Chai v. Comm'r of Internal Revenue

851 F.3d 190

Jason CHAI, Petitioner-Appellant-Cross-Appellee,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee-Cross-Appellant.

Docket Nos. 15-1653 (L)

15-2414 (XAP)

August Term, 2016

United States Court of Appeals, Second Circuit.

Argued: October 25, 2016

Decided: March 20, 2017

Jeremy Klausner (Frank Agostino, Lawrence M. Brody, on the brief), Agostino & Associates, P.C., Hackensack, NJ, for Petitioner-Appellant-Cross-Appellee.

Arthur T. Catterall , Attorney, Tax Division, Department of Justice (Richard Farber, on the brief), for Catherine D. Ciraolo, Acting Assistant Attorney General, Washington, D.C., for Respondent-Appellee-Cross-Appellant.

Before: Katzmann, Chief Judge, Wesley and Carney, Circuit Judges.

Wesley, Circuit Judge:

Taxpayer Jason Chai's appeal and the Commissioner of Internal Revenue's (the "Commissioner") cross-appeal relate to Chai's underreporting of income in his 2003 tax return, principally in connection with a $2 million payment Chai received from Delta Currency Trading, LLC ("Delta") for his role in a now-defunct tax-shelter scheme. The Commissioner issued Chai a timely notice of deficiency asserting that he owed self-employment tax on the $2 million payment, plus a 20% accuracy-related penalty. The original notice of deficiency did not assert an income-tax deficiency because the $2 million increase in Chai's income was initially offset for income-tax purposes (but not self-employment-tax purposes) by his reported share of a partnership loss that could be adjusted only in a separate, partnership-level proceeding. Chai initiated a deficiency proceeding in the United States Tax Court to challenge the Commissioner's self-employment-tax determination.

While Chai's deficiency proceeding was pending, losses reported by Mercato Global Opportunities Fund, LP ("Mercato")—a partnership of which Chai was a member—were disallowed in a partnership tax proceeding (the "Mercato proceeding"). Chai had reported his share of Mercato's losses on his 2003 personal return. With that loss disallowed, Chai would also owe income tax on the $2 million payment if the Tax Court decided that the payment was income. To collect that tax (and another 20% accuracy penalty), the Commissioner filed an amended answer in Chai's personal deficiency proceeding to assert an income-tax deficiency in addition to the original self-employment-tax deficiency. In separate orders, the Tax Court held (1) it lacked jurisdiction over the added income-tax deficiency because I.R.C. § 6230 required the Commissioner to apply the results of the Mercato proceeding to Chai by computational adjustment, rather than in his deficiency proceeding, and (2) Chai owed the self-employment tax and corresponding penalty. In upholding the penalty assessment, the Tax Court rejected as untimely Chai's argument, raised for the first time in post-trial briefing, that the Commissioner failed to carry its burden to show compliance with a statutory written-approval requirement. The Commissioner challenges the first ruling, and Chai challenges the second.¹

For the reasons discussed below, we hereby: (1) VACATE the Tax Court's jurisdictional ruling and, because Chai concedes that the $2 million payment is fully taxable, REMAND the case to the Tax Court to enter a revised decision upholding the income-tax deficiency; (2) AFFIRM the portion of the Tax Court's order upholding the self-employment-tax deficiency; and (3) REVERSE the portion of the Tax Court's order upholding the accuracy-related penalty.

BACKGROUND

I. STATUTORY FRAMEWORK

This case involves the complicated intersection of partnership and individual taxpayer tax court proceedings. Before turning to the facts and procedural background of this case, both of which are encumbered with terminology and concepts that have confounded the parties and the Tax Court, it is helpful to start with a basic outline of the statutory context underlying this case.

When the Internal Revenue Service (the "IRS") audits an individual taxpayer's return and determines that he owes more than he reported, it must follow statutorily prescribed deficiency procedures to recover unpaid tax, including unpaid self-employment tax imposed by I.R.C. § 1401(a), as well as any applicable reporting penalty. See I.R.C. §§ 6211 -6216, 6665(a)(1). Those procedures require the IRS to assert its claim for additional tax and penalty through a notice of deficiency, which the taxpayer may challenge by petition filed in the Tax Court within 90 days of the notice's issuance. See I.R.C. §§ 6212(a), 6213(a).

The Tax Court "exercises jurisdiction only to the extent provided by statute." See GAF Corp. v. Comm'r , 114 T.C. 519, 521 (2000). Its jurisdiction to redetermine a deficiency asserted by the IRS "depends upon a valid notice of deficiency and a timely filed petition." Id. ; see Moretti v. Comm'r , 77 F.3d 637, 642 (2d Cir. 1996) ("A notice of deficiency is ... considered the jurisdictional prerequisite to a taxpayer's suit in the Tax Court for redetermination of his tax liability." (internal quotation marks omitted)). Where the notice of deficiency is invalid, the Tax Court must dismiss the case. See GAF Corp. , 114 T.C. at 528.

The IRS is prohibited from assessing and collecting additional tax deficiencies during the period for filing a Tax Court petition. If the taxpayer timely files, that prohibition remains in place until the decision of the Tax Court becomes final. I.R.C. § 6213(a). Along the same lines, the statute of limitations on the assessment of any additional deficiencies is tolled during that period and for 60 days thereafter. I.R.C. § 6503(a)(1).

Unlike individuals and corporations, partnerships are not separately taxable entities. A partnership's income and expenses pass through to the individual partners, who must pay a tax on their proportionate shares of net gain or may claim a deduction for their shares of net loss. Partnership tax is subject to the procedures set forth in the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), Pub. L. No. 97-248, 96 Stat. 324 (codified as amended at I.R.C. §§ 6221 -6234 ). Central to those procedures is the distinction between partnership and nonpartnership items. "Partnership item[s]" are items more properly determined at the partnership level than at the partner level—e.g., income, gain, loss, deduction, and credit. I.R.C. §§ 6221, 6231(a)(3). "Nonpartnership item[s]" are all of the partnership's remaining income and expenses that are not "partnership item[s]." I.R.C. § 6231(a)(4).

To initiate adjustments to partnership items, TEFRA requires the IRS to conduct a unitary audit of the partnership and issue a final partnership administrative adjustment ("FPAA") to the partners, which the partners may challenge in a single judicial proceeding (a "TEFRA proceeding") in, inter alia , the Tax Court. See I.R.C. §§ 6223(a)(2), 6226. Adjustments to nonpartnership items follow the standard procedures for adjustments to personal income. See I.R.C. §§ 6221, 6230(a)(2)(A). The goal of the TEFRA procedures "is to ensure that, in general, partnership items are adjusted once at the partnership level. All partners, whose tax liability will be affected by its outcome, have the opportunity to participate in the audit allowing each to be bound by its result." Callaway v. Comm'r , 231 F.3d 106, 111 (2d Cir. 2000).

As with the deficiency proceedings for nonpartnership (i.e., personal) items, the IRS is prohibited from making FPAA-related deficiency assessments during the period in which a partner may challenge the FPAA and, if a challenge is commenced, until after a final Tax Court decision is issued. I.R.C. § 6225(a). The statute of limitations is likewise tolled during that period and for one year after a final decision. I.R.C. § 6229(d).

Once a partnership-level tax proceeding becomes final (or the time to seek judicial review of the FPAA expires), the IRS applies the results to each partner's personal return and calculates any deficiencies. If the deficiency calculation would be purely computational, the Commissioner issues to the partner a "notice of computational adjustment,"² rather than a notice of deficiency. I.R.C. § 6225 ; see I.R.C. § 6230(a)(1) ( "Except [in certain circumstances], subchapter B of this chapter [i.e., deficiency procedures] shall not apply to the assessment or collection of any computational adjustment.").; N.C.F. Energy Partners v. Comm'r , 89 T.C. 741, 744 (1987). The deficiency procedures, however, do apply to "affected items"³ that require an individual, partner-level factual determination.⁴ I.R.C. § 6230(a)(2)(A). In such instances, the IRS is required to issue, within one year of the outcome of the TEFRA proceeding, an affected-item notice of deficiency (unless it can be folded into the partner's existing deficiency proceeding).⁵ I.R.C. §§ 6229(d), 6230(a)(2)(A)(i) ; Treas. Reg. § 301.6231(a)(6)-1(a)(3).

The TEFRA provisions (and cases interpreting them) are clear: Partnership-level proceedings must be kept distinct from deficiency proceedings involving individual partners. A problem arises, however, where, as here, a partnership's net loss is so large that it offsets proposed adjustments to nonpartnership items in a partner's personal deficiency proceeding. In that case, the loss offset could eliminate some of the partner's personal tax deficiencies (but not others, such as a self-employment-tax deficiency), and the non-TEFRA adjustments could wind up being uncollectible because of the expiration of the statute of limitations vis-à -vis nonpartnership items.

That was the case in Munro v. Commissioner , 92 T.C. 71 (1989). There, the IRS presumptively—i.e., prior to the conclusion of ongoing partnership-level TEFRA proceedings—issued a notice of deficiency to each partner that disallowed partnership losses for computation purposes.⁶ Id. at 72-73. The taxpayers moved to dismiss for lack of jurisdiction, asserting that the deficiency was attributable to partnership-level...