Katz v. C.I.R.

• Decision Date: 07 July 2003
• Docket Number: Docket No. 01-9009.,Docket No. 01-9010.,Docket No. 01-9011.
• Citation: 335 F.3d 1121
• Parties: Aron B. KATZ and Phyllis A. Katz, Petitioners-Appellants, v. COMMISSIONER of INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

335 F.3d 1121

Aron B. KATZ and Phyllis A. Katz, Petitioners-Appellants, v. COMMISSIONER of INTERNAL REVENUE, Respondent-Appellee.

Docket No. 01-9009.

Docket No. 01-9010.

Docket No. 01-9011.

United States Court of Appeals, Tenth Circuit.

July 7, 2003.

Andrew M. Low (Laurence E. Nemirow, with him on the briefs), of Davis Graham & Stubbs LLP, Denver, CO, for Petitioners-Appellants.

Robert J. Branman, Attorney, Tax Division, Department of Justice (Eileen J. O'Connor, Assistant Attorney General, and Bruce R. Ellisen, Attorney, Tax Division, Department of Justice, with him on the brief), Washington, D.C., for Respondent-Appellee.

Before LUCERO and HARTZ, Circuit Judges, and ROBINSON, District Judge.^*

HARTZ, Circuit Judge.

This case involves the intersection of the laws governing income taxes and bankruptcy. Mr. Aron Katz (Taxpayer) was a partner in a number of partnerships that suffered substantial losses during a year in which he filed for bankruptcy. On his income tax return for that year, Taxpayer allocated between himself and his bankruptcy estate the losses attributable to his interests in the various partnerships. The question before us is whether the Commissioner of Internal Revenue can challenge that allocation in a proceeding involving only the Taxpayer, or whether the Commissioner must first bring a partnership-level proceeding. We hold that a partnership-level proceeding is necessary.

I. Background

Taxpayer's partnerships did not do well in 1990. The losses attributable to his interests exceeded $19 million. The losses generated by one of the partnerships, a real estate investment company called Century Centre Associates, Ltd. (Century), accounted for 96.7% of this total. On July 5, 1990, Taxpayer filed a petition for Chapter 7 bankruptcy relief. Although he could have elected to bifurcate his 1990 tax year into two short years, 26 U.S.C. (I.R.C.) § 1398(d)(2)(A), Taxpayer opted instead to file a single return for the entire year, resulting in his 1990 income taxes being treated as a post-petition debt not subject to the bankruptcy proceedings.

The Internal Revenue Code and related regulations require partnerships to prepare Schedule K-1 forms that report each partner's share of partnership income and losses. I.R.C. § 6031; Treas. Reg. §§ 1.6031(b)-1T(a)(1), (3). For the year 1990, Century and several other partnerships filed returns that included two separate K-1 forms relating to Taxpayer. The first K-1 issued by each of these partnerships concerned Taxpayer in his individual capacity and showed the income and losses that had accrued prior to Taxpayer's filing for bankruptcy. The second K-1 concerned Taxpayer's bankruptcy estate and reported post-petition tax items. The remaining partnerships of which Taxpayer was a member did not distinguish between pre-petition and post-petition items in the K-1 forms they prepared, instead allocating all items to Taxpayer. As to these partnerships, Taxpayer filed Notices of Inconsistent Treatment in which he allocated the tax items between himself as an individual and his bankruptcy estate.

On his individual tax return for 1990, Taxpayer reported that he had suffered over $19 million in losses before he declared bankruptcy. These losses exceeded the amount that he could apply to reduce his tax liability for 1990, so Taxpayer carried the losses over to tax years 1991, 1992, 1993, and 1994. Disputing the validity of those carryovers, the Commissioner issued notices of deficiency to Taxpayer and his wife, Phyllis Katz, for all four years. (Although the couple had filed separate tax returns for 1990, they filed jointly the next four years.) The Commissioner contended that Taxpayer could not allocate the 1990 partnership losses between himself and his bankruptcy estate and that Taxpayer's interest in any partnership losses incurred during 1990 passed to the bankruptcy estate when he filed for bankruptcy. Thus, the Commissioner argued, Taxpayer in his individual capacity could not claim deductions based on those losses.

Taxpayer and his wife contested the notices of deficiency in the Tax Court. The parties settled all matters of dispute except the treatment of partnership losses. With respect to this issue, Taxpayer argued that the Tax Court lacked jurisdiction to enforce the notices insofar as they concerned adjustments to partnership items. To understand this argument requires a brief discussion of the governing statute and regulations.

Under the Internal Revenue Code, "[p]artnerships, as such, are not subject to the federal income tax." Kaplan v. United States, 133 F.3d 469, 471 (7th Cir.1998). Instead, "partnership income and expenses `pass through' to the individual partners." Chimblo v. Comm'r, 177 F.3d 119, 121 (2d Cir.1999) (citing I.R.C. §§ 701, 6031). Until 1982 the process of reviewing tax returns of individual partners, rather than the return of the partnership itself, created a significant administrative problem. To address tax issues arising from a single partnership, the IRS needed to initiate multiple proceedings. Id. "[T]he IRS was forced to conduct distinct investigations for and, where appropriate, enter separate settlement agreements with each individual partner." Crnkovich v. United States, 202 F.3d 1325, 1328 (Fed.Cir.2000). In response to this problem, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), I.R.C. §§ 6221-6233, included "unified partnership audit examination and litigation provisions," which "centralized the treatment of partnership taxation issues, and ensure[d] equal treatment of partners by uniformly adjusting partners' tax liabilities." Chimblo, 177 F.3d at 121 (internal quotation marks and citations omitted). See generally Callaway v. Comm'r, 231 F.3d 106, 107-12 (2d Cir. 2000) (discussing TEFRA treatment of partnerships).

Section 6221 of TEFRA states that "[e]xcept as otherwise provided in this subchapter, the tax treatment of any partnership item ... shall be determined at the partnership level." A partnership-level proceeding is the exclusive means for adjusting a partnership item. See Maxwell v. Comm'r, 87 T.C. 783, 788-89, 1986 WL 22033 (1986). The Tax Court lacks authority to make partnership-item adjustments in a partner-level proceeding except in circumstances not pertinent to this case. See Kaplan, 133 F.3d at 473.

A similar rule applies to an item whose tax treatment is dependent on the treatment of a partnership item. Such an item is called an "affected item." See I.R.C. § 6231(a)(5) ("The term `affected item' means any item to the extent such item is affected by a partnership item."). The Tax Court has explained that "`because the tax treatment of an "affected item" depends upon the partnership-level determination, affected items generally cannot be tried as part of a partner's tax case prior to the completion of the partnership-level proceeding.'" GAF Corp. & Subsidiaries v. Comm'r, 114 T.C. 519, 2000 WL 863148 (2000) (quoting Gillilan v. Comm'r, 66 T.C.M. (CCH) 398, 1993 WL 311552 (1993)).

The dispositive issue here is whether the Commissioner's proposed adjustments to Taxpayer's income tax liability required an adjustment to either a partnership item or an affected item. The Internal Revenue Code provides a common-sense definition of "partnership item," but permits the Secretary of the Treasury to provide for appropriate exceptions by regulation. It states:

The 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.

I.R.C. § 6231(a)(3).

Taxpayer argued that "his share of the partnerships' 1990 net operating losses were `partnership items' and that the carryforwards of these losses to subsequent years were `affected items.'" Aplt. Br. at 9. To support this claim, he cited to the general rule set forth in Treas. Reg. § 301.6231(a)(3)-1(a)(1)(i):

(a) In general. For purposes of subtitle F of the Internal Revenue Code of 1954, the following items which are required to be taken into account for the taxable year of a partnership under subtitle A of the Code are more appropriately determined at the partnership level than at the partner level and, therefore, are partnership items:

(1) The partnership aggregate and each partner's share of each of the following:

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

. . . .

(emphasis added). Consequently, in Taxpayer's view, the Commissioner could adjust these losses only in a partnership-level proceeding.

In response to Taxpayer's argument, the Commissioner relied on Treasury Regulation § 301.6231(c)-7T(a) (the Bankruptcy Regulation), which specifically addresses the impact of bankruptcy on the characterization of items as partnership items. According to the Commissioner, the regulation (which will be discussed below) converted Taxpayer's 1990 partnership losses into nonpartnership items.

The Tax Court rejected Taxpayer's jurisdictional argument. It did not, however, rely on the Bankruptcy Regulation. Rather, the court reasoned that the allocation of partnership tax items between the Taxpayer and his bankruptcy estate is not a "partnership item," an analysis that had not been suggested by the Commissioner.

The Tax Court's decision turned on its view that "a partner in bankruptcy and his bankruptcy estate are appropriately treated as a single partner for purposes of TEFRA procedures." Katz v. Comm'r, 116 T.C. 5, 12, 2001 WL 30538 (2001). In particular, the court said that "once the partnership has determined the distributive share of a partner who happens to be in bankruptcy, there exists no statutory obligation upon the partnership to subdivide the distributive share between such partner and his bankruptcy...