McNeill: Tax Court Gives Partners New Avenue to Challenge Penalties

In McNeill v. Commissioner, 148 T.C. No. 23 (June 19, 2017), the Tax Court held that taxpayer challenges to penalties imposed in the wake of a TEFRA partnership audit or litigation can be challenged in collection due process (CDP) proceedings. It was always clear that if a taxpayer had personal defenses to a penalty asserted at the partnership level, the taxpayer could pay the penalty (and any associated interest), file a claim for refund, and have his personal defenses considered by the IRS and the courts. Prior to the McNeill opinion, however, it was unclear whether the taxpayer could decline to pay the tax, and instead ask to have the merits of his personal defenses considered by the IRS and the courts in the context of a CDP case. The McNeill case is good news for partners who do not have the ability (or the desire) to full pay the penalty in order to obtain consideration of their defenses.

In 1982, Congress enacted the TEFRA partnership audit and litigation rules, which require the IRS to make adjustments to most partnership tax returns at the entity level, although the adjustments are “passed through” to the partners, who ultimately pay the tax bill. If no information related to the specific partners’ tax situations is necessary to pass through the partnership level audit adjustments, the IRS can simply make a computational adjustment to the partners’ tax returns, without issuing a notice of deficiency to the partners. Sometimes, penalties imposed in a TEFRA partnership audit fall into the computational adjustment category and are simply assessed by the IRS, with no ability on the part of taxpayers to raise any personal defenses to the penalty. These penalties are often 20% or 40% of the additional tax.

Prior to McNeill, a taxpayer’s only remedy was to full pay the penalty and seek a refund in the district court or the Court of Federal Claims. In McNeill, the Tax Court held that personal defenses to the penalty (e.g. “I relied on tax advice from independent tax counsel who affirmed the correctness of the position taken on the partnership return.”) should be considered by the IRS in a collection due process hearing, and are subject to de novo review by the Tax Court if the IRS Settlement Officer decides the issue against the taxpayer. This will give taxpayers who do not have the means (or desire) to full pay the penalty an opportunity to have their day in court without first having to fork over a substantial amount of money.

While the TEFRA partnership audit and litigation rules have been repealed and replaced by the Bipartisan Budget Act of 2015 (“BBA”) for tax years beginning after December 31, 2017 (eliminating partner level penalty defenses for partnerships which do not opt out of the new BBA system), there is a substantial amount of audit and litigation activity related to prior years’ partnership returns, and the IRS will have to audit 2016 and 2017 partnership tax returns under the TEFRA rules.