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Since their enactment more than 25 years ago, the TEFRA partnership audit procedures have presented difficulties combining concept with reality. In no place has this produced a less reasoned result than in the determination of the applicable statute of limitations for adjustments of TEFRA partnership items. As a result, the current state of the law is strained interpretations with illogical results leading to opportunities for mistakes by both the taxpayers and the IRS.

The TEFRA partnership audit procedures were long sought by the IRS as a means to bring procedural order to the chaos that resulted from the tax shelter boom in the 1970s and 1980s. Even though many of these tax shelters were implemented through partnerships with many partners, the IRS was required to make determinations and monitor the statute of limitations for each partner individually. This led to different partners having different statutes of limitations and (frequently) different outcomes. The TEFRA procedures were designed to consolidate the determination of “partnership items” in a unified TEFRA partnership proceeding. This unified proceeding was then ostensibly subject to a unified partnership item statute of limitations. See 624 T.M., Audit Procedures for Pass-Through Entities, for a complete discussion of the TEFRA procedures.

The worthy concepts underlying the TEFRA procedures proved difficult to implement in practice. Difficult issues arose defining the boundaries between partnership items (which are determined in the unified proceeding), affected items (i.e., items which are not partnership items but which are affected by partnership item determinations and are necessarily determined after the end of the partnership proceeding), and nonpartnership items (which are not dependent in any way on the partnership item determinations). As the courts were struggling with these boundaries, the issue was presented as to whether the determination of the partnership item statute of limitations is itself a partnership item. Based more on a conceptual interpretation of the TEFRA procedures than a literal interpretation of the applicable statutes, the courts generally held that the partnership item statute of limitations is itself a partnership item to be determined in a partnership proceeding. See Davenport Recycling Assocs. v. Comr., 220 F.3d 1255 (11th Cir. 2000); Chimblo v. Comr., 177 F.3d 119 (2d Cir. 1999), cert. denied 120 S. Ct. 1159 (2000).

Unfortunately, the Tax Court chose to torpedo the conceptual underpinnings of TEFRA with a technical interpretation of the manner in which the partnership item period of limitations is computed. In Rhone-Poulenc Surfactants and Specialties, L.P. v. Comr., 114 T.C. 533 (2000), appeal dism'd 249 F.3d 175 (3d Cir. 2001), the Tax Court held that the partnership item period of limitations for the unified proceeding set forth in §6229 is not the exclusive period of limitations for partnership items, but rather, is only the minimum period. Therefore, according to the Tax Court, the period of limitations for adjusting an individual partner's partnership items is the longer of the unified §6229 period of limitations (which is based on the filing of the partnership return) or the individual partner's §6501 period of limitations (which is based on the filing of the partner's return with applicable extensions). In spite of its conceptual deficiencies, the position espoused by the Tax Court in Rhone-Poulenc has now been generally accepted by the courts.

The combination of these two lines of cases has resulted in a process for determining the applicable period of limitations for partnership items which can only be described as untenable. Because the partnership item statute of limitations has been interpreted to be a partnership item itself, the seemingly simple question of whether the notice of final partnership administrative adjustment (FPAA) was timely must be determined in the TEFRA partnership proceeding. Based on the technical interpretation in Rhone-Poulenc and its progeny, however, this statute of limitations determination requires two inquiries: (1) was the FPAA issued before expiration of the unified §6229 partnership statute of limitations; and (2) if not, was the FPAA issued before the expiration of every individual partner's §6501 period of limitations (as may have been extended with respect to partnership items). If the FPAA was not issued within the §6229 period of limitations, it is therefore necessary to examine every single partner's §6501 statute of limitations before a determination can be made that the FPAA was untimely. Since the partnership item statute of limitations is a partnership item, this examination of each partner's separate statute of limitations must be made in the unified partnership proceeding. This is exactly the type of partner-level determination that the TEFRA procedures were designed to avoid.

A change is needed to correct this untenable situation. The best remedy would be a legislative fix that overrules the Rhone-Poulenc interpretation of the partnership item statute of limitations. Failing that, it may be appropriate for the courts to revisit the conceptual interpretation of the TEFRA partnership statute of limitations as a partnership item. The unified proceeding is not the place to examine each individual partner's statute of limitations. A more rational solution would be to determine only the §6229 period in the unified TEFRA proceeding. The §6501 partner statute of limitations would then be determined in a partner-level proceeding, if necessary. Whatever the ultimate outcome, the current state of disarray will undoubtedly lead to errors by the IRS. These statute of limitations issues should be examined in detail any time the FPAA is issued more than three years after the partnership return has been filed.

For more information, in the Tax Management Portfolios, see Mather, 624 T.M., Audit Procedures for Pass-Through Entities, and in Tax Practice Series, see ¶3855, TEFRA Partnership Audit Procedures.