IRS-induced conflict of interest terminates TMP status.

Are limited partners in a TEFRA partnership bound by a consent to extend the statute of limitations (SOL) on assessment signed by the tax matters partner (TMP) while they are under IRS criminal investigation? Reversing the Tax Court, the Second Circuit has held that they are not (Transpac Drilling Venture 1982-12, 6/26/98).

Background

Before 1982, IRS audits of passthrough entities ordinarily took place at the individual level. The result was administrative confusion and complexity for the Service, particularly when syndicated tax shelter arrangements with numerous individual and entity investors and multiple tiers were involved. Largely to alleviate the administrative burden, Congress enacted unified audit and litigation (UAL) rules applicable to most partnerships as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA partnerships).

Under the UAL scheme generally, tax disputes with respect to partnership items are resolved at the entity level. The tax impact of partnership-level adjustments (whether agreed or adjudicated) automatically flows to each partner in the form of a deficiency assessment or credit/refund. Only the TMP acts as the liaison between the IRS and the partners. The TMP is responsible for keeping partners informed of tax administrative and judicial proceedings relating to the partnership (Sec. 6223(g)). The TMP has the authority to extend the SOL on assessment with respect to partnership items on behalf of all partners (Sec. 6229(b)(1)(B)). He can bind partners holding a less-than 1% partnership interest to a settlement with the Service (Sec. 6224(c)(3)) and determine the forum (e.g., Tax Court or Court of Federal Claims) in which to litigate a partnership tax controversy

A TEFRA partnership may designate a general partner as TMP for a particular tax year (Sec. 6231(a)(7)). In the absence of a designation, the TMP is typically the general partner with the largest profits interest for the year. In some circumstances, the IRS (or the courts) may appoint the TMP.

Because the TMP's role under the UAL procedures is pivotal, it is crucial for the Service to keep track of the TMP's identity at any point in time. To that end, the IRS has released detailed regulations on the circumstances under which TMP status terminates. Among those circumstances are death or an adjudication of incompetence in the case of an individual TMP (Regs. Sec. 301.6231(a)(7)-1(1)(1)(i) and (ii)), and dissolution or liquidation in the case of an entity TMP (Regs. Sec. 301.6231 (a)(7)-1(1)(1)(iii)). Another circumstance is the conversion of a TMP's partnership items to nonpartnership items by reason of the application of Sec. 6231(c), relating to "special enforcement areas" (Regs. Sec. 301.6231 (a)(7)-1 (1) (1) (iv)).

Special enforcement areas include jeopardy and termination assessments, criminal investigations, the use of indirect methods of proving income, foreign partnerships, and any other area prescribed by Treasury in regulations as presenting special enforcement considerations. Under Sec. 6231(c)(2), any partnership item in a special enforcement area is to be treated as a nonpartnership item, to the extent that Treasury determines and provides by regulation that partnership-item treatment would interfere with the effective and efficient enforcement of the tax laws. Congress also has expressly authorized Treasury to write such "special rules" for special enforcement areas as necessary to effectuate the purposes of TEFRA (Sec. 6231(c)(3)).

Treasury has exercised that authority with respect to criminal tax investigations. Specifically, Temp. Regs. Sec. 301.6231(c)-5T provides that the treatment of partnership items with respect to a partner does, indeed, interfere with the efficient enforcement of the tax laws. The temporary regulation also provides, however, that such items do not convert to nonpartnership items unless and until the Service notifies the partner both that he is the subject of a criminal investigation and that his partnership items will be treated as nonpartnership items (the "-5T notice"). In the case of a TMP under criminal tax investigation, TMP status does not terminate under the regulations until the IRS sends him the "-5T notice" (Regs. Sec. 301.6231 (a)(7)-1 (1)).

Facts

The Service solicited consents from the limited partners of several TEFRA limited partnerships engaged in oil and gas exploration. When the limited partners refused to extend the SOL on assessment, the IRS obtained signed consents, purporting to bind all the partners, from the partnerships' TMPs.

The TMPs knew that they were targets of a criminal tax investigation of the partnerships. Some eventually cooperated with the government in exchange for immunity from prosecution. Neither the Service nor the TMPs (acting under government instructions) alerted the limited partners to the criminal investigation.

After later becoming aware of the facts, the limited partners challenged the validity of the consents in Tax Court. They argued that in signing the documents, the TMPs had breached their fiduciary duties. The criminal investigation had created a conflict of interest that stripped them of authority to act on behalf of the limited partnerships.

Relying on Sec. 6231(c)(1) and (3) and Temp. Regs. Secs. 301.6231(a) (7)1T(1)(1) and 301.6231(c)-5T, the IRS argued that it had sole discretion as to whether and when to remove a TMP because of a criminal tax investigation. The Service also contended that, until it exercised such authority by sending a "-5T notice" (which it had not sent to the TMPs in question), a TMP retained the statutory power to extend the SOL on behalf of his partners.

Siding with the IRS, the Tax Court held that acceptance of the limited partners' position, which invoked principles of agency and trust law, would defeat Congress' purpose in enacting the UAL procedures (i.e., simplifying the resolution of tax controversies involving passthrough entities). (The Court of Federal Claims has since adopted the Tax Court's reasoning under similar facts; see Transpac Drilling Venture 1983-2 (1995) (holding that "the applicable statutory provisions and regulations do not explicitly provide for agency-based limitations on the TMP's power"), aff'd on other grounds, 83 F3d 1410 (Fed. Cir. 1996).)

On appeal, the Second Circuit reversed. It agreed with the limited partners that the TMPs owed them a fiduciary duty. The court analogized a TMP's role to that of a class representative in class-action proceedings. The court also branded as frivolous the Ser vice's assertion that even a competent fiduciary would have executed the consents. Likewise rejected was the contention that had the consents not been executed by the TMPs, the IRS necessarily would have taken timely, alternative steps to protect the SOL.

As to the argument that the regulatory authority conferred by Sec. 6231 gives the Service unfettered discretion to decide whether and when to oust a TMP, the court was similarly unimpressed. Were that position upheld, the court reasoned, the IRS would be free to capitalize on conflicts of its own making, simply by declining to send the "-5T notice" to the TMP. The Second Circuit refused to ascribe such a purpose to Congress, declaring that a party that stands to benefit from a conflict of interest should not be the one to decide whether a conflict exists. The court held that "where serious conflicts exist, a TMP may be barred from acting on behalf of the partnership, quite apart from the issuance of a government letter under current Regulation 301.6231 (c)-5T."

The court also had little difficulty concluding that a serious conflict existed under the facts. It emphasized several factors: the Service's failed efforts to obtain consents from the limited partners; the intense pressure on the TMPs to accommodate the government because of the criminal investigation; and the fact that news of the investigation was deliberately withheld from the limited partners by the government and the TMPs.

Finally, the court invited Treasury to write regulations providing for the automatic removal of a TMP when a conflict of interest arises.

Comment: The result reached by the Second Circuit squares with general legal principles. It is well settled that a general partner owes the highest fiduciary duty to limited partners and acts as an agent on behalf of the limited partnership. Actions taken outside the scope of a general partner's actual or apparent authority (e.g., for his sole benefit and at the expense of the limited partners) will not necessarily bind the partnership. Moreover, a third party that deals with an agent is not free to ignore the potential for limitations on the scope of his authority.

Narrowly construed from the tax perspective, Transpac makes clear that a serious conflict of interest on the part of a TMP, at least one instigated by the IRS, may vitiate actions purportedly carried out in his representative capacity. The opinion, to be sure, leaves open the question of what constitutes a "serious" conflict in a particular case. The appellate court's careful choice of words suggests that it was not prepared to treat every putative conflict as a disqualifying event. The question is what will suffice. Is the pressure of a potential criminal prosecution necessary, or would the threat of civil monetary sanctions (e.g., a promoter penalty action) be sufficient? May the Service take advantage of a conflict which it did not create, but of which it has knowledge? Future cases will likely address such questions.

Transpac's real significance may lie in its broader implications for TEFRA partnership tax controversies. In particular, the decision may be taken to mean that the UAL rules do not constitute the sole frame of reference for determining the scope of a TMP's powers. Off-Code authority (e.g., local case and statutory law) may be relevant as well. Put another way, the validity for tax purposes of TMP actions authorized under the UAL scheme (such as signing consents, entering into settlement agreements with the IRS and filing court papers) may be subject to more than one level of scrutiny.

Such an approach is not unprecedented. The Tax Court, for example, has invoked state partnership and contract law to validate partnership consents executed by persons who ostensibly fall outside the literal terms of the UAL rules; see, e.g., Cambridge Research O Develop. Group, 97 TC 287 (1991) or Amesbury Apartments Ltd., 95 TC 227 (1990).

Whether the Tax Court will follow Transpac to any extent outside the Second Circuit is uncertain. (In a case pending that should prove revealing, the Tax Court must decide whether a TMP retained authority by reason of the UAL scheme to bind limited partners, despite his previous removal as TMP in a separate action brought by the government; see Davenport Recycling Assoc., Docket No. 12801-89.) As for the Service, a change in litigating position seems unlikely for now. Although the Second Circuit did not purport to invalidate Temp. Regs. Sec. .301.6231(c)-5T, the IRS may regard Transpac as an inappropriate infringement upon its regulatory authority in special enforcement areas.