Napoliello v. Commissioner

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT

MICHAEL E. NAPOLIELLO, 
Petitioner, No. 09-72389
v.
 Tax Ct. No.
13983-06
COMMISSIONER OF INTERNAL
REVENUE, OPINION
Respondent.

Appeal from a Decision of the
Tax Court of the United States

Argued and Submitted
May 4, 2011—Pasadena, California

Filed August 23, 2011

Before: John T. Noonan and Kim McLane Wardlaw, Circuit
Judges, and Edward R. Korman,, Senior District Judge.*

Opinion by Judge Noonan

*The Honorable Edward R. Korman, Senior District Judge for the U.S.
District Court for Eastern New York, Brooklyn, sitting by designation.

11437
11440 NAPOLIELLO v. CIR
COUNSEL

Edward Robbins, Hochman, Salkin, Rettig, Tocher & Perez,
P.C., Beverly Hills, California, for the petitioner.

Joan Oppenheimer, Department of Justice, Washington, DC,
for the respondent.

OPINION

NOONAN, Circuit Judge:

Michael Napoliello appeals the United States Tax Court’s
decision in favor of the Commissioner of Internal Revenue.
We have jurisdiction under 26 U.S.C. § 7482(a), and we
affirm.

FACTS

This case arises from the Internal Revenue Service’s
(“IRS”) investigation of a tax shelter. The type of shelter is
known as a “Son-of-BOSS” (being a variant of the Bond and
Options Sales Strategy (“BOSS”) shelter). Son-of-BOSS tax
shelters involve a series of transactions connected to offset-
ting foreign currency options. See generally Desmet v.
Comm’r of Internal Revenue, 581 F.3d 297, 299-300 (6th Cir.
2009). The shelters’ purpose is “to generate artificial tax
losses designed to offset income from other transactions.”
Kornman & Assocs., Inc. v. United States, 527 F.3d 443, 446
n.2 (5th Cir. 2008).

This particular Son-of-BOSS tax shelter worked as follows.
On October 25, 2000, Napoliello established and became the
sole member of MN Trading LLC (“MN Trading”). On behalf
of MN Trading, Napoliello entered into two pairs of long and
short foreign currency option contracts. Each long option had
 NAPOLIELLO v. CIR 11441
a premium of $30 million and each short option had a pre-
mium of $29.25 million. On November 15, 2000, Napoliello
exchanged his interest in MN Trading for an interest in a
recently-formed partnership, AD FX Trading 2000 Fund LLC
(“AD Trading”). Napoliello subsequently withdrew from AD
Trading in exchange for shares of publicly-traded securities
(“AD Trading securities”) and $392,492 in cash. Napoliello
then sold the securities on December 27, 2000 for $358,296.
On his 2000 tax return, Napoliello reported $60,942,026 in
losses from the sale.

Napoliello’s claimed losses masked the offsetting effects of
the foreign currency options. To arrive at the losses, Napol-
iello subtracted the sales value of the AD Trading securities
from his “basis” (i.e., value for tax purposes) in those securi-
ties. Napoliello’s basis, in turn, consisted of his claimed “out-
side basis” in AD Trading (i.e., interest in the partnership for
tax purposes) at the time he withdrew less the cash he
received. Because of his transferred interest from MN Trading
to AD Trading, Napoliello’s outside basis in AD Trading
reflected the value of the foreign currency options. In calcu-
lating that value, Napoliello included the premiums paid to
acquire the long options but did not offset those amounts by
the premiums received on sale of the short options.

The IRS determined that AD Trading was a sham. On
December 3, 2004, the IRS sent a notice of Final Partnership
Administrative Adjustment (“FPAA”) to AD Trading. The
FPAA concluded, among other things, that AD Trading
lacked economic substance and was formed only for purposes
of tax avoidance. The FPAA also made adjustments to AD
Trading’s partnership tax return. These adjustments reduced
to zero AD Trading’s capital contributions, distributions of
property other than money, distributions of money, and inter-
est expense. None of the partners in AD Trading contested the
determinations in the FPAA.

Following issuance of the FPAA, the IRS reviewed Napol-
iello’s taxes. On April 28, 2006, the IRS sent Napoliello a
11442 NAPOLIELLO v. CIR
deficiency notice of $12,072,927 for tax year 2000. The
notice recalculated Napoliello’s basis in the AD Trading
securities as $358,383 — instead of as nearly $61,300,322, as
Napoliello initially claimed — by accounting for the offset-
ting short options.

PROCEEDINGS

After receiving the deficiency notice, Napoliello brought
this action in Tax Court. On summary judgment, Napoliello
raised two issues, including a jurisdictional argument also
made in this appeal. The Tax Court rejected both of Napoliel-
lo’s arguments and granted the IRS’s motion for summary
judgment. The Tax Court also redetermined Napoliello’s defi-
ciency, making minor adjustments to the amount owed.

Napoliello appeals the Tax Court’s decision.

ANALYSIS

There are two issues on appeal. Both of these issues are
jurisdictional. We review the Tax Court’s jurisdiction de
novo. Abatti v. Comm’r of the Internal Revenue Serv., 859
F.2d 115, 117 (9th Cir. 1988).

[1] Napoliello asserts that the Tax Court lacks jurisdiction
even though he, not the Commissioner, brought the action.
The reason for this curious position is the structure of Tax
Court litigation. See generally Leandra Lederman, ‘Civil’izing
Tax Procedure: Applying General Federal Learning to Statu-
tory Notices of Deficiency, 30 U.C. Davis L. Rev. 183, 204-14
(1996). The IRS ordinarily may assess, and then collect on, a
tax deficiency only after issuing a deficiency notice to the tax-
payer. See 26 U.S.C. § 6213(a). If the taxpayer contests the
validity of the notice in Tax Court, as Napoliello did here, the
challenge acts as a challenge to the court’s jurisdiction. See
Scar v. Comm’r of Internal Revenue, 814 F.2d 1363, 1366-67
(9th Cir. 1987) (no Tax Court jurisdiction when deficiency
 NAPOLIELLO v. CIR 11443
notice is invalid). A determination that the Tax Court lacks
jurisdiction because of an invalid notice strips the IRS of
power to assess taxes based on that notice. See generally id.
at 1370 (“Jurisdiction is at issue here. Failure to comply with
statutory requirements renders the deficiency notice null and
void and leaves nothing on which Tax Court jurisdiction can
rest.”). The determination typically also prevents the IRS
from assessing the tax through other means, because in many
cases — including this one — the statute of limitations for
doing so has expired by the time the determination is made.
See 26 U.S.C. § 6503(a)(1) (ordinarily suspending running of
the statute of limitations during period in which IRS cannot
make assessment); Shockley v. Comm’r of Internal Revenue,
Nos. 28207-08, 28208-08, 28210-08, 2011 WL 1641884, at
*8 (U.S. Tax Ct. May 2, 2011) (“An invalid notice of defi-
ciency does not suspend the running of the period of limita-
tions for assessment.”). Thus when a taxpayer challenges a
deficiency notice, the IRS’s assessment of that deficiency
often depends on the Tax Court’s proper exercise of jurisdic-
tion.

***

The first issue is whether the Tax Court had jurisdiction to
redetermine Napoliello’s deficiency based on the notice he
received. The Tax Court’s jurisdiction to redetermine a defi-
ciency is based on, inter alia, the IRS’s issuance of a valid
notice to the taxpayer. See 26 U.S.C. § 6213(a).

[2] The Tax Equity and Fiscal Responsibility Act of 1982
(“TEFRA”) establishes the process for assessing tax deficien-
cies against partners, including the issuance of a valid defi-
ciency notice. See 26 U.S.C. §§ 6221-6234. Under TEFRA,
the IRS first sends an FPAA to the partnership when the IRS
changes the tax treatment of “partnership items” on the part-
nership’s return. These partnership items are “any item
required to be taken into account for the partnership’s taxable
year under any provision of subtitle A [of the Internal Reve-
11444 NAPOLIELLO v. CIR
nue Code] to the extent regulations prescribed by the Secre-
tary provide that . . . such item is more appropriately
determined at the partnership level than at the partner level.”
26 U.S.C. § 6231(a)(3). The IRS then sends an “affected
item” notice of deficiency to a partner if there are affected
items — non-partnership items that are affected by partner-
ship items — that require determinations at the partner level.
See 26 U.S.C. § 6230(a)(2)(A)(i); 26 C.F.R. § 301.6231(a)(5)-
1(a). If the affected items do not require a partner-level deter-
mination, or if only partnership items are involved, the IRS
may make a direct computational adjustment based on the
FPAA. See 26 U.S.C. § 6230(a)(1); Olson v. United States,
172 F.3d 1311, 1317 (Fed. Cir. 1999). Napoliello argues that
the deficiency notice issued to him was invalid because the
IRS should have made a direct computational adjustment
instead.

[3] We hold that the IRS properly sent Napoliello an
affected item notice of deficiency because the deficiency
required a partner-level determination. In reaching this hold-
ing, we follow the Sixth Circuit’s reasoning in Desmet,
another case involving a son-of-BOSS tax shelter. See 581
F.3d 297. As in Desmet, a partner-level determination was
necessary because “the identity of the property cannot be
determined from the FPAA. Even if it could be determined
. . . the IRS needed to determine ‘the portion of the stock actu-
ally sold, the holding period for the stock, and the character
of any gain or loss.’ ” Id. at 303 (quoting Domulewicz v.
Comm’r, 129 T.C. 11, 20 (2007)). The FPAA did not conclu-
sively resolve these factual issues because AD Trading did
not sell the securities. Therefore, the IRS could not make a
direct computational adjustment of Napoliello’s deficiency
based on the FPAA.

[4] Napoliello’s arguments to the contrary lack merit. He
cites several cases for the proposition that a notice of defi-
ciency was unnecessary, and therefore invalid, in this context.1
1
We do not reach the question of whether the notice of deficiency would
be invalid if no partner-level determination were necessary. We note, how-
 NAPOLIELLO v. CIR 11445
See Olson, 172 F.3d 1311; Bob Hamric Chevrolet, Inc. v.
United States, 849 F. Supp. 500 (W.D. Tex. 1994); Bush v.
United States, 78 Fed. Cl. 76 (2007). Those cases involve set-
tlements in which the partners “had stipulated to the amount
of tax credits improperly claimed before the IRS assessed
their liability via computational adjustment.” Desmet, 581
F.3d at 304. Therefore, the cases are inapposite. Similarly,
Gosnell v. United States merely holds that the IRS was not
required to issue a notice of deficiency in an instance in which
the partner disclosed the tax benefits from the Son-of-BOSS
transactions. No. CV-09-01399-PHX-NVW, 2011 WL
2559832, at *12-*13 (D. Ariz. June 28, 2011). Thus, no reso-
lution of partner-level factual issues was required. Id. Here,
by contrast, Napoliello did not disclose his Son-of-BOSS tax
benefits, so partner-level determinations were necessary. The
other case cited by Napoliello, Estate of Quick v. Comm’r,
also does not support his argument. See 110 T.C. 172, 183,
supplemented by 110 T.C. 440 (1998). Estate of Quick holds
that the relevant affected item, unrelated to ones here, requires
a notice of deficiency. Id. at 440-43.

***

[5] The second issue is whether the Tax Court had jurisdic-
tion to redetermine affected items in a deficiency notice that
relied on the FPAA determination that AD Trading was a
sham. The Tax Court’s jurisdiction to redetermine affected
items in a deficiency notice is limited to those items that
reflect FPAA adjustments of partnership items. See 26 U.S.C.
§ 6230(a)(2)(A)(i); 26 U.S.C. § 6231(a)(5); 26 U.S.C.

ever, that Napoliello’s proposition would deprive taxpayers of procedural
safeguards were we to adopt it. (The argument would benefit Napoliello,
however, for statute of limitations reasons.) By issuing a notice of defi-
ciency, the IRS permits a partner to dispute the amount owed before pay-
ing the tax. Desmet, 581 F.3d at 302; see 26 U.S.C.§ 6213(a). If the IRS
assesses taxes through a direct computational adjustment, a partner’s only
recourse is to pay the tax and to file a refund suit. See 26 U.S.C. § 6230(c).
11446 NAPOLIELLO v. CIR
§ 6231(a)(3). Napoliello argues that the FPAA could not
determine that AD Trading was a sham because such a deter-
mination does not fall within the statutory definition of a part-
nership item. As a result, according to Napoliello, any Tax
Court redetermination based on the FPAA conclusion that AD
Trading was a sham is beyond the Tax Court’s jurisdiction.

[6] We join the D.C. and Eighth Circuits in holding that a
determination as to a partnership’s validity, such as the deter-
mination that AD Trading was a sham, falls within the defini-
tion of a partnership item. See Petaluma FX Partners, LLC v.
Comm’r of Internal Revenue, 591 F.3d 649 (D.C. Cir. 2010);
RJT Invs. X v. Comm’r of Internal Revenue, 491 F.3d 732 (8th
Cir. 2007); see also 26 U.S.C. § 6231(a)(3) (partnership item
defined). We reach this conclusion by breaking down the defi-
nition of partnership item into two parts.

[7] First, for an item to be a partnership item it must be
taken into account for the partnership’s taxable year under
Subtitle A of the Internal Revenue Code. See 26 U.S.C.
§ 6231(a)(3). Subtitle A concerns income taxes. Items that
must be taken into account under Subtitle A thus include part-
nership items affecting partners’ personal income tax liability.
See generally RJT, 491 F.3d at 735-36.

[8] We find that Napoliello had to consider the validity of
AD Trading in calculating his income taxes, satisfying the
first part of partnership item’s definition. “When filling out
individual tax returns, the very process of calculating an out-
side basis, reporting a sales price, and claiming a capital loss
following a partnership liquidation presupposes that the part-
nership was valid.” Id. at 736. Therefore, we, like the D.C.
Circuit, “have little difficulty concluding that application of
the income tax provisions of Subtitle A to the tax liability of
a taxpayer who receives income from a purported partnership
entails a determination of the validity of that partnership.”
Petaluma, 591 F.3d at 653; see also RJT, 491 F.3d at 736.
 NAPOLIELLO v. CIR 11447
[9] Second, an item is a partnership item only if it is more
appropriately determined at the partnership, rather than part-
ner, level. See 26 U.S.C. § 6231(a)(3). Items more appropri-
ately determined at the partnership level “include, among
other things, the partnership’s method of accounting, its
inventory method, and even ‘whether partnership activities
have been engaged in with the intent to make a profit for pur-
poses of § 183 [the section setting forth the for-profit test].’ ”
RJT, 491 F.3d at 737 (citing 26 C.F.R. § 301.6231(a)(3)-1(b)).

[10] The determination of AD Trading’s validity is more
appropriately determined at the partnership level, in line with
the second part of the definition of partnership item. A deter-
mination of the validity of a partnership affects the tax liabil-
ity of all partners. “Logically, it makes perfect sense to
determine whether a partnership is a sham at the partnership
level. A partnership cannot be a sham with respect to one
partner, but valid with respect to another.” Petaluma, 591
F.3d at 654; see also RJT, 491 F.3d at 737-38.

[11] Because both parts of the definition are met, we con-
clude that a determination as to the validity of a partnership
is itself a partnership item. Therefore, the Tax Court had juris-
diction to redetermine affected items based on the partnership
item determination in the FPAA.

Napoliello advances several contrary arguments on this
point, which we reject. Napoliello lacks authority for his
proposition that partnership items solely comprise accounting
entries and the legal and factual determinations underpinning
them (income, deduction, etc.). We do not believe that the
regulation is so limited. RJT, 491 F.3d at 737 (“The regulation
does not limit its applicability to line items and technical
accounting issues as [petitioners] suggest.”); see also 26
C.F.R. § 301.6231(a)(3)-1(b). Also unavailing is Napoliello’s
argument that determinations in the “Explanation of Items”
section of the FPAA do not have force. This argument lacks
authority, and we decline to endorse it here.
11448 NAPOLIELLO v. CIR
***

For the reasons above, the judgment of the Tax Court is
AFFIRMED.