Settling deficiencies proposed by the IRS.

Facts

On June 1, 1989, White invested $50,000 to acquire a 0.5% limited partnership interest in a partnership engaged in the acquisition, training and racing of thoroughbred horses. The partnership included a total of 200 partners. White included all the items of income, deduction and credit as shown on the Schedule K-1 furnished to him by the partnership on his 1989 individual income tax return. In November 1992, White received notice that the IRS was going to audit the 1989 partnership tax return. He took no action to participate in the audit. On Dec. 1, 1992, he received notice from the Tax Matters Partner (TMP) that the Service had proposed an addition to partnership taxable income resulting in an addition of $5,000 to White's 1989 taxable income. White wishes to contest this addition, and has asked his tax adviser for advice as to his alternatives.

Issues

What alternatives does Mute have with respect to the proposed deficiency? Is he bound by audit changes agreed to at the partnership level?

Analysis

The Tax Equity and Fiscal Responsibility Act completely changed the procedures for IRS examinations of partnership returns and altered partners' rights and remedies with respect to such examinations. Although these procedures are complex, the essence of these rules is that the tax consequences of partnership items are now generally determined at the partnership level through a unified administrative or judicial proceeding (rather than through separate audits of each partner).

The first element of the unified audit procedures is a formalized set of notice requirements. At the start of the audit, the Service must provide a formal notice of the audit directly to every known partner. In the case of partnerships with over 100 partners, only partners with a 1 % or more interest must be notified, unless these under-1% partners have banded together under special rules to form a 5% notice group. When the IRS has no obligation to provide various notices to partners, the TMP must notify these partners of the start and completion of the audit.

Having received notice from the TMP that the partnership was to be audited, White could have participated in the audit proceedings with the TMP. Every partner has a right of participation unless he specifically waives this right in writing. Also, every partner has the right to file a statement with the Service declaring that the TMP does not have the authority to enter into a settlement agreement on his behalf. The right to participate in the audit proceedings accrues to each partner unless affirmative steps are taken to waive that right, but just the opposite is true if a partner wishes to deny the TMP authority to enter into a settlement agreement. In the latter case, an affirmative notice of the denial of the authority must be sent to the IRS.

When a partner is notified of an impending audit, that partner must consider the practical aspects of attempting to participate in the audit proceedings. Although in most situations it would be impractical for a limited partner holding a small interest in a partnership to participate, it may be in the

partner's best interests to file the statement with the Service that the TMP cannot enter into a settlement agreement for that partner, particularly ff the TMP has substantially conflicting interests.

At the completion of the audit, the IRS must notify the TMP and notice partners of the resulting final partnership administrative adjustment (FPAA). The TMP must then notify all the other partners of the receipt of the FPAA. White may choose to do nothing and thus be bound by the FPAA. In such case, White's taxable income or credits would be adjusted in accordance with the FPAA.

White is a nonnotice partner. As a practical matter, he has little incentive to deny the TMP the right to enter into a settlement agreement, since he would be offered an administrative settlement consistent with that offered to the other partners. Further, he could not separately litigate the outcome of the FPAA.

Conclusion

Since White did not enter into agreement with other partners to form a 5% notice group, he must agree with settlements reached by the TMP. The formation of such a group should have been considered especially if the interests of the The conflict with White's interests, or if it is likely that the TMP would not contest the outcome of the audit.