Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. No. 17 (2007). The IRS goes for the trifecta and loses.

The IRS had some “notable” wins in Kligfeld Holdings et al. v. Commissioner; 128 T.C. No. 16 (2007) and G-5 Investment Partnership v. Commissioner, 128 T.C. No. 15 (2007) but a win in Bakersfield would have made every partner in a partnership potentially subject to a six year statute. Yes, the IRS was focused on tax shelters but its argument had applications far greater than those partners involved in tax shelters. Thus, Bakersfield was the crown jewel in the battle as to the statue of limitations and the IRS lost.

In Kligfeld Holdings, the IRS was able to secure an extension to the statute of limitations as to a TEFRA partnership due to a John Doe summons at the partner level. In G-5, the Tax Court agreed with the Court of Claims and found that the carryover deductions from a TEFRA partnership were similar to NOL carryovers and thus allowed the Service to investigate the carryover amount attributable to the TEFRA partnership.

Needless to say, both opinions have limited application to most legitimate TEFRA partnerships. After all how often will a partner be the subject of a John Doe summons? The answer is not very often.

As to the NOL argument in G-5, most tax shelters have a huge permanent impact in the first year and the remaining years are usually either timing issues or the permanent deductions are not nearly as great as the first year. Thus, the IRS was looking for a bigger stick – a six year statute and in Bakersfield the IRS lost that pivotal argument.

The relevant facts in Bakersfield are as follows: the IRS issued a Notice of Final Partnership Administrative Adjustment (FPAA) on October 4, 2005 to the TEFRA partnership. The FPAA alleged that the TEFRA partnership had overstated its basis in certain gas reserves sold during the taxable year 1998. According the IRS the TEFRA partnership had a $0 basis in the gas reserves it sold during the taxable year 1998 and any optional basis adjustment under section 743(b) was the result of a sham transaction, a transaction lacking economic substance that had no business purpose and no economic effect and/or was availed for tax avoidance purpose and should not be respected for tax purposes. Thus, the inflated basis caused an understatement of the partnership’s income by more than 25 percent of the amount stated in the return.

The Tax Court disagreed with the IRS. The Court commenced its opinion by reminding the IRS that § 6229 did not create a completely separate statute of limitations for assessments attributable to partnership items, instead, § 6229 supplements § 6501. Thus, for the Statute of Limitations to be open, the IRS had to convince the Court that Colony, Inc. v. Commissioner, 357 U.S. 28 (1958) did not apply.

The Tax Court cited to Colony, Inc. v. Commissioner, 357 U.S. at 37 as follows:

We think that in enacting section 275(c) Congress manifested no broader purpose than to give the Commissioner an additional two years [now three] to investigate tax returns in cases where, because of a taxpayer's omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors. In such instances the return on its face provides no clue to the existence of the omitted item. On the other hand, when, as here, the understatement of a tax arises from an error in reporting an item disclosed on the face of the return the Commissioner is at no such disadvantage. * * * [ Id. at 36.]

This language led the Tax Court to hold that “The precise holding of the Supreme Court in Colony, Inc. v. Commissioner, supra, was that the extended period of limitations applies to situations where specific income receipts have been “left out” in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis.”

To the Tax Court the Supreme Court was clear in Colony, Inc. “omits” means something “left out” and not something put in and overstated. How he IRS will react to this major loss remains to be seen but there is only one conclusion: The loss in Bakersfield is a major blow for the IRS and I would expect it will seek legislative relief in this area.