IRS not bound to sec. 6222 procedures by notice of inconsistent treatment.

The Tax Court recently considered the Service's alternatives after a Notice of Inconsistent Treatment has been filed by a partner under Sec. 6222.

Aimed at partnerships and S corporations, Secs. 6221 through 6233 (which define audit procedures) were added to the Internal Revenue Code by the Tax Equity and Fiscal Responsibility Tax Act of 1982 (TEFRA). This part of TEFRA had two goals:

1. Consistent treatment among all partners of a partnership.

2. Administrative and judicial economy due to unified audit procedures.

These Code sections apply to most partnerships, S corporations and real estate mortgage investment conduits (REMICs), although small organizations are exempted. "Small" is defined differently for each type of entity; however, each exemption is based on the number of owners.

Four categories of items are defined by TEFRA:

1. Partnership items: The tax treatment of the item is more appropriately determined at the partnership level.

2. Affected items: Either items computationally affected by partnership items (e.g., the amount of deductible medical expense changes when partnership income changes) or items that require substantive partner-level determinations.

3. Nonpartnership items: Other items on the tax return.

4. Converted items: Items that were once partnership items but have become nonpartnership items.

Sec. 6222 requires that a partner treat all partnership items consistently with the way the items were treated on the partnership tax return. According to Temp. Regs. Sec. 301.6222(b)-2T, if the partner notifies the IRS of the inconsistent treatment of a partnership item, the Service generally may not make an adjustment with respect to that partnership item unless it conducts a partnership-level proceeding or notifies the partner that all partnership items arising from that partnership will be treated as nonpartnership items.

In a recent Tax Court decision, Jenkins, 102 TC No. 21 (1994), it was held that the inconsistent treatment must be of a partnership item, rather than of an affected item, to require that the Service conduct a partnership-level proceeding or notify the partner that all partnership items will be treated as nonpartnership items.

In this case, a partner in a law partnership was disabled during 1988. The firm paid her $75,000 in exchange for her agreement not to exercise her rights under the waiver-of-premium provision of the firm's group life plan. The partner excluded the $75,000 from her gross income as compensation received for disability. She filed Form 8082, Notice of Inconsistent Treatment, because the partnership had reported the payment as a guaranteed payment to her. The IRS issued a deficiency notice to the partner, stating that the $75,000 should have been reported as income.

After receiving the deficiency notice, the partner filed a petition in Tax Court and also filed a Motion to Dismiss, contending that the deficiency notice was invalid and that the court had no jurisdiction to consider a partnership item in a partner-level proceeding.

A key factor in the Tax Court decision was that the $75,000 payment was determined to be an affected (rather than a partnership) item. A guaranteed payment is a partnership item. However, the determination of whether that income was attributable to disability must be determined at the partner level and, therefore, is an affected item on the partner's return.

The court concluded that the partner had not treated a partnership item inconsistently, but had characterized an affected item. In other words, the excluded $75,000 was still considered by the court to be a guaranteed payment characterized as income excluded under Sec. 104(a) on the partner's return. The IRS could directly challenge the characterization without conducting a partnership-level proceeding or treating all partnership items as nonparrnership items.

Another important aspect of this decision is that the court noted that, if the partner had clearly stated on Form 8082 that she disagreed with the partnership's reporting of the payment as a guaranteed payment, a different decision might have been reached.