McKnight v. Commissioner

United States Court of Appeals,

Fifth Circuit.

No. 92-5150.

Sam A. McKNIGHT and Ann V. McKnight, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nov. 22, 1993.

Appeal from a Decision of the United States Tax Court

Before KING and JOLLY, Circuit Judges and PARKER,* District Judge.

KING, Circuit Judge:

Sam A. McKnight and Ann V. McKnight appeal the decision of the United States Tax Court

upholding its jurisdiction over the deficiency determination with respect to which the Commissioner

did not use unified partnership-level audit procedures. Because we agree with the tax court that the

taxpayers' partnership qualified for the small partnership exemption to the unified procedures under

I.R.C. § 6231(a)(1)(B), we affirm.

I. PROCEDURAL BACKGROUND

The McKnights filed a petition in the United States Tax Court seeking redetermination of a

deficiency for $55,906 in income tax for 1983. The Commissioner's determination of a deficiency had

been based, in part, on the disallowance o f the McKnights' distributive share of loss from their

investment in MLSL Partnership (MLSL).

Almost four years after they had filed their petition, the McKnights filed a motion to dismiss,

arguing that the tax court lacked jurisdiction to redetermine any deficiency. They contended that

MLSL was not subject to the exemption for small partnerships under I.R.C. § 6231(a)(1)(B).

Although losses and self-employment expense were allocated to the partners using the same loss

sharing percentage, this percentage was not the same as the partners' shares of capital, liabilities, or

cash distributions. Thus, contended the McKnights, their partnership did not meet the "same share"

*
Chief Judge of the Eastern District of Texas, sitting by designation.
prerequisite of I.R.C. § 6231(a)(1)(B)(i)(II) for the small partnership exception to unified

partnership-level audit proceedings. They therefore maintained that provisions of the Tax Equity and

Fiscal Responsibility Act (TEFRA) required the Commissioner to make a determination of

adjustments to MLSL items at the partnership level, not the individual partner level. They also

contended that because the small-partnership exemption was inapplicable in their case, TEFRA

partnership audit and litigation provisions required that the Commissioner issue a final partnership

administrative adjustment (FPAA) before the tax court could exercise jurisdiction over the

Commissioner's determination of a tax deficiency at the partnership level. See I.R.C. §§ 6223(a)(2),

6225. They therefore asserted that because t he Commissioner had failed to follow TEFRA

provisions, i.e., he had failed to issue an FPAA, the tax court was without jurisdiction to redetermine

any portion of a deficiency attributable to "partnership items." See Frazell v. Commissioner, 88 T.C.

1405, 1987 WL 49334 (1987); Maxwell v. Commissioner, 87 T.C. 783, 1986 WL 22033 (1986).

The tax court denied the McKnights' motion in a memorandum opinion. To determine its own

jurisdiction, the tax court necessarily had to decide whether MLSL satisfied the requirements of the

small-partnership exemption and thus whether the Commissioner was required to issue an FPAA as

a condition precedent to the tax court's jurisdiction. In reaching the conclusion that it had

jurisdiction, the tax court initially acknowledged that MLSL satisfied the first requirement for being

considered a small partnership because MLSL had fewer than ten partners. See I.R.C. §

6231(a)(1)(B)(I). The t ax court then decided that MLSL satisfied the second requirement, the

same-share requirement, see I.R.C. § 6231(a)(1)(B)(II), because pursuant to Temp.Treas.Reg. §

301.6231(a)(1)-1T(a)(3) each MLSL partner's share of the partnership items specified in Treas.Reg.

§ 301.6231(a)(3)-1(a)(i) through (iv) was the same as that partner's share of each of the other

partnership items specified in that section during the taxable year.

In deciding that MLSL satisfied this second requirement, the tax court relied on the decision

in Harrell v. Commissioner, 91 T.C. 242, 246, 1988 WL 84267 (1988), and explained that the

determination of whether MLSL satisfied the same-share requirement was correctly made by the

Commissioner as of the date of the commencement of the partnership audit, but not necessarily on
that date, by examining the partnership's tax return and corresponding Schedules K-1. The tax court

acknowledged that MLSL had reported only two items on its tax return—ordinary loss of $233,787

from African-American Enterprises and net loss of $255 from self-employment—and that these losses

had been proportioned according to the loss-sharing distribution as set forth in the McKnights'

Schedule K-1. That is, the McKnights were allocated 45 percent of both of these items.

Furthermore, the percentages of both of these items allocated to the other partners were J. Lyndon

McKnight, 45 percent; Marguerite McKnight, 10 percent; and Lea U. McKnight, nothing. The

court then concluded that MLSL satisfied the same-share requirement of the small-partnership

exemption because each partner's share of each of the partnership items reported for the 1983 tax

year was the same as his share of every other item available for distribution during the same year.

Having thus decided that MLSL satisfied both requirements of the small-partnership exemption, the

tax court determined that it had jurisdiction to review the Commissioner's deficiency determination.

The McKnights then filed motions to vacate and to reconsider, alleging that they had been

denied due process because they had not been afforded an opportunity to respond to issues raised by

the Commissioner in his response to their motion to dismiss. They further alleged either that the tax

court and the Commissioner had misinterpreted Temp.Treas.Reg. § 301.6231(a)(1)-1T(a)(3) or that

if such an interpretation were correct, the regulation itself was invalid because it conflicted with

Congress' intent in enacting the small-partnership exemption in I.R.C. § 6231(a)(1)(B). The tax court

denied these motions, concluding that the regulation in question was valid inasmuch as it coincided

with the plain language, origin, and purpose of I.R.C. § 6231(a)(1)(B), and issued a judgment for tax

deficiency. This appeal followed.

II. STANDARD OF REVIEW

We review tax court decisions in the same manner as we review decisions of a district court.

Grigg v. Commissioner, 979 F.2d 383, 384 (5th Cir.1992); McIngvale v. Commissioner, 936 F.2d

833, 836 (5th Cir.1991). Thus, we review questions of law, including jurisdictional questions, de

novo and findings of fact under the clearly erroneous standard. See Grigg, 979 F.2d 383; Estate of

Clayton v. Commissioner, 976 F.2d 1486, 1490 (5th Cir.1992). The construction of a statute or the
determination of the validity of an administrative regulation is a question of law. See Dresser

Industries, Inc. v. Commissioner, 911 F.2d 1128, 1132-41 (5th Cir.1990).

III. ANALYSIS

The McKnights contend that the tax court was without jurisdiction to review the

Commissioner's deficiency determination. They argue that the tax court misinterpreted

Temp.Treas.Reg. § 301.6231(a)(1)-1T(a)(3) and that the court therefore erred in determining that

MLSL came under the small-partnership exemption of I.R.C. § 6231(a)(1)(B). The McKnights argue

further that if the tax court's interpretation is correct, the regulation itself is invalid. They point out

that this regulation provides that only items specified in Treas.Reg. § 301.6231(a)(3)-1(a)(1)(i)

through (iv) can be considered in determining whether the same-share requirement of I.R.C. §

6231(a)(1)(B)(i)(II) is satisfied and thus whether a partnership is within the statute's small-partnership

exemption. They assert that Congress intended for all partnership items listed in Treas.Reg. §

301.6231(a)(3)-1(a)(1) to be considered in determining whether the same-share requirement has been

satisfied. They accordingly maintain that the interpretation of Temp.Treas.Reg. § 301.6231(a)(1)-

1T(a)(3) on which the Commissioner and the tax court relied unreasonably narrows the scope of the

small-partnership exemption.

In reviewing the tax court's exercise of jurisdiction over the Commissioner's deficiency

determination, we must assess whether the tax court correctly decided that MLSL satisfied the

small-partnership exemption requirements. In making that assessment, however, we must first

address the validity of Temp.Treas.Reg. § 301.6231(a)(1)-1T(a)(3), the basis upon which the tax

court determined that MLSL satisfied those requirements.

A. Appellate Review of Treasury Regulations

When reviewing a treasury regulation, the weight which we must accord such regulation

depends upon the source of authority under which the regulation was promulgated. Dresser, 911

F.2d at 1137; see United States v. Vogel Fertilizer Co., 455 U.S. 16, 24, 102 S.Ct. 821, 827, 70

L.Ed.2d 792 (1982). We must accord legislative regulations, those which are "issued under a specific

grant of authority to ... prescribe a method of executing a statutory provision," more weight than
interpretive regulations, those which are promulgated under a more general authority. Chevron,

U.S.A., Inc. v. Natural Resource Defense Council, Inc., 467 U.S. 837, 843-44, 104 S.Ct. 2778, 2782,

81 L.Ed.2d 694 (1984); Dresser, 911 F.2d at 1137. Thus, legislative regulations are given

controlling weight unless they are arbitrary, capricious, or manifestly contrary to the underlying

statute. Chevron, 467 U.S. at 843-44, 104 S.Ct. at 2782; Batterton v. Francis, 432 U.S. 416, 424-

26, 97 S.Ct. 2399, 2405-06, 53 L.Ed.2d 448 (1977); Dresser, 911 F.2d at 1137. Interpretive

regulations are upheld if they "harmonize ... with the plain language of the statute, its origin, and its

purpose." Rowan Cos. v. United States, 452 U.S. 247, 253, 101 S.Ct. 2288, 2292, 68 L.Ed.2d 814

(1981); Dresser, 911 F.2d at 1137-38.

An interpretive regulation may have particular force if it is a substantially contemporaneous

construction of the statute by those presumed to have been aware of congressional intent. See

National Muffler Dealers Ass'n, Inc., 440 U.S. 472, 477, 99 S.Ct. 1304, 1307, 59 L.Ed.2d 519

(1979). Such a regulation is reviewed not to circumscribe the Secretary of the Treasury's rule-making

power, but to ensure t hat the regulation does not create an interpretation contrary to Congress'

purposes in enacting the statute. See id. at 488, 99 S.Ct. at 1312. Thus, an interpretive treasury

regulation is valid if it harmonizes with the plain language of the statute and the statute's origin and

purpose. See Vogel, 455 U.S. at 25-26, 102 S.Ct. at 827-28; Dresser, 911 F.2d at 1137-38.

Although the tax court determined that Temp.Treas.Reg. § 301.6231(a)(1)-1T was

interpretive, a question has arisen on appeal as to whether this regulation should instead be

categorized as legislative. We need not resolve this issue, however, for even if we assume arguendo

that the tax court's categorization of this regulation as interpretive is correct and that the regulation

is thus accorded less judicial deference than a legislative regulation, the tax court appropriately upheld

the regulation because the regulation harmonizes with the plain language, the origin, and the purpose

of TEFRA's small-partnership exemption.

B. TEFRA's Small-partnership Exemption and Related Treasury Regulations

Sections 6221 through 6232 of the Internal Revenue Code, which set forth an elaborate

scheme for auditing partnership returns, were enacted as part of TEFRA in September 1982.
Congress enacted TEFRA in response to "mushrooming administrative problems experienced by the

IRS in auditing returns of partnerships, particularly tax shelter partnerships with numerous partners."

BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES AND GIFTS ¶

112.3.1, at 112-68 (2d ed. 1992). An exception to the auditing procedures mandated by TEFRA was

provided in I.R.C. § 6231(a)(1)(B) for partnerships which met the statutory requirements therein for

"small" part nerships. These requirements, including that known as the "same share rule," were

implemented to ensure that only "simple" partnerships1 would be excepted. See Tax Compliance Act

of 1982 and Related Legislation: Hearings on H.R. 6300 Before the House Committee on Ways and

Means, 97th Cong., 2d Sess. 259-61 (1982). The same share rule requires that each partner's share

of each "partnership item" be the same as his share of every other item. See I.R.C. §

6231(a)(1)(B)(II).

Although Congress aptly described what "partnership item" generally means, see I.R.C. §

6231(a)(3), it did not disclose which specific partnership items were to be used in determining

whether the requirements of the same share rule had been satisfied in a given case. Subsection (a)(3)

of I.R.C. § 6231 merely provides that

[t]he term "partnership item" means, with respect to a partnership, 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
(emphasis added).

Although this section itself does not specifically delegate to the Secretary of the Treasury the

authority to prescribe the regulations referenced therein, Congress generally delegated such authority

to the Secretary in I.R.C. § 6230(k), which provides that the Secretary shall "prescribe such

regulations as may be necessary to carry out the purposes" of TEFRA.2 See I.R.C. § 6230(k).

1
These "simple" partnerships were described as those whose partners treated the partnership as
a "co-ownership" in which each "co-owner" would resolve his tax responsibilities with the IRS
separately as an individual. Tax Compliance Act of 1982 and Related Legislation: Hearings on
H.R. 6300 Before the House Committee on Ways and Means, 97th Cong., 2d Sess. 260 (1982).
2
Section 6230(k), along with the general rule-making authority given to the Secretary pursuant
to I.R.C. § 7805, which generally authorizes him to issue rules and regulations interpreting the
Internal Revenue Code, was cited as the issuing authority in the Treasury Decision promulgating
Temp.Treas.Reg. § 301.6231(a)(1)-1T. See T.D. 8128, 1987-1 C.B. 325, 325-26.
 In January 1983, and hence substantially contemporaneously with TEFRA's enactment, the

Secretary issued proposed regulations outlining what items were more appropriately determined at

the partnership level than at the partner level and, thus, were partnership items for purposes of I.R.C.

§ 6231(a)(3). See 48 Fed.Reg. 1759 (Jan. 14, 1983). Thereafter, the Secretary issued the treasury

regulations of concern in this case, i.e., Temp.Treas.Reg. § 301.6231(a)(1)-1T and Treas.Reg. §

301.6231(a)(3)-1, which dealt with the small-partnership exemption and items which could be

considered "partnership items" in determining whether that exemption was applicable. See 52

Fed.Reg. 6789 (March 5, 1987) & 51 Fed.Reg. 13,231 (April 18, 1986). Subsection (a)(3) of

Temp.Treas.Reg. § 301.6231(a)(1)-1T provides that

[t]he requirement of section 6231(a)(1)(B)(i)(II) [the same share rule] is satisfied for a taxable
year if during all periods within that taxable year each partner's share of each of the
partnership items specified in § 301.6231(a)(3)-1(a)(1)(i) through (iv) is the same as that
part ner's share of each of the other partnership items specified in that section during that
period (even though the partner's share of all such specified partnership items changes from
period to period within that taxable year) (emphasis added).3

The McKnights would interpret the "that section" language in the above temporary regulation to

require a comparison of the items delineated in Treas.Reg. § 301.6231(a)(3)-1(a)(1)(i)-(iv), i.e., their

loss allocations, with the items delineated in other portions of Treas.Reg. § 301.6231(a)(3)-1(a), i.e.,

their shares of partnership capital, liabilities, and cash distributions. Because MLSL's partners shared

losses 45%-45%-10%-07 even though their capital accounts were 33%-33%-16.7%-16.77,

respectively, the McKnights argue that MLSL violates the same share rule. The McKnights further

argue that to interpret the above temporary regulation as limiting the comparison to items only listed

in Treas.Reg. § 301.6231(a)(3)-1(a)(1)(i)-(iv) would violate I.R.C. § 6231(a)(3), which defines

3
The partnership items specified in Treas.Reg. § 301.6231(a)(3)-1(a)(1) are

(i) Items of income, gain, loss, deduction, or credit of the partnership;

(ii) Expenditures by the partnership not deductible in computing its taxable income
(for example, charitable contributions);

(iii) Items of the partnership which may be tax preference items under section
57(a) for any partner;

(iv) Income of the partnership exempt from tax[.]
partnership items as all those items which the regulations, i.e., Treas.Reg. § 301.6231(a)(3)-1,

provide should be determined at the partnership level.

After reading the provisions of Temp.Treas.Reg. § 301.6231(a)(1)-1T together with I.R.C.

§ 6231—particularly subsections (a)(3), in which Congress did not specifically delineate which

partnership items were to be considered for the same share rule, and (a)(1)(B)(II), the same share rule

itself, we find unpersuasive the McKnights' argument that the regulation is in direct conflict with

statutory provisions. Additionally, we do not find this regulation incompatible with Treas.Reg. §

301.6231(a)(3)-1. The former is used to exempt small partnerships from partnership-auditing

procedures, and as such requires a limited and narrowly focused definition of partnership items in

order to avoid unnecessarily disqualifying small partnerships from TEFRA auditing procedures. In

comparison, the latter determines the tax treatment of partnership items at the partnership level, and

as such requires a broader and more inclusive definition of those items. It therefore includes other

"partnership items" than those to be used in determining whether the small-partnership exemption

applies.

Furthermore, the conference committee report on TEFRA provisions states that under the

legislation, "the tax treatment of items of partnership income, loss, deductions, and credits will be

determined at the partnership level in a unified partnership proceeding rather than in separate

proceedings with the partners." H.R.CONF.REP. No. 97-760, 97th Cong., 2d Sess. 600 (1982),

reprinted in 1982 U.S.C.C.A.N. 1190, 1372. This reference suggests that Congress intended the

term "partnership items" to include at a minimum items of income, loss, deductions, and credits. A

partner's share of all of those items mentioned in the committee report are indeed required to be

compared under Temp.Treas.Reg. § 301.6231(a)(1)-1T(a)(3), the regulation at issue in this case.

In light of the above discussion, we agree with the tax court's conclusion that

Temp.Treas.Reg. § 301.6231(a)(1)-1T does not directly conflict with either the origin or purpose of

TEFRA in general or the small-partnership exemption specifically. As the tax court pointed out in

Harrell, 91 T.C. at 247, what is needed to determine whether unified or separate audit procedures

should be followed is a quick check of the face of the partnership tax return and the Schedules K-1.
Limiting the comparison to the items listed in Treas.Reg. § 301.6231(a)(3)-1(a)(1)(i)-(iv) serves that

purpose and prevents taxpayers from availing themselves of the protection of the statute of limitations

by making post-hoc challenges to the type of audit procedure used.

The tax court was thus correct in determining that MLSL was exempt from TEFRA's

litigation and auditing procedures because it satisfied the requirements of the small-partnership

exemption. Accordingly, the Commissioner was not required to issue an FPAA to MLSL, and the

tax court had jurisdiction to review the deficiency determination.

IV. CONCLUSION

For the foregoing reasons, we conclude that the tax court had jurisdiction to review the

deficiency determination issued by the Commissioner and that the court was correct in upholding this

determination pursuant to Temp.Treas.Reg. § 301.6231(a)(1)-1T. We AFFIRM the judgment of the

tax court.