Issuu

PROCEDURALLY TAXING tax notes federal Here We Go Again: What Is a Partnership Item? Part 2

Jenni Black is a managing director in Citrin Cooperman’s national tax office and the practice leader of the tax procedure and controversy practice. She is also a contributing author for Procedurally Taxing. In this post, Black examines the courts’ approach to what qualifies as a partnership item. This post reflects the author’s personal views and not necessarily those of Citrin Cooperman. As mentioned in part 1 of this post, there has been recent attention on what it takes to be a partnership item, specifically in the case of net earnings from self-employment (NESE) reported on the partnership return. And there have been questions about whether certain factors are determinative of whether something is a partnership item. We don’t have to walk alone. Courts have considered what it takes to be a partnership item for decades. Here in part 2, I look at how the courts have viewed factors such as whether an item must impact more than one partner or not be based (in part) on partner-level facts and circumstances to be a partnership item. Here we go again. Going down the only road I’ve ever known, let’s talk Tax Equity and Fiscal Responsibility Act of 1982. TEFRA uses a bifurcated system. First, the tax treatment of partnership items is determined at the partnership level. Second, after the partnership-level proceeding is over, how those partnership items impact the partners’ tax is determined. Partnership items cannot be

determined in a subsequent partner-level proceeding. That’s why everything that can be determined at the partnership level must be 1 determined prior to the partner-level proceeding. Keep in mind that the partnership’s determination of NESE, just like the applicability of penalties at 2 the partnership level, is provisional. It is income that may be subject to self-employment tax. The actual amount of any self-employment taxes on that amount is determined in a later partner-level proceeding based on partner-level facts and circumstances3 — just like the penalties the Supreme Court held were determined at the 4 partnership level in Woods. What about partner-level facts and circumstances? If you need to inquire into partnerlevel facts and circumstances to determine an item, does that impact whether an item is a

See, e.g., NCF Energy Partners v. Commissioner, 89 T.C. 741, 743-744 (1987); Maxwell v. Commissioner, 87 T.C. 783, 792 (1986) (because the tax treatment of affected items depends on partnership level determinations, affected items cannot be tried as part of a partner’s personal tax case until the completion of the partnership level proceeding). 2

See United States v. Woods, 571 U.S. 31, 40 (2013). If you want to get super technical (and who doesn’t?) you could probably argue all items on the partnership return are “provisional” as the actual tax impact is not determined at the partnership level. 3

In Olsen-Smith Ltd. v. Commissioner, T.C. Memo. 2005-174, the Tax Court correctly held that the “net earnings from self-employment” reported on the partnership return is a partnership item but the ultimate amount the partners pay self-employment tax on is an affected item. This opinion is hard to read so it can be confusing. The court uses the term “net earnings from self-employment” to refer to both the amount reported by the partnership and the amount the partners ultimately pay tax on. The court ruled in favor of respondent and held that partnership must determine, and report, NESE based on the characteristics of its direct partners (e.g., what type of entities they were and whether they are limited partners) and its income and that whether any ultimate taxpayer would pay self-employment and on what amount is an affected item and does not affect the partnership’s reporting. The odd thing about this case is that the partnership reported NESE and the IRS conceded any adjustment to it, so I guess petitioner was challenging how the partnership reported it on the partnership return. 4

The Supreme Court correctly did not hold that the applicability of penalties is a partnership item, but rather is an item required to be determined at the partnership level under section 6221. Both the tax treatment of partnership items and the applicability of penalties to any adjustment to those partnership items must be determined at the partnership level under TEFRA.

TAX NOTES FEDERAL, VOLUME 192, AUGUST 24, 2026 For more Tax Notes Federal content, visit www.taxnotes.com.

1497

by Jenni Black

PROCEDURALLY TAXING

See, e.g., Rhone-Poulenc Surfactants & Specialties LP v. Commissioner, 114 T.C. 533 (2000). 6

Even if the section 6229 minimum period is still active, a partner may have converted out of TEFRA under section 6231(b) (prior to repeal by the BBA) which is based on an individual partner’s circumstances. 7

Even though indirect partners cannot file a petition to challenge the adjustments in the FPAA (except for 5 percent groups and I’ve never seen one of these), they arguably can file a petition solely to raise that their period of limitations is closed. See section 6226(d)(1) (flush language) (prior to repeal by the BBA). 8

Section 6231(b) (prior to repeal by the BBA) listing the circumstances under which partnership items become nonpartnership items. See also Curr-Spec Partners LP v. Commissioner, 579 F.3d 391, 399 (5th Cir. 2009).

1498

to partnership items is itself a partnership item, regardless of whether it’s based on the section 6229 minimum period or not (this also doesn’t go into the partnership’s net income and isn’t on the partnership return).9 So, it can’t be that, to be a partnership item, it can only be determined (in part or in whole) by partnership-level facts. There’s nothing in TEFRA that requires a partnership item to have no partner-specific 10 facts. Similarly, if the item only impacts a single partner, can it be a partnership item? There are plenty of court cases in which the item being adjusted was allocable only to a single partner (that is, son-of-BOSS). One could argue that anything that impacts the partnership (including how it’s required to report its items) by definition affects the partnership “as a whole.” It is, after all, a whole (not partial) partnership.11 Haha! But, seriously, if an item is reported on the partnership how does it not affect the partnership and its partners as a whole? To use another example of something that perhaps is a little closer to how NESE works, let’s look at section 751. Under section 751, if a partner sells their interest in the partnership, certain amounts of their gain or loss may be ordinary or capital based on the types of assets the partnership holds and their value. Therefore, we are talking about a partner-level gain or loss on the sale of something “outside” the partnership (that is, an interest in the partnership itself instead of something like the partnership’s own assets). How does that work under TEFRA (I mean, aside from “not well”)? In the case of section 751, the amount of the partner’s gain and its character are 9

See, e.g., Irvine v. United States, 729 F.3d 455, 462 (5th Cir. 2013); Keener v. United States, 551 F.3d 1358, 1363 (Fed. Cir. 2009); Davenport Recycling Assocs. v. Commissioner, 220 F.3d 1255, 1260-1261 (11th Cir. 2000); Chimblo v. Commissioner, 177 F.3d 119, 125 (2d Cir. 1999); Williams v. United States, 165 F.3d 30 (6th Cir. 1998) (table decision); Kaplan v. United States, 133 F.3d 469, 473 (7th Cir. 1998). 10

See, e.g., Woods, 571 U.S. at 40 (“Prohibiting courts in partnershiplevel proceedings from considering the applicability of penalties that require partner-level inquiries would be inconsistent with the nature of the ‘applicability’ determination that TEFRA requires.”). 11

In some ways, this could be viewed similarly to the “entity” versus “aggregate” theory of partnerships. But even though TEFRA takes a more “aggregate” approach while BBA is clearly an “entity” approach, both take an “entity” view on determining adjustments to item on the partnership return. In other words, regardless of whether you view a partnership as an aggregate of its members or a standalone entity not tied to its partners, both TEFRA and BBA require adjustments to items on the partnership return to be made at the “entity” level.

TAX NOTES FEDERAL, VOLUME 192, AUGUST 24, 2026 For more Tax Notes Federal content, visit www.taxnotes.com.

partnership item? Partner-specific facts and circumstances often go into the determination of partnership items. One of the most common ones is the period of limitations. Unlike the Bipartisan Budget Act of 2015, TEFRA does not have an 5 independent period of limitations. Section 6229 (prior to repeal by the BBA) provides a minimum period under which no partner’s period of limitations on assessment (section 6501) will expire. It’s a minimum period, not a maximum period. Because it’s not a maximum period, a partner’s individual period of limitations may be open even if the TEFRA minimum period is not. And, if it is, the IRS can assess tax attributable to partnership items. Whether a specific partner’s period of limitations was open at the time the notice of final partnership administrative adjustment was issued is based entirely on partner-level facts and circumstances that would be completely 6 unknown to the partnership. In fact, in many cases, the partnership won’t even know who the ultimate partners are, and they are the ones that matter. The partner could be an indirect partner 7 five tiers up! And it could very well be the case that only a single partner’s period of limitations is open so that any adjustments to partnership items will now only impact that single partner. Those adjustments are still determined at the partnership level under TEFRA. If a partner’s period of limitations is closed, it does not convert partnership items into nonpartnership items.8 With NESE, there are partnership-level facts and circumstances to determine, such as what type of business the partnership engages in, what is the character of its income, and who provides services for/to it. Not so for the period of limitations. And it’s well-settled law that the period of limitations on assessing tax attributable

PROCEDURALLY TAXING

A Rose by Another Name? Let’s assume NESE is not a partnership item. If it’s not a partnership item, it must be an affected item as the amount partners will ultimately pay self-employment tax on is affected by the character and amount of the partnership’s income. But, affected items cannot be determined before the partnership item that affects the item is determined. A statutory notice of deficiency can contain affected items only after the partnershiplevel proceeding is complete.14 But, you say, the only reason there could possibly be an adjustment at the partnership level is because the IRS has made it so by requiring a partnership to report NESE. Putting aside whether a partnership can be required to report NESE on its return, let’s kick the tires a little on this. I’ll focus on the (current) partnership hot topic of the day: What is a limited partner? 15 As we all know, a “partnership” is a creature of state law. State law and the partnership agreement lay out the various rights and obligations of its partners and federal law assigns federal consequences and nuances to these rights and obligations. On its return, a partnership identifies whether its partners are “limited” or “general” (it’s that check box on the Schedule K-1 no one seems to get right). Now let’s take NESE off the Form 1065 and say a partner does not treat any of the partnership’s income as subject to selfemployment because they are a “limited partner.” But it’s partnership-level facts that determine whether a partner is general or limited, right? Sure, it depends, in part, on state law, but it’s state law as applied to the type of entity the partnership is. And how state law applies to the partnership varies based on what’s in the partnership agreement, right? And the partnership classifies its partners as “general” or “limited” on its return, right? Do you see where I am going with this? Regardless of NESE being on the partnership return, wouldn’t whether a partner was “limited” or not still be determined at the partnership level

See, e.g., Regents Park Partners v. Commissioner, T.C. Memo. 1992-336; see also Glade Creek Partners v. Commissioner, T.C. Memo. 2023-82, at *9 n.10. I have to imagine that in many (if not most) cases the partnership will have to determine the value of its assets solely for purposes of this sale. 13

See, e.g., Hambrose Leasing 1984-5 LP v. Commissioner, 99 T.C. 298, 308-312 (1992).

See, e.g., id.; Chai v. Commissioner, 851 F.3d 190, 206-208 (2d Cir. 2017); Harris v. Commissioner, 99 T.C. 121, 125-127 (1992). 15

As everyone is a limited liability company nowadays.

TAX NOTES FEDERAL, VOLUME 192, AUGUST 24, 2026 For more Tax Notes Federal content, visit www.taxnotes.com.

1499

not partnership items; they are affected items. But what are partnership items are the partnershiplevel components that go into determining the amount and character of the partner’s gain or loss, such as the types of assets owned by the 12 partnership and their value. The partnershiplevel components needed for the partner to determine how much of their gain is ordinary versus capital only relates to that specific partner (and may not be something the partnership would normally have to determine for that tax year); yet they are partnership items. This is also similar to how at-risk under section 465 works under TEFRA. Courts have held that there are both partnership-level and partner-level determinations needed to establish whether a partner is at risk. At the partnership level, whether a partnership’s liabilities are recourse or nonrecourse are partnership items 13 that must be determined at the partnership level. Aside from how the partnership has decided to allocate its liabilities, whether partnership liabilities are recourse or nonrecourse impacts only whether the partner is at risk under section 465, right? Whether a partner is at risk is an affected item and reporting liabilities as recourse vs. nonrecourse impacts only something that can only be ultimately determined at the partner level. I guess you could say the classification of liabilities is “provisional” to determining whether a partner is at risk. The reporting has no other purpose; it’s an “input” into the solely partnerlevel determination of at-risk. NESE is similar. It is an item reported by the partnership that is used to determine something that, ultimately, can be determined only at the partner level. But, as with the classification of liabilities, it requires determination of items at the partnership level, such as the nature and amount of the partnership’s business, the type of partners it has, and the nature of services provided by it and by whom.

PROCEDURALLY TAXING

and be influenced by federal law as applied to the partnership’s activities?16 Partner Identity Cases

In the SECA campaign cases, the argument is being made that “limited partner” under section 1402(a)(13) means limited partner under state law, right? But wouldn’t whether a partner is a limited partner under state law be a partnership item? After all it depends on what type of entity the partnership is and the partnership agreement. So aren’t we still dealing with a partnership item? 17

See, e.g., Katz v. Commissioner, 116 T.C. 5 (2001); Hang v. Commissioner, 95 T.C. 74 (1990); Grigoraci v. Commissioner, T.C. Memo. 2002-202. 18

Alpha I LP v. United States, 682 F.3d 1009, 1018-1026 (Fed. Cir. 2012).

1500

Katz v. Commissioner, 335 F.3d 1121, 128-129 (10th Cir. 2003).

TAX NOTES FEDERAL, VOLUME 192, AUGUST 24, 2026 For more Tax Notes Federal content, visit www.taxnotes.com.

Now let’s discuss a small elephant in the room — the partner identity cases. These few cases are the only cases I am aware of where a court has determined that an item appearing on the partnership return is not a partnership item. I do not think these cases are applicable, I think they are wrongly decided and not consistent with other case law, and I’m not sure they’re still good law (but let me tell you how I really feel). In the “partner identity” cases (that is, whether who is a partner in the partnership is a partnership item — say that five times fast), the Tax Court held that partner identity (that is, who is the true partner) is only a partnership item if that determination impacts the allocation of the partnership’s items to “other” partners (it didn’t specify, but I will assume this means more than one) or the 17 aggregate of the partnership’s items. Now, I don’t need to point out that this dealt with identity of partners and not NESE, but I will. As an initial matter, if the partnership files a return listing S corporation (which is wholly owned by A) as a partner, and the IRS determines A is the true partner, how does that not impact the allocations of more than one partner? After all, there is a reallocation from S corporation to A. Those are separate legal entities. Why would the fact they are related matter? Seems like a multi-partner allocation to me. After all, if they were unrelated I think the court would find partner identity impacted the allocations. You know who else thinks so? The circuit courts. In Alpha I,18 the Federal Circuit, in a very carefully crafted opinion (which didn’t directly overturn any of the Tax Court cases), held that partner identity is a partnership item if (because?) it impacts partner allocations. Wait, didn’t I just

say I disagreed with this? Ah, ha! You see, the Federal Circuit noted that there is a “close relationship” between allocation and partner identity because the partnership must identify who receives a distributive share. In this case, even though (like in the Tax Court cases) the IRS determined that the beneficial owners of the trusts were the partners instead of the trusts, it could still impact the allocation among the partners. The Federal Circuit pointed out that the court could disagree with the substitutions and that partner identity is part of determining the proper allocation of the partnership’s items. You know what this means — while the Federal Circuit was very careful not to expressly overturn the Tax Court cases, it made clear that it thinks that determining who the partners in the partnership are impacts how the partnership’s items are allocated. The Tenth Circuit was a little more overt. In 19 Katz, the court focused on the fact of allocation, not the change. “To say that allocation is not a partnership item is to confuse the process with the result.” It held that “there may be sound policy reasons for not requiring a full-blown partnership-level proceeding when an alleged error in one partner’s return affects only one other taxpayer rather than all the partners. But for now the law is otherwise.” At the trial level, the Tax Court held that the partner and his bankruptcy estate are the same partner and, therefore, reallocating items between the partner and the estate did not impact the allocations of the other partners and, thus, was not a partnership item. The Tenth Circuit said this was a “red herring.” The circuit court made up its mind that whether partner identity is a partnership item is not dependent on whether any potential change impacts the allocation to more than one partner — it’s whether there’s an allocation at all (which, the court noted, could be $0 or $1 million). Therefore, we cannot hang on the promises in cases of yesterday to say that, to be a partnership item, it must impact more than one partner. While the Tax Court has held that in the past in cases of partner identity, two circuits have viewed it differently. The “partner identity cases” are also

PROCEDURALLY TAXING

Tune in to Tax Notes Talk. Join host David Stewart as he chats with guests about the wide world of tax, including changes in federal, state, and internaঞonal tax law and regulaঞons. taxnotes.com/podcast

Subscribe on iTunes or Google Play today!

TAX NOTES FEDERAL, VOLUME 192, AUGUST 24, 2026 For more Tax Notes Federal content, visit www.taxnotes.com.

1501

inconsistent with the cases on other items (which are more similar to NESE than partner identity) that may not impact more than one partner such as the period of limitations and “hot assets.” I’m gonna hold on for the rest of my days that anything reported on the partnership’s return is a partnership item. I think those that try to “unapply” TEFRA to items that revolve around features, characteristics, and decisions made by a partnership are walking along a lonely street of dreams. Give us all the strength to carry on as courts once again make up their mind regarding what is a partnership item. Here we go again. 