Originally published on Forbes.com Sept 19th, 2013
Jimastowlo Oil LLC, a recent Tax Court decision, illustrates how rules that are supposed to make things easier can make them harder. The preferred vehicle for tax shelters has been the partnership for a long time. Since it is partners, not partnerships, that pay taxes there was the potential for one bogus transaction to spawn a plethora of litigation. The solution for this was to require that certain determinations be made at the partnership level. The partnership would designate a “tax matters partners”, who would duke it out with the IRS over a final partnership administrative adjustment (FPAA). The final result is generally binding on all the partners.
The practical impact of this on individual taxpayers is that they need to take very seriously whatever shows up on their K-1s. Even things, like liability classification, that the partnership tax preparers were not paying much attention to. If something is a partnership item, it can only be adjusted at the partnership level. Taxpayers who want to fly in the face of their K-1s need to attach Form 8082 (Notice of Inconsistent Treatment).
The Case
In the case, there are two LLCs, treated as partnerships for tax purposes, Jimastowl Oil LLC and Oil Coming We Are Humming, LLC (Can’t make this stuff up.) Let’s call them JO and OC. Both JO and OC paid a corporation called Energytec for “working interests” in oil and gas leaseholds. Energytec apparently had quite a few of these “working interests” to peddle, since the ones JO and OC bought were designated “Income Program 105”, “Income Program 70″and “Income Program 107”. Energytec’s programs are actually part of what might be a more interesting story than the one I am telling, since there seems to be litigation indicating that Energytec was running a Ponzi scheme. According to the Tax Court decision, Energytec’s bankruptcy caused that litigation to go into suspense.
Big Fleas Have Little Fleas
A partnership can, itself, be a partner in another partnership (It can go deeper than that, with even more tiers, but you will start getting headache if you don’t already have one). When that happens, determinations about the lower-tier partnership have to be made at the level of that partnership. Of course, JO and OC were not partners in any partnerships. They owned “working interests” in oil and gas deals. JO and OC did not think those things were partnerships. Energytec, which presumably would have been the general partner, if there were partnerships, did not think the things were partnerships. The IRS did not think they were partnerships.
Surprise, Surprise, Surprise
As it turns, out the “Income Programs” were partnerships. Why is it that the “Income Programs” were partnerships ? The short answer is that the Tax Court says they were. Here is a bit of the longer answer. After much detail on the exact course of events we get:
Each LLC was, thus, a coowner with Energytec (and others) of a working interest in an oil and gas leasehold, which working interest entitled the coowners thereof to find and extract oil and gas. To exploit the working interest, the coowners had to cooperate. During the audit years, Energytec, acting as common agent, operated the wells on a cooperative basis for the working interest owners. No working interest owner could take his share of production in kind or sell it independently of the other owners. The coowners were not merely sharing expenses. They were jointly carrying on a trade or business and dividing the proceeds therefrom.
Where Does That Leave Us ?
The Tax Court made this helpful observation:
It is true that, had someone at or acting on behalf of Energytec determined that the well operations did create partnerships for its many joint drilling ventures (including those to which the LLCs were parties) and, on account of that determination, did file partnership returns on behalf of those relation ships, then the question of whether the well operations did, in fact, give rise to partnerships for Federal income tax purposes would appropriately be determined in partnership-level proceedings directed at the putative partnerships.
In other words, if Energytec was saying it had created a bunch of partnerships, the Tax Court could decide whether they had or not. Of course, that is not the situation. Instead, we get:
Whether we are precluded from deciding the substantive issues in these consolidated cases and, therefore, must dismiss the cases for lack of jurisdiction depends on whether for Federal tax purposes the well operations created entities separate from the coowners (including LLCs) of the working interests. If they did, and the entities are properly classified as partnerships, then the substantive issues involve partnership items or affected items, and all partnership items (including whether the part nerships are to be disregarded, e.g., as shams or for lack of economic sub stance) must be determined first in a partnership-level proceeding, before the consequences of any partnership-level determinations may be applied to the LLCs (i.e., to the partners).
I am really puzzled as to how the IRS and the taxpayers are supposed to unscramble this egg. The Tax Court apparently has just ruled that there are hundreds (?) of unfiled putative partnership returns with a default tax matters partner, which is in bankruptcy.
Everything I Know About Oil And Gas
I was going to say that everything I know about oil and gas, I learned from tax shelter salesmen. That is not strictly true. High net worth people and some not so high net worth people buy into oil and gas deals, which produce horrendously complicated K-1s. We do the best we can with them. The “working interest” exception to the passive activity loss rules was a sop thrown to the oil patch, which apparently relies heavily on New England dentists for its capital, when the Tax Reform Act of 1986 was passed. It appears that the IRS may have just been told by the Tax Court that there are about a zillion and one unfiled partnership returns out there. The penalties which are per K-1, per month might solve the deficit. We’ll see.
You can follow me on twitter @peterreillycpa.
Other Commentary
Monte Jackel seems to really like this decision:
It is at least a welcome sign that the Tax Court, in this case through Judge Halpern, does recognize that there may indeed be an issue with whether the check-the-box regulations have displaced the prior case law on what is a partnership and who is a partner.
Lew Taishoff also wrote a good analysis.
Frankly, this case is a little on the lawyerly side for the likes of me, but the practical implications for the simple minded people who do returns rather than structure deals makes me think that it deserves a bit more attention.