Tax lawyers are telling their clients who invest in tax shelters that take the form of partnerships -- and everything from real estate to research and development deals DOES take that form -- that the rules are radically changing whenever there is a dispute with the Internal Revenue Service. "You might end up being bound by something you've never heard of," warns McGee Grigsby, an expert on partnership taxation.
The new approach was called for in the 1982 tax law, but because of the lag in the new provisions taking effect and the time it takes the IRS to begin an audit, it is just beginning to hit now. The Tax Court's rules on litigated challenges to outcomes from the new procedures will not even be published until year's end, with no cases expected there before spring. The change does not alter the tax structure -- how much is due on what -- but it gives tax collectors a lot more clout in disputes with tax shelter promoters over how that tax structure applies to a particular deal.
Basically, partnerships do not pay taxes. All the tax obligations -- and benefits -- flow through to those who invest in such arrangements. Until now, if the IRS thought that the partnership's favorable interpretation of the laws was wrong, it had to fight out the issue with each individual partner in a separate proceeding. In reality, many were missed -- or deemed not worth the resources the IRS would have to put into the battle. And even when the authorities did try to collect more because of a disagreement about the operations of a tax shelter, a victory in one dispute had little bearing on the cases of other partners in the same scheme. The IRS might concede the disputed point with partner A, in return for his concessions on other questions involving his return. But that concession did not let Partner B off the hook.
The truth is, not all investors will benefit from the same tax treatment. Take a real estate partnership that sold quite a few parcels of real estate during the year. Is it or is it not a real estate dealer? Most often, the partnership would say it is not, so that gains are capital gains; for dealers, they would be ordinary income. Investors with ordinary losses elsewhere in their portfolios, however, would be better off treating the partnership gain as ordinary income. Since it is a close call anyway, they could legitimately call the partnership a real estate dealer, and chances were good that the IRS would never even notice the discrepency.
That has all changed. All questions about how partners treat the results of the partnership operation will be handled in one consolidated case. Each partnership must designate a "tax matters partner" (or the IRS will pick the general partner with the biggest stake), and the auditors deal with that person. Any settlement or eventual court ruling is binding on all investors. Investors have a right to participate in the negotiation or litigation proceeding, but as things stand now they might not even know it is going on.
The only persons the IRS must inform when a partnership's books are under scrutiny are those with at least a 1 percent interest. In a lot of the big deals, most investors have less than that. So lawyers are now going to the general partners and trying to get the partnership agreement amended, adding a legal duty to inform everyone when an audit is pending. Advisors who put a lot of clients into tax shelters say they have been successful in getting such rewrites.
Even investors who do not want to run up the legal bills that formal intervention in the proceedings would entail are being told to check with the tax matters partner on what position he or she will be taking. Take as simple a matter as whether to give the IRS more time than the law allows to finish up an investigation. Most taxpayers routinely grant such requests from the IRS, since to say no will almost insure a deficiency notice. But persons who are in a situation where they have to know just what the assets and liabilities are (because, say, they might go into a new investment scheme if they had enough uncommitted cash) need a speedy resolution of the dispute. They would want to refuse a time extension. Some lawyers are even asking that the tax matters partner not grant an extension unless a majority of the investors vote to authorize it.
And they are taking a close look at who the tax matters partner is. Someone who can put together an advantageous deal may not be the best one to negotiate with the IRS. Style and knowledge both figure in. But there is also the question of self-interest. Most general partners want to win any fights with the IRS in order to arouse interest in their next deal. But there are times when short-range interests might override. For instance, tax shelters typically allocate 99 percent of losses to the limited partners, which they can deduct from other income, thereby reducing their taxes. But often the IRS feels that a 50-50 split between limited and general partners is fairer. A limited partner might worry that a general partner, who would benefit from the IRS interpretation, "at some point might just lie down and say to the IRS, 'you're right,' " admits New York tax lawyer Richard Cohen.
The IRS is planning to capitalize on the new procedures by putting more manpower into scrutinizing the books of tax shelter partnerships. That means "the rate of partnership audits will pick up considerably," predicts Ronald B. Lewis, a Washington tax lawyer who has written about the new rules. But it really won't change basic investment strategy. Partnerships now, Lewis says, "are clearly less attractive to high flyers who want to play the audit lottery, but they're just about the only game in town."
In a recent case, a court ruled that:
* The Commodity Futures Trading Commission has less power than it thought. The Commodity Exchange Act lets the regulatory agency resolve disputes between investors and futures brokers over whether Commission rules have been obeyed. The Commission also has decreed that it will consider any counterclaims against the investors by the broker. That is going too far, the U.S. Court of Appeals in Washington ruled. There are serious constitutional problems in moving what are, in effect, breach-of-contract suits out of the courts and having them decided by commissioners appointed by the president with none of the protection of the federal judiciary, the opinion says. The ruling limits CFTC jurisdiction to allegations about its own regulations or the underlying commodity trading statute.
(Schor v. CFTC, August 10)