived by an individual from any
trade or business carried on by such individual, less
the deductions allowed by this subtitle which are
attributable to such trade or business, plus his
distributive share (whether or not distributed) of
income or loss described in section 702(a)(8) from any
trade or business carried on by a partnership of which
he is a member * * *. [Sec. 1402(a).3]
The 1999 instructions to the 1999 return generally required LTD
for purpose of that return’s Schedule K, Partner’s Shares of
Income, Credits, Deductions, etc., to report all of LTD’s
ordinary income from trade or business activities as NESE except
3
Sec. 702(a)(8) provides that "In determining his income
tax, each partner shall take into account separately his
distributive share of the partnership's * * * taxable income or
loss, exclusive of items requiring separate computation under
other paragraphs of this subsection."
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to the extent that the income was allocated to limited partners,
estates, trusts, corporations, exempt organizations, or IRAs.
See the 1999 Instructions to Form 1065, at 23-24.
Petitioner argues that the reporting of LTD’s ordinary
income as NESE is within our jurisdiction because it is a
characterization of partnership income that is a partnership item
under section 6231(a)(3). According to petitioner, LTD had no
NESE in that neither it nor any of its partners had a partner or
member who was an individual. Petitioner asserts more
specifically that none of the three individuals was a partner and
asks the Court to decide the same. Petitioner asserts that the
identity of LTD’s actual partners also may affect the allocation
of income among those partners, another indicium of a partnership
item under section 6231(a)(3). See infra p. 11. LTD paid
salaries and fringe benefits to the three individuals, and as
petitioner sees it, section 707 would operate to disallow LTD’s
deduction of the payroll taxes paid on the salaries and to treat
the fringe benefits as guaranteed payments, if the three
individuals were in fact partners of LTD.
Respondent argues that the Court’s jurisdiction as to the
issue at hand is narrower than that espoused by petitioner.
According to respondent, the Court in a TEFRA partnership-level
proceeding may decide only the amount of a partnership’s NESE as
ascertained mechanically under the instructions to Form 1065. In
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that those instructions neither require nor permit the
consideration of any information concerning indirect partners,
respondent asserts, the Court may not in this proceeding look
through the two tiers of passthrough entities connected to LTD
and identify LTD’s indirect partners.
We begin our analysis with section 6231(a)(3). That section
provides that a partnership item is “any item required to be
taken into account for the partnership’s taxable year under any
provision of subtitle A to the extent regulations prescribed by
the Secretary provide that, for purposes of this subtitle, such
item is more appropriately determined at the partnership level
than at the partner level.” Thus, in accordance with this
section, the Court will have jurisdiction over the disputed issue
(in that it will be a partnership item) if we find that a
reporting of LTD’s ordinary income as NESE is (1) an item
required to be taken into account for LTD’s 1999 taxable year
under a provision of subtitle A and (2) an item that the
regulations provide is more appropriately determined at the
partnership level than at the partner level. We do not make
either finding.
Subtitle A did not require that LTD determine dispositively
the amount of its ordinary income that was NESE. Subtitle A
requires that a partnership separately state the amount of income
that may affect partners differently, or as applicable here, the
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amount of income that would be NESE in the hands of the ultimate
recipients if those recipients were in fact individuals. Cf.
Hambrose Leasing v. Commissioner, 99 T.C. 298, 310 (1992). Thus,
as to the issue at hand, LTD was excused by subtitle A (and the
1999 instructions to Form 1065) from reporting separately that
portion of its ordinary income that was not NESE because that
portion was allocated to direct partners which were limited
partners, estates, trusts, corporations, exempt organizations, or
IRAs. See, e.g., the 1999 Instructions to Form 1065, supra at
23-24. Whether an individual actually was a member of one or
more of the passthrough entities (LLCs) at issue, and thus was an
indirect partner of LTD, was not a determination that LTD was
required to make under subtitle A. Where as here a partnership
interest is held by a direct partner that is an LLC, the
partnership must state that its ordinary income is NESE, without
consideration of the nature or identity of the actual or reported
owners of the LLC. The actual taxability of the separately
stated amount as NESE, if later disputed by the Commissioner, is
then determined at the indirect partner level through an affected
item notice of deficiency issued after the TEFRA partnership-
level proceeding is complete.
Petitioner seeks a contrary conclusion by focusing on the
definition of NESE set forth in section 1402(a). Petitioner
notes that this definition requires the presence of an individual
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as a direct or indirect recipient of self-employment income and
states that it knows conclusively that neither it nor any of its
partners had a member or partner who was an individual.
Petitioner concludes that LTD had no NESE within the meaning of
section 1402(a) and asserts that the Court will conclude
similarly by deciding the question of whether any of the three
individuals was an actual partner of LTD. According to
petitioner, if the Court were to decide that one or more of the
three individuals was in fact a partner of LTD, that decision
would impact the characterization of LTD’s income, the tax
treatment of LTD’s payments to the three individuals, and the
distributive share of income and loss to LTD’s partners.
We disagree with petitioner’s assertions and conclusions.
First, respondent has not determined that any of the three
individuals was or was not actually a partner of LTD. Nor has
respondent taken a position in this case that is inconsistent
with the position taken by LTD on its 1999 return that none of
the three individuals was such a partner. Petitioner is
attempting to raise in this proceeding an issue as to the
identity of LTD’s “actual partners” by requesting that the Court
rule that the three individuals’ status in LTD was as reported;
i.e., that none of the three individuals was a partner of LTD.
We view petitioner’s request that the Court decide this issue as
a request for an advisory opinion, which we decline to render.
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We also consider it inappropriate to opine on the hypothetical
potential adjustments that respondent might propose if any of the
three individuals was in fact a partner of LTD.
Nor do we conclude that LTD’s reporting of its ordinary
income as NESE is an item that the regulations provide is more
appropriately determined at the partnership level than at the
partner level. Section 301.6231(a)(3)-1, Proced. & Admin. Regs.,
lists those items that are partnership items because they are
more appropriately determined at the partnership level. In
relevant part, that list includes a partnership’s
characterization of its items of income, credit, gain, loss, or
deduction. As discussed above, LTD was not required at the
partnership level to characterize the amount of its ordinary
income that was in fact NESE. LTD was required at that level to
determine the entity status of its three direct partners and to
report perfunctorily its ordinary income as NESE except to the
extent that the ordinary income was allocated to a direct partner
that was a limited partner, estate, trust, corporation, exempt
organization, or IRA. LTD was not required to determine the
identity of its indirect partners, and it was not required to
determine whether any member of those indirect partners was
itself a passthrough entity. LTD also was not required to
determine the ultimate recipients of its ordinary income. Each
of these matters that LTD was not required to determine had no
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effect on LTD, its books or records, or any other aspect of the
partnership. Cf. Hambrose Leasing v. Commissioner, supra at 311.
While petitioner argues that it believes that LTD did not have an
indirect partner who was an individual, the finding of a
partnership item does not hinge on whether the item is
determinable from information actually available at the
partnership level. That finding turns on whether the partnership
is required to make a determination of the item. See Dakotah
Hills Offices Ltd. Pship. v. Commissioner, T.C. Memo. 1996-35;
cf. Dial U.S.A., Inc. v. Commissioner, 95 T.C. 1, 4 (1990).
Our conclusion as to the issue at hand is further supported
by analogy to two of this Court’s previous holdings. First, in
Hang v. Commissioner, 95 T.C. 74, 80 (1990), the Court held that
the determination of whether a father was the true and beneficial
owner of shares in an S corporation held in the name of his sons
was properly made at the individual shareholder level.4 We
reasoned that the true and beneficial ownership of the shares was
4
Under the S corporation audit and litigation procedures,
secs. 6241 through 6245, a “subchapter S item” denotes “any item
of an S corporation to the extent regulations prescribed by the
Secretary provide that, for purposes of this subtitle, such item
is more appropriately determined at the corporate level”. Sec.
6245. The tax treatment of a subch. S item generally must be
determined in an entity level proceeding. See sec. 6241. While
these S Corporation procedures were enacted shortly after the
TEFRA procedures as part of the Subchapter S Revision Act of
1982, Pub. L. 97-354, sec. 4(a), 96 Stat. 1691, the S Corporation
procedures were repealed as of Dec. 31, 1996, by the Small
Business Job Protection Act of 1996, Pub. L. 104-188, sec.
1307(c)(1), 110 Stat. 1781.
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more appropriately determined at the individual level because the
determination depended upon factors that could not be determined
at the corporate level and required participation of the
allegedly true owner of the shares.5 Id. at 80-81.
Second, in Grigoraci v. Commissioner, T.C. Memo. 2002-202,
we applied the stated reasoning of Hang to reach a similar
result. In Grigoraci, two partnerships were each owned by
subchapter S corporations which, in turn, were each owned by an
individual/accountant. Respondent argued that the accountants
were the actual owners/partners of the partnerships. We held
that we lacked jurisdiction in that TEFRA partnership-level
proceeding to decide that issue. We noted that the issue was a
nonpartnership item in that the partnerships could not determine
whether their corporate partners should be respected for Federal
tax purposes without consideration of information that was not
available at the partnership level; e.g., information as to the
manner in which the corporations’ activities were conducted,
whether they were properly formed, whether they had valid
purposes, and whether they actually conducted business. We also
noted that most of the evidence relevant to determining whether
the corporations or the individuals were the partners centered on
5
While a partnership reports its income on Form 1065, an S
corporation reports its income on Form 1120S, U.S. Income Tax
Return for an S Corporation. In contrast to Schedule K of
Form 1065, Schedule K to Form 1120S does not require that an S
corporation separately state its earnings from self-employment.
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the acts, motives, and intentions of the individuals and not on
actions taken by the partnerships.
Here, as in Hang and Grigoraci, a decision as to LTD’s NESE
turns on a determination of LTD’s true and beneficial owners, and
that determination depends upon facts that may not be
determinable as the partnership level. Petitioner attempts to
distinguish those cases by arguing that an identification of
LTD’s actual partners may affect the allocation of LTD’s income
or loss which in and of itself is an indicium of a partnership
item under section 6231(a)(3). For the reasons stated above, we
find this attempt unavailing.
We shall grant respondent’s motion to strike for lack of
jurisdiction. All arguments made by the parties have been
considered, and those arguments not discussed are irrelevant or
without merit. Accordingly,
An appropriate order will
be issued, and decision will
be entered under Rule 155.