In a published decision, Dynamo Holdings Limited Partnership v. Commissioner, 150 TC 10 (2018), the US Tax Court held, for the first time, that the IRS does not have the initial burden of proof (also known as the burden of production) when the applicability of penalties to a partnership adjustment is litigated in a partnership-level TEFRA proceeding. This has the effect of placing the burden of production on the taxpayer to prove the inapplicability of penalties asserted by the IRS in a notice of final partnership administrative adjustment (“FPAA”), including raising the issue of the absence of supervisory approval of certain penalties.
Under section 7491(c), the government has the burden of production in any court proceeding where the liability of an individual for a penalty or other addition to tax is at issue. In such cases, the government must introduce enough evidence to establish the validity of the penalty, otherwise the court will rule for the taxpapyer. This burden includes proving compliance with section 6751(b), which requires certain penalties to be approved personally (and in writing) by the immediate supervisor of the IRS employee who initially determined the penalty (see Graev, Lawrence G. et ux. v. Commissioner, 149 TC 23 (2017)).
In Dynamo Holdings (issued in connection with a separate opinion dealing with the substantive tax issues at hand, see other Dynamo Holdings alert),the IRS issued an FPAA to a limited partnership proposing the applicability of both the negligence and substantial understatement penalties under section 6662(a) and (b). During the proceeding, the Court raised whether the government had sufficiently proved that the proposed penalties carried proper supervisory approval. The government then moved to reopen the record to introduce additional evidence of supervisory approval. The Tax Court’s response to this motion is the primary subject of the Court’s opinion.
In responding to the government’s motion, the Tax Court held, in a reviewed opinion, that, since a partnership is not an individual as that term is conventionally defined, then the burden of production under section 7491(c) did not attach to the government. The Tax Court held that this applied notwithstanding the fact that partnership penalties may ultimately be paid, partially or exclusively, by individuals, as to hold otherwise would violate the general rule that a TEFRA partnership is dealt with as a single entity in a unified proceeding that determines the tax liability of the partners related to partnership items. As a result, the Tax Court held that reopening the case record was unnecessary, as the government did not need to prove that the penalties at issue were properly approved under section 6751(b).
The Tax Court noted that this did not outright foreclose the lack of supervisory approval as a defense to penalties asserted by the IRS; however, it must be affirmatively raised by the taxpayer as a defense. Since the taxpayer in Dynamo Holdings did not raise this issue in its petition, at trial, or on brief, or seek to reopen the record to raise the issue, the defense was deemed to be waived.
It is of note that this holding is only directly relevant to partnership proceedings under TEFRA, which is currently being phased out in favor of the new partnership audit regime under the Bipartisan Budget Act of 2015 (the BBA) for tax years beginning on or after Jan. 1, 2018. However, as the new regime generally provides for even more centralized determinations than under TEFRA, it seems likely that the Tax Court would hold similarly under the BBA. Both the TEFRA and BBA regimes provide exceptions for certain defined, “small partnerships,” in which each partner is dealt with individually. Although not directly addressed in the Court’s opinion, it is our sense that the government would still bear the burden of production in small partnership cases where the proceedings involve only the individual and not the partnership.