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Coordinated Issue - All Industries - Leveraged Oil and Gas Drilling Partnerships

LMSB4-0709-030
EFFECTIVE DATE:  JULY 31, 2009

UIL:  263.02-01

Note:  This issue paper is not an official pronouncement of the law or the position of the Service and can not be used, cited or relied upon as such.

This paper addresses the use of partnerships by investors (“Investors”) in certain drilling operations to claim losses and current deductions for intangible drilling and development costs (“IDC”) in amounts that exceed both the partnerships’ actual IDC and the Investors’ economic outlay.  The type of transaction described in this paper is structured by a third-party promoter (“Promoter”) that forms a partnership through which Investors participate in oil and gas drilling activities, which are conducted through contractual arrangement between the partnership and Promoter-controlled entities.  One Promoter-controlled entity is responsible for acquiring working interests in oil and gas wells (the “Promoter Exploration Company”), and another entity is designated as the party responsible for providing subcontracted drilling services for the wells (the “Promoter Turnkey Driller”).  Investors acquire interests in a partnership (“Partnership”) by contributing to Partnership a small amount of cash and a promissory note (“Investor Promissory Note,” or “IPN”).  Partnership then uses the cash contributed by Investors and a note collateralized by the IPNs (the “Driller Promissory Note”) to meet its payment obligations on the contract with the Promoter Turnkey Driller.  Partnership’s costs far exceed its income in its first year or years of existence.  Partnership passes through these losses to Investors.  Investors, through use of leveraging of their investment in Partnership, may claim these losses in excess of their cash contributions. 

Although many partnership investments in oil and gas ventures do not give rise to tax abuse or avoidance, the transactions described in this paper differ from non-abusive transactions in that Partnership overstates the amount of IDC deductions for which it is eligible, and in that Investors’ use of leveraging causes them to claim losses in excess of their economic losses.

This issue paper discusses the grounds for disallowing all or a portion of the IDC deductions and resulting losses claimed by Investors as a result of these transactions.

ISSUES

  1. Whether amounts claimed by Partnership as IDC deductions represent deductible IDC under § 263(c) of the Internal Revenue Code.
  2. Whether deductions claimed for IDC associated with turnkey drilling contracts meet the economic performance test of § 461(h) and the regulations thereunder.
  3. Whether Investor has sufficient basis in his Partnership interest under § 704(d) to deduct his share of Partnership losses.
  4. Whether Investor has sufficient amounts at risk under § 465 to deduct his share of Partnership losses.
  5. Whether, assuming the dollar thresholds and other criteria are met and reasonable cause and good faith elements are not otherwise met, accuracy related penalties under § 6662 should be asserted. 

CONCLUSIONS

  1. Amounts claimed as IDC by Partnership based on the “Turnkey Contract”  are not properly deductible as IDC under § 263(c).  Partnership may deduct as IDC under § 263(c) only its proportionate share of costs which are incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas.
  2. Amounts claimed as IDC associated with the Turnkey Contract do not meet the economic performance tests of § 461(h) and the regulations thereunder.
  3. Investor’s basis in his Partnership interest is limited to actual cash he contributes to the Partnership.  If Investor contributes an IPN to the Partnership, Investor’s basis in his partnership interest is increased only by the amount of any payments the Investor makes on the IPN, at the time he makes such payments.
  4. Investor does not have sufficient amounts at risk under § 465 to deduct Investor’s share of Partnership losses.
  5. Investor is subject to accuracy related penalties under § 6662.  If it is determined that the value or adjusted basis of any property claimed on a return is overstated by 400% or more of the amount determined to be the correct amount, the Investor may be liable for the 40% overvaluation penalty under § 6662(h)(2)(A).

DESCRIPTION OF TRANSACTION

In a leveraged oil and gas drilling partnership transaction, a promoter (“Promoter”) forms a general partnership (“Partnership”) to participate in the drilling of oil and gas wells located primarily in the United States and for the production and sale of hydrocarbons.  Partnership acquires a non-operating working interest in a collection of wells from a Promoter entity.  Partnership uses the accrual method of accounting.  Investors (“Investor” in the singular, “Investors” in the plural) purchase units in Partnership for the right to share in any profits from Partnership’s wells.  As a result of Partnership’s ownership of a non-operating working interest, the Investors are entitled to their proportionate share of IDC deductions.   Promoter informs prospective investors that, for federal tax purposes, Partnership will be classified as a partnership. 

Investment in Partnership

An Investor acquires an interest in Partnership with a combination of cash and debt.  The face amount of an Investor’s note (the “Investor Promissory Note,” or “IPN”) exceeds the amount of cash he contributes.  The amount by which the IPN exceeds Investor’s cash investment varies, but typically the debt-to-cash ratio is within a range of 2-to-1 to 4-to-1.

The IPN has a term ranging from 15 to 20 years and bears interest at or above a market rate (typically, 6% to 8%).  Payment of the principal balance is due at the end of the term.  Interest is typically payable annually or semi-annually out of Partnership’s profits.  If Partnership’s profits are insufficient to cover Investor’s interest obligation, in some cases the interest accrues unpaid until the end of the IPN’s term, and in other cases either Investor must make interest payments out of pocket, or Partnership is required to obtain outside financing to offset Investor’s interest obligations.  Investor’s liability for the IPN is fully recourse, and is secured by Investor’s interest in Partnership and Investor’s rights to profits from Partnership.  Payment of the IPN principal and interest is typically made first out of Investor’s share of Partnership profits, but Partnership looks to Investor to pay any portion of the IPN not covered by Investor’s share of profits.  In some cases, if a successful well is drilled, the IPN can be converted for a fee to a nonrecourse obligation to the extent of Investor’s allocable share of anticipated profits from the well.

Partnership’s balance sheet generally shows the Investor Promissory Notes as the majority of its assets, and usually classifies the IPNs as “Accounts Receivable.”  In some cases, however, the IPNs are shown as assets in other areas of Schedule L.  Partnership’s balance sheet includes the face amount of the Investor Promissory Note in the total amount of capital contributed to the Partnership.  In the year the IPN is contributed to capital, Partnership often presents the contribution on Schedule M-2 as a cash contribution.

Partnership’s Operation

Partnership, through a Managing Partner,  signs a prospect agreement (“Prospect Agreement”) with an entity owned or controlled by Promoter (the “Promoter Exploration Company”).  The Prospect Agreement assigns working interests in oil and gas leases held by the Promoter Exploration Company to Partnership.  The Promoter Exploration Company is not the leasehold Operator of those properties, but rather holds non-operating working interests.  Partnership typically does not allocate any amount paid for the leasehold assigned under the Prospect Agreement to reflect the acquisition of working interests.  In addition, Partnership’s balance sheet (Schedule L) typically does not reflect the acquisition of interests in oil and gas properties. 

The Partnership enters into an agreement based on a document entitled “Turnkey Contract” with another entity owned or controlled by the Promoter (the “Promoter Turnkey Driller”) to drill oil and gas wells on the leasehold for a fixed price.  Partnership pays “management fees” and “overhead costs” to the Promoter Turnkey Driller under the Turnkey Contract.  Partnership prepays the Promoter Turnkey Driller for a portion of its drilling services at the time the parties execute the Turnkey Contract.  Partnership’s prepayment consists of both cash (from the cash contributed by Investors) and a note (the “Driller Promissory Note,” or DPN). 

Similar to the Investor Promissory Notes, the terms of the DPN can vary from one Partnership to another, but in most cases the DPN issued by a particular Partnership has the same maturity date and interest rate as the IPNs contributed by that Partnership’s Investors.  The DPN is secured by Partnership’s assets, including the unpaid balance of the IPNs.  Further, Investors assume personal liability for their pro rata share of the DPN, to the extent of the unpaid balance of their IPN.  In some cases, an Investor’s personal liability is provided for in the terms of his IPN, and in other cases the Investor assumes personal liability by entering into a separate Assumption Agreement with the Promoter Turnkey Driller.  The Promoter Turnkey Driller, which uses the cash method of accounting, includes the cash received from Partnership in income, but does not include any unpaid amount of the Driller Promissory Note.

In many cases, however, the Promoter Turnkey Driller is a shell entity with no employees or equipment of its own, and the Turnkey Contract is not a true turnkey contract.  Any actual drilling is performed under agreements between unrelated drilling contractors and the leasehold Operator.  Neither the Promoter Turnkey Driller, nor the Promoter, nor the Promoter Exploration Company, nor Partnership is a signatory to these agreements or in anyway is responsible for causing the wells to be drilled.  Furthermore, the leasehold Operator of the wells is generally unaware of the transfer of working interest from Promoter Exploration Company to Partnership and, thus, will continue to look to Promoter Exploration Company for payment of its proportionate share of costs associated with the drilling and operation of the wells.   

Variations

Variations exist to the transaction described above and some possible variations include: 

Terms of the IPNs and DPNs

In some cases, Investor is given an option to extend the term of the IPN, and/or Partnership is given an option to extend the term of the DPN.  Extension options can vary from 5 to 15 years, and generally require that some form of payment be made in order to exercise the option, either in the form of an outright fee, or as a partial prepayment on the note’s principal.  In many of the cases that provide for an extension, Investor, in the case of an IPN, or Partnership, in the case of a DPN, must also purchase an investment instrument (generally, a zero coupon bond or other marketable security, often referred to in Partnership’s agreement and related documents as a “debt instrument”) with a value at maturity equal to a substantial percentage of the unpaid obligation, and with a maturity date no later than the end of the extended term. 

In some cases, the terms of the DPN provide that 50% of the unpaid balance of the DPN is payable out of Partnership’s net profits.  In these cases, it is unclear if this provision is intended to limit 50% of Partnership’s liability to its profits, or if the term merely establishes a priority of payment sources for the DPN.

In some cases, Investor is given the right to contribute marketable securities to Partnership in partial satisfaction of its liability for the IPN and/or the DPN.  Alternatively, in some cases, at the time of subscription a portion of Investor’s initial cash contribution to Partnership is designated for the purchase of a zero coupon bond sufficient to cover a portion of the IPN at maturity. 

Form of Partnership

In some cases, upon completion of all drilling, Partnership’s agreement allows for Partnership to be converted from a general partnership to either a limited partnership or a limited liability company.

Investor and Promoter Activity (Informal Agreements)

In some cases, notwithstanding the terms of the agreements executed by Investors and Promoter, extrinsic evidence indicates that Investors and Promoter have an understanding that the Investor Promissory Notes will not be enforced against Investors beyond Investors’ contributions to Partnership.  Investors and Promoters in these cases often have a similar understanding that the Driller Promissory Notes will not be enforced against Investors.  In some cases, consistent with this understanding, there is no evidence of Promoter enforcing collection on the Investor Promissory Notes, either at maturity or thereafter, when Investor’s profits from Partnership prove insufficient to cover payment of the IPN.  In other cases, however, Promoter does enforce the terms of the IPNs against Investors.  Therefore, the facts of each case must be examined carefully to determine whether the IPN and DPN are treated by both parties as truly recourse to Investor.

Drilling Activity

With respect to Partnership’s working interests, in some cases there are significant variances between actual drilling and drilling activity claimed.  For example, in some cases wells are drilled prior to Partnership’s formation.  In other cases, wells are drilled beyond 90 days after the end of the tax year in which IDC were claimed.  In still other cases, there is no evidence of any drilling activity at all. 

Discussion

Issue 1 – Deduction of Entire Investment as IDC and Other Expenses 

Section 263(a) generally disallows a deduction for capital expenditures.  However, § 263(c) provides that, except as provided in § 263(i), under regulations prescribed by the Secretary, a taxpayer may elect to deduct as current expenses intangible drilling and development costs (“IDC”) in the case of oil and gas wells.  Section 263(i) requires that IDC paid or incurred with respect to a well located outside the United States must either be capitalized or deducted ratably over a ten-year period; however, costs paid or incurred with respect to a nonproductive well are not subject to the requirement of § 263(i).

Treas. Reg. § 1.612-4 implements § 263(c) to permit an "operator" (one who holds a working or operating interest in an oil and gas property) to elect to deduct IDC in the case of oil and gas wells, in lieu of capitalizing such costs.  This IDC option applies to all expenditures made by an operator for wages, fuel, repairs, hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas.  IDC includes the cost to operators of any drilling or development work (excluding amounts payable only out of production or gross or net proceeds from production, if such amounts are depletable income to the recipient, and amounts properly allocable to the cost of depreciable property) done for them by contractors under any form of contract, including turnkey contracts.

Rev. Rul. 73-211, 1973-1 C.B. 303, provides that a taxpayer's investment in an oil and gas venture under a contract designating a dollar amount as IDC is deductible pursuant to an election under § 263(c) only to the extent that the costs would have been incurred in an arms-length transaction with an unrelated drilling contractor.  Therefore, if Partnership acquires both a working interest in oil and gas and certain rights to the performance of drilling services, the portion of the total investment allocable to the drilling services, and therefore deductible as IDC, is limited to that amount that would otherwise be incurred in an arm’s length transaction with an unrelated drilling contractor.  See also, Bernuth v. Commissioner, 57 T.C. 225 (1971), aff’d, 470 F.2d 710 (2nd Cir. 1972), and Rev. Rul. 75-304, 1975-2 C.B. 94. 

In the transactions described in this issue paper, the arm’s-length transaction with an unrelated drilling contractor is represented by the agreement between the drilling contractor and the leasehold Operator, not by the Turnkey Contract.  In these transactions, the amounts claimed by the Investors through Partnership as IDC are associated with the Turnkey Contract, but these amounts do not represent IDC if they are not expenditures incident to and necessary for the drilling of the wells or the preparation of the wells for the production of oil or gas.  Rather, the Investors through the Partnership would be able to claim as IDC an appropriate proportionate amount of those expenditures incurred pursuant to the agreements between the leasehold Operator and the unrelated drilling contractors with respect to those wells.  The IDC would be deductible no sooner than the taxable year or years the leasehold Operator paid the unrelated drilling contractors.  Rev. Rul. 80-71, 1980-1 C.B. 106.  For further discussion regarding the timing of the IDC deductions, please see Issue 2 below. 

Issue 2 - Economic Performance and Clear Reflection of Income

IDC deductions under § 263(c) must be taken in accordance with a taxpayer’s method of accounting.  Section 461(a).  Partnership in these cases uses the accrual method of accounting, which provides that expenses are deductible when all events have occurred to fix the liability and income is taxable when received or earned.  Section 461(h).

Section 461(h)(1) provides that, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test applicable to accrual basis taxpayers will not be treated as having been met any earlier than when "economic performance" with respect to such item occurs.  For purposes of § 461(h), the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of the liability can be determined with reasonable accuracy.  Section 461(h)(4) and Treas. Reg. § 1.461-4.

Section 461(h)(2)(A) provides that, except as otherwise provided in the regulations, if a taxpayer’s liability for payment arises out of (1) the providing of services to the taxpayer by another person, economic performance occurs as the person provides the services, (2) the providing of property to the taxpayer by another person, economic performance occurs as the person provides the property, and (3) the use of property by the taxpayer, economic performance occurs as the taxpayer uses the property. 

Treas. Reg. § 1.461-4(d) provides, in pertinent part, that, except as otherwise provided in paragraph (d)(5) of that section (relating to liabilities that are assumed in connection with the sale of a trade or business), if the liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided. 

Treas. Reg. § 1.461-4(d)(7) provides examples which illustrate when economic performance occurs.  Example 4 provides an example pertaining to turnkey drilling contracts.  In that example, LP1, a calendar year, accrual method limited partnership, owns the working interest in a parcel of property containing oil and gas.  During December 1990, LP1 enters into a turnkey contract with Z Corporation pursuant to which LP1 pays Z $200,000 and Z is required to provide a completed well by the close of 1992.  In May 1992, Z commences drilling the well, and, in December 1992, the well is completed.  The example concludes that economic performance with respect to LP1's liability for drilling and development services provided to LP1 by Z occurs as the services are provided.  Consequently, $200,000 is incurred by LP1 for the 1992 taxable year.  Thus, economic performance with respect to IDC incurred under a turnkey drilling contract is deemed to occur only as the well is drilled and prepared for production, regardless of when a contract is entered into. 

Section 461(i)(2)(A) provides that, in the case of a “tax shelter,” economic performance with respect to amounts paid during the taxable year for drilling an oil or gas well shall be treated as having occurred within a taxable year if drilling of the well commences before the close of the 90th day after the close of the taxable year.

Section 461(i)(3) defines the term "tax shelter" to include (1) any enterprise (other than a C corporation) if, at any time, interests in the enterprise have been offered for sale in any offering required to be registered with any Federal or state agency having the authority to regulate the offering of securities for sale (2) any syndicate within the meaning of § 1256(e)(3)(B), or (3) any tax shelter (within the meaning of § 6662(d)(2)(C)) which requires that a significant purpose of the transaction be tax avoidance or evasion.  A "syndicate" is defined by § 1256(e)(3)(B) to mean “any partnership or other entity (other than a corporation which is not an S corporation) if more than 35% of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of Section 464(e)(2)).”  Section 464(e)(2) defines a "limited entrepreneur" as any person who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of the enterprise. 

In the transactions at issue, although Investors generally are not limited partners, Investors also do not actively participate in the management of Partnership.  In fact, Partnership’s partnership agreement restricts participation significantly in most instances.  Thus, Investors are always either “limited partners” or “limited entrepreneurs” as those terms are defined in § 464(e)(2).  Therefore, in any case in which Partnership allocates 35% or more of its losses to Investors during a taxable year, Partnership is a “syndicate” within the meaning of § 1256(e)(3)(B), and therefore a “tax shelter” for purposes of § 461(i)(2)(A) and (i)(3).

If the facts in a case indicate that tax avoidance was a key element in Investor’s investment in Partnership, Partnership may also fit the definition of a tax shelter under § 6662(d)(2)(C).  The term "tax shelter," as it is defined in § 6662(d)(2)(C), refers to a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of federal income tax.  See § 6662(d)(2)(C)(ii). See also Treas. Reg. § 1.6662-4(g)(2).  

For tax shelters within the meaning of § 461(i)(2)(A), economic performance with respect to prepaid drilling expenses is deemed to occur in the taxable year of prepayment if drilling commences before the close of the 90th day after the close of the taxable year.   Prepayments for drilling services do not meet the economic performance requirement under this provision unless the services for which payment is rendered are actually performed before the close of the 90th day after the taxable year in which the prepayment is made.

Partnership’s payments of IDC are deductible under § 263(c) only if economic performance has occurred under the rules of § 461.  Agents should verify that the drilling services giving rise to a claimed IDC deduction were in fact performed no later than the 90th day of the year following the taxable year of IDC prepayment.  In those cases in which drilling does not occur until after the 90th day of the year following the taxable year of the IDC deduction, economic performance has not occurred, and an IDC deduction is not available.

Issue 3 – Losses are Limited to Partner’s Basis in his Partnership Interest

Limitation on Losses

Under § 704(d), a partner's distributive share of partnership loss is allowable only to the extent of the adjusted basis of such partner's interest in the partnership at the end of the partnership year in which such loss occurred.  Section 704(d) suspends all losses that exceed a partner’s outside basis in the partnership and allows such losses when and to the extent a partner has sufficient basis at the end of the partnership year.

If a partnership is a tax shelter defined in § 461(i)(3), IDC deductions that are allowable by reason of § 461(i)(2)(A) (that is, deductions relating to amounts paid within the 90 days following the close of the taxable year for which the IDC deduction is claimed, but not those deductions that relate to amounts paid during the actual taxable year) are limited by § 704(d) to a partner’s “cash basis” rather than his “adjusted basis.”  Section 461(i)(2)(B).  A partner's “cash basis” in his partnership interest, for this purpose, is equal to the adjusted basis of his interest in the partnership, determined without regard to (i) any liability of the partnership, and (ii) any amount borrowed by the partner with respect to such partnership which was arranged by the partnership or by any person who participated in the organization, sale, or management of the partnership (or any person related to such person within the meaning of § 465(b)(3)(C)), or was secured by any asset of the partnership.

Partner’s Basis in a Partnership

Section 705 provides that the adjusted basis of a partner’s interest in a partnership is determined under § 722 (in the case of a contribution), subject to certain increases and decreases arising from the pass through by the partnership of certain types of income, losses, deductions, and credits. 

Section 722 provides that a contributing partner’s basis in a partnership interest, in the case of a contribution of property, is the adjusted basis of the contributed property to the contributing partner at the time of its contribution.  Section 723 provides that a partnership’s basis in contributed property is the adjusted basis of such property in the hands of the contributing partner at the time of the contribution, increased by any gain recognized by the contributing partner under § 721(b) upon the property’s contribution.

Rev. Rul. 80-235,1980-2 C.B. 229, provides that a contributing partner does not increase basis in his partnership interest under § 722 by contributing his own note until such time, and in such amounts, as he makes payments on the note.  Likewise, under Section 723, the partnership’s inside basis in the contributed note is zero, until such time as the contributing partner makes payments on the note.  Consistent with Rev. Rul. 80-235, the Ninth Circuit held in Levy v. Commissioner, 732 F.2d 1435, 1437 (9th Cir. 1984), that a partner cannot deduct expenses allocated to him in excess of his cash contributions to the partnership. In so holding, the Court expressly rejected the partner's assertion that the promissory notes he had issued to the partnership should be treated as additional capital contributions to the partnership.  The Court stated in this regard that promissory notes "do not give rise to equity in the partnership.  Such notes represent only a promise to pay and not the paying out or reduction of assets." See also, e.g., Gemini Twin Fund III v. Commissioner, T.C. Memo 1991-315 (1991), aff’d unpub. Opinion (9th Cir. 1993) (partner’s contributed note has zero basis); Oden v. Commissioner, T.C. Memo 1981-184 (1981), aff’d unpub. opinion (4th Cir. 1982) (partner’s outside basis in his partnership interest not increased by contribution of note due to zero basis in note).

Section 752(a) provides that any increase in a partner’s share of the liabilities of a partnership, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership.  Thus, a deemed contribution of money by a partner under § 752(a) will increase the partner’s basis in its partnership interest under § 722 by the amount of the deemed contribution.  However, not all obligations of a partnership are “liabilities” for purposes of § 752(a), and therefore not all partnership obligations, when assumed by a partner, increase the partner’s basis under § 722.

Whether an item is a liability of the partnership is determined under the definition set forth in Treas. Reg. § 1.752-1(a)(4)(i) for items incurred or assumed by a partnership on or after June 24, 2003.   Under this definition, a liability is any obligation only if, when, and to the extent that incurring the obligation (A) creates or increases the basis of any of the obligor’s assets (including cash); (B) gives rise to an immediate deduction to the obligor; or (C) gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital.

Regardless of whether an item is a § 752 liability, a taxpayer may not include in his basis a liability that, for any economic reason, does not constitute a genuine debt.  Estate of Upham v. Commissioner, 923 F.2d 1328, 1335 (8th Cir. 1991), aff'g T.C. Memo. 1989-253; Estate of Baron, 798 F.2d at 68-69; Chamberlain v. Commissioner, T.C. Memo. 1987-20.  When debt used to purchase an asset is unlikely to be paid by the taxpayer, the debt does not represent a bona fide capital investment by the taxpayer and will be excluded from the basis of the asset.  Estate of Upham, 923 F.2d at 1335; Durkin v. Commissioner, 872 F.2d 1271, 1276 (7th Cir. 1989), aff'g 87 T.C. 1329 (1986); Estate of Baron v. Commissioner, 83 T.C. 542, 550-53 (1984), aff'd, 798 F.2d 65 (2d Cir. 1986).  A debt may be considered as unlikely to be paid by the taxpayer when the principal is to be paid solely out of exploitation proceeds; the loan is nonrecourse, shielding the taxpayer from personal liability; and the purchase price of the asset unreasonably exceeds its fair market value.  Durkin, 872 F.2d at 1276; Estate of Baron, 83 T.C. at 550- 53.  The rationale for excluding such debt from basis is that the taxpayer is not entitled to enjoy benefits for which there has been no economic incentive or expectation of repayment.  Estate of Baron, 798 F.2d at 68-69; Estate of Franklin, 544 F.2d at 1048-49.

The Investor Promissory Note

The amount of IDC deductions Investor can claim is limited under § 704(d) to the amount of Investor’s basis in his Partnership interest.  Under Rev. Rul. 80-235, Investor cannot increase his basis in Partnership by the amount of the Investor Promissory Note until such time as Investor makes principal payments on the IPN.  Therefore, in determining the amount of the claimed IDC deduction available to an Investor, agents should verify that Investor’s claimed basis in Partnership does not include the unpaid portion of the IPN.

The Driller Promissory Note

In most cases, Investor should not be able to claim an increase in basis in his Partnership interest by the amount of his share of the Partnership’s obligation under the “Driller Promissory Note.”  Several different provisions in the Code and case law compel this result. 

First, Partnership’s obligation under the Driller Promissory Note in most cases will not meet the definition of a § 752 liability, as set forth in Treas. Reg. § 1.752-1(a)(4)(i).  The DPN is effectively an obligation to make payments to the Promoter Turnkey Driller for future services; therefore, the payments will be deductible by the Partnership as they are made, but the DPN does not increase the Partnership’s basis in its assets, does not give rise to an immediate deduction, and does not give rise to an expense that is properly chargeable to capital.  Under this analysis, the Driller Promissory Note is not a liability of the Partnership for § 752 purposes, and therefore the Investor cannot increase his basis by the amount of his share of the obligation.

Second, even if the Driller Promissory Note is a § 752 liability, the special rules for tax shelters under § 461(i), as they apply in coordination with § 704(d), will prevent an Investor from including his share of the obligation represented by the DPN in his basis in his Partnership interest when determining the allowable amount of Investor’s IDC deduction.  As concluded in the discussion under Issue 3, supra, Partnership meets the definition of a “tax shelter” set forth in § 461(i)(2)(A).  Therefore, Investor’s IDC deduction, if it relates to drilling taking place within the 90-day period after the close of the taxable year for which the deduction is claimed, is limited by § 461(i)(2)(B) to his “cash basis” in Partnership, which excludes by definition any § 752 liabilities of Partnership.

Finally, in some cases either the Investor Promissory Notes or the Driller Promissory Notes, or both, may not constitute genuine debt.  The facts may indicate the notes are not genuine if the IPN and/or the DPN are effectively unenforceable against Investor (i.e., extrinsic evidence or the terms of the IPN or DPN themselves preclude the ability of Promoter to pursue Investor personally for payment on the IPN or DPN), the note will be paid solely out of profits earned by Partnership, and the note overstates the value of the property or services for which it is given in payment.  However, the presence of these factors will not in all cases necessitate a conclusion that the debt is not genuine.  See Estate of Franklin v. Commissioner, 544 F.2d 1045, 1047 (9th Cir.1976).  Agents should be aware that finding and proving the presence of these factors may be difficult in most cases; in particular, although extrinsic evidence in some cases indicates Promoter assured Investor he would not be pursued for payment on the IPN or DPN, Promoter may nonetheless have intended to enforce the note personally against Investor (as indicated by one or more cases in which a Promoter has, in fact, filed a suit for payment against an Investor).  However, where the facts in a case indicate clearly that the IPN or DPN is not regarded by either of the parties as true debt, the applicability of this argument should be considered.

Issue 4 - Amounts at Risk under Section 465

Section 465 generally limits deductions for losses in certain activities to the amount for which the taxpayer is at risk.  In the case of an individual taxpayer and certain types of C corporations,  § 465(a) provides that a loss arising from an activity for a taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk (within the meaning of § 465(b)) for such activity at the close of the taxable year.  Section 465(c)(3) provides that § 465(a) applies to all activities engaged in by the taxpayer in carrying on a trade or business or for the production of income.

Section 465(b)(1) provides that a taxpayer is considered at risk for an activity with respect to amounts including (A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and (B) amounts borrowed with respect to such activity.  Under § 465(b)(2), a taxpayer is considered at risk for an activity with respect to amounts borrowed for use in an activity to the extent that the taxpayer (A) is personally liable for the repayment of such amounts, or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the net fair market value of the taxpayer’s interest in such property). 

However, under § 465(b)(3), amounts borrowed for use in an activity will not increase the amount for which a taxpayer is at risk if the amount is borrowed from a person having an interest other than as a creditor in the activity.  Section 465(b)(3)(A) provides that, except to the extent provided in regulations, amounts borrowed shall not be considered to be at risk with respect to an activity if the amounts are borrowed from any person who has an interest in the activity, or if the amounts are borrowed from a person related to a person (other than the taxpayer) having an interest in the activity.  Section 465(b)(3)(C) provides that persons are related if they bear a relationship described in § 267(b) or § 707(b)(1), or if they are engaged in trades or businesses under common control.  Treas. Reg. § 1.465-8(a)(1) provides that this rule applies even if the borrower is personally liable for the repayment of the loan or the loan is secured by property not used in the activity.  Section 465(b)(3)(B)(i) provides that § 465(b)(3)(A) does not apply to an interest as a creditor in the activity.  Treas. Reg. § 1.465-8(b) provides that, for purposes of applying § 465(b)(3)(A), a person shall be considered a person with an interest in the activity other than that as a creditor only if the person has either a capital interest in the activity or an interest in the net profits of the activity.  Under Treas. Reg. § 1.465-8(b)(2), a capital interest in an activity is an interest in the assets of the activity which is distributable to the owner of the capital interest upon the liquidation of the activity.  Treas. Reg. § 1.465-8(b)(2) provides further that the partners of a partnership are considered to have capital interests in the activities conducted by the partnership. 

Under Treas. Reg. § 1.465-8(b)(3), it is not necessary for a person to have any incidents of ownership in the activity in order to have an interest in the net profits of the activity.  For example, an employee or independent contractor any part of whose compensation is determined with reference to the net profits of the activity will be considered to have an interest in the net profits of the activity.

Section 465(b)(4) provides that, notwithstanding the other provisions of § 465, a taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.  In applying § 465(b)(4), the Tax Court generally considers whether the taxpayer faces any “realistic possibility of economic loss,” and in at least one case has considered long-term notes unlikely to be repaid as presenting no such realistic possibility. Levien v. Commissioner, 103 T.C. 120
(1994), aff'd, 77 F.3d 497 (11th Cir. 1996). 

However, the circuits differ in how they apply § 465(b)(4).  The Second, Eighth, Ninth, and Eleventh Circuits look to the underlying economic substance of an arrangement and the commercial realties of a transaction to see if it “is structured—by whatever method—to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable.”  American Principals v. United States, 904 F.2d 477, 483 (9th Cir. 1989).  See also Waters v. Commissioner, 978 F.2d 1310, 1316 (2nd Cir. 1992), Young v. Commissioner, 926 F.2d 1083, 1089 (11th Cir. 1991), and Moser v. Commissioner, 914 F.2d 1040 (8th Cir. 1990).  In contrast, the Sixth Circuit has adopted a worst-case scenario approach and determined that the issue of whether a taxpayer is “at risk” for purposes of § 465(b)(4) “must be resolved on the basis of who realistically will be the payor of last resort if the transaction goes sour and the secured property associated with the transaction is not adequate to pay off the debt.”  Emershaw v. Commissioner, 949 F.2d 841, 845 (6th Cir. 1991), quoting Levy v. Commissioner, 91 T.C. 838, 869 (1988). 

Whether one or more of the provisions of § 465 will apply to limit the availability to Investors of a current deduction depends heavily on the terms of the IPN and DPN at issue, as well as any surrounding facts or extrinsic evidence.  Therefore, agents should look closely at the terms of the notes of a transaction in considering whether to apply a provision of § 465.

Section 465(b)(2) limits the at-risk amount of an Investor, with respect to the IPN and allocable share of the DPN (collectively, “Investor’s Debt”), to the amount for which Investor is personally liable or has pledged as security property that is not used in the activity at issue.  Agents should consider the terms of the IPN and DPN and any related agreements (such as an Assumption Agreement) to determine to what extent Investor has personal liability.  In some cases, the terms of these documents will make Investor personally liable for all or part of Investor’s Debt.  In other cases, however, Investor’s liability may in fact be limited, notwithstanding statements in the documentation of Investor’s Debt that the debt is recourse.  For example, if some portion of Investor’s Debt is payable only out of Partnership’s profits, or only out proceeds from an associated zero coupon bond, Investor is not personally liable for that portion, and therefore not at risk under § 465(b)(2).

In addition, § 465(b)(3) may be applicable to limit at-risk amounts for Investors with respect to the Driller Promissory Notes.  Section 465(b)(3) will apply to those cases in which Promoter or a Promoter-controlled entity is both the creditor on the DPN and a partner in Partnership. Revenue agents are most likely to find such a fact pattern in cases in which Partnership’s Managing Partner is related to Promoter Turnkey Driller within the meaning of § 465(b)(3)(C).  If such a relationship exists, none of Partnership’s Investors will be at risk with respect to the DPN, even if the Investors are personally liable for the DPN under § 465(b)(2) analysis. 

Finally, § 465(b)(4) may also be applicable in some cases.  Depending on the governing circuit, agents should consider whether the terms of the IPN, DPN , and any associated Assumption Agreement prevents Investor from facing any “realistic possibility of economic loss.”   In some cases, Investor’s ultimate payment liability may be limited to his allocable share of Partnership’s profits.  Alternatively, in those cases in which Investors can contribute zero coupon bonds in partial or total satisfaction of Investor’s Debt, Investor’s liability may be limited to the excess of Investor’s Debt over the value at maturity of the bond. 
 
At risk recapture

Under § 465(e), if zero exceeds the amount for which the taxpayer is at risk in any activity at the close of any taxable year, the taxpayer shall include in his gross income for such taxable year (as income from such activity) an amount equal to such excess. 

In most cases, Investor assumes personal liability for the Investor Promissory Note and a portion of the Driller Promissory Note.  However, in at least some of those cases Investor is given an option to extinguish some or all of his liability by one or more means.  By operation of the rules under § 465, if Investor terminates his personal liability by one of these means, in most cases Investor’s amount at risk is reduced by the amount of personal liability terminated.  In such cases, § 465(e) will apply to require Investor to recapture any previous Partnership loss he claimed, to the extent the reduction in Investor’s at-risk amount goes below zero.

Issue 5 - Application of Penalties

Sections 6662(a) and (b) impose an accuracy-related penalty in an amount equal to 20 percent of the portion of an underpayment attributable to, among other things: (1) negligence or disregard of rules or regulations, (2) any substantial understatement of income tax, and (3) any substantial valuation misstatement.  Section 6662(h) imposes a penalty of 40 percent on the portion of an underpayment attributable to a gross valuation misstatement where the value or basis of any property is overstated by 400 percent or more.  Stacking of the accuracy-related penalties is not permitted.  Thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is 20 percent (40 percent in the case of a gross valuation misstatement), even if that portion of the underpayment is attributable to more than one type of misconduct (e.g., negligence and substantial valuation misstatement). See § 1.6662-2(c).

A. Negligence or Disregard of the Rules or Regulations
 
Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code or to exercise ordinary and reasonable care in the preparation of a tax return. See § 6662(c) and § 1.6662-3(b)(1).  Negligence also includes the failure to do what a reasonable and ordinarily prudent person would do under the same circumstances.  Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff'g 43 T.C. 168 (1964).  Negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return that would seem to a reasonable and prudent person to be "too good to be true" under the circumstances.  Section 1.6662-3(b)(1)(ii).  Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993) (penalty for negligence was imposed on underpayment resulting from transaction that lacked economic substance).  When an investment has such obviously suspect tax claims as to put a reasonable taxpayer under a duty of inquiry, a good faith investigation of the underlying viability, financial structure, and economics of the investment is required.  Keller v. Commissioner, T.C. Memo 2006-131 (citing Laverne v. Commissioner, 94 T.C. 637, 652-653).  

The term "disregard" includes any carelessness, reckless or intentional disregard of rules or regulations.  A disregard is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to a rule or regulation.  A disregard is reckless where the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances which are a substantial deviation from the standard of conduct observed by a reasonable person.  Additionally, a disregard is intentional where the taxpayer has knowledge of the rule or regulation that it disregards.  Treas. Reg. § 1.6662-3(b)(2).

"Rules or regulations" include the provisions of the Code, temporary or final Treasury regulations, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin.  Treas. Reg. § 1.6662- 3(b)(2).  Therefore, if the facts indicate that a taxpayer took a return position contrary to any published notice or revenue ruling, the taxpayer may be subject to the accuracy related penalty for an underpayment attributable to disregard of rules and regulations, if the return position was taken subsequent to the issuance of the notice or revenue ruling.

The accuracy related penalty for disregard of rules and regulations will not be imposed on any portion of underpayment due to a position contrary to rules and regulations if:  (1) the position is disclosed on a properly completed Form 8275 or Form 8275-R (the latter is used for a position contrary to regulations) and (2), in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of a regulation.  Treas. Reg. § 1.6662-3(c).  This adequate disclosure exception applies only if the taxpayer has a reasonable basis for the position and keeps adequate records to substantiate items correctly. Treas. Reg. § 1.6662-3(c)(1).  Moreover, a taxpayer who takes a position contrary to a revenue ruling or a notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.  Treas. Reg. § 1.6662-3(b)(2).

In most cases, the facts indicate that the Investors, who generally have no experience in oil and gas exploration, undertook no due diligence before or after investing in these ventures beyond what was provided by the promoter or his agents.  If there is no indication that the Investors made any attempt to ascertain the correctness of the tax treatment of their investments, including by obtaining independent advice from a tax advisor, despite the fact that the Promoters promised in many cases that the investors would receive tax deductions of several times the amount of cash invested, a penalty for disregard of rules or regulations may be appropriate.  For example, the penalty may be appropriate if the limitation on partnership basis under the analysis in Rev. Rul. 80-235 or the limitations on deduction imposed by the at-risk rules of § 465 apply clearly to an Investor, yet the Investor nonetheless claims deductions in excess of these limits without conducting any inquiry into whether such deductions are proper. 

The negligence penalty is appropriate where a taxpayer reports losses from a transaction which greatly exceed his investment.  The Third Circuit, in sustaining the accuracy-related penalty due to negligence explicitly warned that when “a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril."  Neonatology Associates, P.A., et al. v. Commissioner, 299 F.3d 221 (3d Cir. 2002), aff'g 115 T.C. 43.

In many of these transactions, the Investors report losses that to a reasonable and prudent person would seem to be "too good to be true."  However, aside from promises made by the Promoter, there is little if any indication that Investors undertook investigation of the tax aspects of the transaction or that the Investors sought advice from tax professionals independent of the Promoter.  In such cases, an accuracy-related penalty attributable to the negligence or disregard of rules or regulations is generally appropriate unless the taxpayer acted with reasonable cause and in good faith.

B. Substantial Understatement of Income Tax

Section 6662(a) and (b)(2) provides that a 20 percent accuracy-related penalty applies to any portion of an underpayment for which there is a substantial understatement of income tax.  A substantial understatement of income tax exists for a taxable year of a non-corporate taxpayer if the amount of understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. Section 6662(d)(1)(A).  In many cases, the understatement attributable to the disallowance of the losses claimed exceeds this threshold amount.  Therefore, an accuracy-related penalty attributable to a substantial understatement may be applicable.

Specific rules apply to the calculation of the understatement when any portion of the understatement arises from an item attributable to a tax shelter.  For purposes of § 6662(d)(2)(C), a tax shelter is a partnership or other entity, an investment plan or arrangement, or other plan or arrangement where a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax.  Section 6662(d)(2)(C)(iii).  Because a significant purpose in forming the Partnerships is tax avoidance, the Partnerships are tax shelters pursuant to § 6662(d)(2)(C).

In the case of any item of a non-corporate taxpayer attributable to a tax shelter, understatements are generally reduced by the portion of the understatement attributable to:  (1) the tax treatment of items for which there was substantial authority for such treatment, and where (2) the taxpayer reasonably believed that the tax treatment of the item was more likely than not the proper treatment.  Section 6662(d)(2)(C)(i).

Treas. Reg. § 1.6662-4(d)(2) provides the substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. It is less stringent than the "more likely than not" standard (the standard that is met when there is a greater than 50 percent likelihood of the position being upheld), but more stringent than the "reasonable basis" standard required to avoid the negligence penalty under Treas. Reg. § 1.6662-3(b)(3).  There is substantial authority for the tax treatment of an item only if the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.  All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists.  Treas. Reg. § 1.6662-4(d)(3)(i).  The substantive discussion in the foregoing pages of this document indicates that it is generally unlikely that the transactions engaged in by the Partnerships or the Investors will meet the substantial authority test.

A taxpayer is considered to have reasonably believed that the tax treatment of an item is more likely than not the proper tax treatment if (1) the taxpayer analyzes the pertinent facts and authorities, and based on that analysis reasonably concludes, in good faith, that there is a greater than fifty-percent likelihood that the tax treatment of the item will be upheld if the Service challenges it, or (2) the taxpayer reasonably relies, in good faith, on the opinion of a professional tax advisor, which clearly states (based on the advisor's analysis of the pertinent facts and authorities) that the advisor concludes there is a greater than fifty percent likelihood the tax treatment of the item will be upheld if the Service challenges it.  Treas. Reg. § 1.6662-4(g)(4).  Moreover, if the taxpayer is relying on tax advice to establish reasonable belief, the taxpayer must also meet the requirements generally applicable to relying on advice to establish good faith and reasonable cause.  See Treas. Reg. § 1.6662-4(g)(4)(ii).

C. Substantial Valuation Misstatement

For the accuracy-related penalty attributable to a substantial valuation misstatement to apply to a non-corporate taxpayer, the portion of the underpayment attributable to a substantial valuation misstatement must exceed $5,000.  A substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 200 percent or more of the amount determined to be the correct amount of such value or adjusted basis. Section 6662(e)(1)(A).   If the value or adjusted basis of any property claimed on a return is 400 percent or more of the amount determined to be the correct amount of such value or adjusted basis, the valuation misstatement constitutes a "gross valuation misstatement."  Section 6662(h)(2)(A).  If there is a gross valuation misstatement, then the 20 percent penalty under § 6662(a) is increased to 40 percent.  Section 6662(h)(1).

Thus, if the claimed value or adjusted basis of any property claimed on a return exceeds 200 percent or more of the correct amount, then a substantial valuation misstatement exists and the 20% penalty should be asserted; if the claimed value or adjusted basis of any property claimed on a return exceeds 400 percent or more of the correct amount, then a gross valuation misstatement exists and the 40% penalty should be asserted. 
 
In addition, if the liability to the Promoter Turnkey Drilling Company represented by the Driller Promissory Notes is included in Investor’s outside basis in his Partnership interest, Investor’s basis is likely overstated under § 704(d) (as discussed in Issue 3, supra) .  Moreover, to the extent any economic interests in assets were acquired by Partnership, the facts may indicate that the purchase price of the asset(s) unreasonably exceeds its fair market value. Durkin, 872 F.2d at 1276; Estate of Baron, 83 T.C. at 550- 53.  The rationale for excluding such debt from basis is that the taxpayer is not entitled to enjoy benefits for which there has been no economic incentive or expectation of repayment.  Estate of Baron, 798 F.2d at 68-69; Estate of Franklin, 544 F.2d at 1048-49.  As noted, the facts developed may indicate little if any incentive or expectation of repayment.

If Investor has overstated his basis in Partnership, Investor likely has also overstated the amount of available loss deduction flowing through to Investor from Partnership.  Accordingly, if it is determined that the claimed adjusted basis of the Partnership interest is 200 percent or more of the correct amount, then a substantial valuation misstatement exists.  If the adjusted basis of a Partnership interest is 400 percent or more of the correct amount, then a gross valuation misstatement exists. 

 D.  Reasonable Cause and Good Faith

Section 6664 provides an exception to the imposition of the accuracy-related penalty if the taxpayer shows that there was reasonable cause for the underpayment and that the taxpayer acted in good faith.  Section 6664(c). The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all relevant facts and circumstances.  Treas. Reg. § 1.6664-4(b)(1) and (f)(1).  All relevant facts, including the nature of the tax investment, the complexity of the tax issues, issues of independence of a tax advisor, the competence of a tax advisor, the sophistication of the taxpayer, and the quality of an opinion, must be developed to determine whether the taxpayer was reasonable and acted in good faith.

Generally, the most important factor to determine reasonable cause and good faith is the extent to which the taxpayer exercised ordinary business care and prudence in attempting to assess his or her proper tax liability.  See Treas. Reg. § 1.6664-4(b)(1).  See also Larson v Commissioner, T.C. Memo. 2002-95; Estate of Simplot v. Commissioner, 112 T.C. 130, 183 (1999) (citing Mandelbaum v. Commissioner, T.C. Memo. 1995-255), rev'd on other grounds, 249 F.3d 1191 (9th Cir. 2001).  Circumstances which may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including taxpayer's experience, knowledge, sophistication, and education. The taxpayer's mental and physical conditions, as well as sophistication with respect to the tax laws, at the time the return was filed, are relevant in deciding whether the taxpayer acted with reasonable cause.  See Kees v. Commissioner, T.C. Memo. 1999-41.  If the taxpayer is misguided, unsophisticated in tax law, and acts in good faith, a penalty is not warranted.  See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988); cf. Spears v. Commissioner, T.C. Memo. 1996-341 (court was unconvinced by the claim of highly sophisticated, able, and successful investors that they acted reasonably in failing to inquire about their investment and simply relying on offering circulars and accountant, despite warnings in offering materials and explanations by accountant about limitations of accountant's investigation).

Reliance upon a tax opinion provided by a professional tax advisor may serve as a basis for the reasonable cause and good faith exception to the accuracy-related penalty.  The reliance, however, must be objectively reasonable.  For example, the taxpayer must supply the professional with all the necessary information to assess the tax matter.  The advice also must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances.

The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.  For example, the advice must not be based upon a representation or assumption which the taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer's purposes for entering into a transaction or for structuring a transaction in a particular manner.  Treas. Reg. § 1.6662-4(c)(1)(ii).

Where a tax benefit depends on nontax factors, the taxpayer has a duty to investigate the underlying factors rather than simply relying on statements of another person, such as a promoter.  See Novinger v. Commissioner, T.C. Memo. 1991-289.  Further, if the tax advisor is not versed in these nontax matters, mere reliance on the tax advisor does not suffice.  See Addington v. United States, 205 F.3d 54 (2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988); Freytag v. Commissioner, 89 T.C. 849 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990).

Although a professional tax advisor's lack of independence is not alone a basis for rejecting a taxpayer's claim of reasonable cause and good faith, the fact that a taxpayer knew or should have known of the advisor's lack of independence is strong evidence that the taxpayer may not have relied in good faith upon the advisor's opinion.  Neonatology Assoc., P.A. v. Commissioner, 115 T.C. 43, 98 (2001), aff'd, 299 F.3d 221 (3rd Cir. 2002) ("Reliance may be unreasonable when it is placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about"); Goldman v. Commissioner, 39 F.3d 402, 408 (2nd Cir. 1994), aff'g T.C. Memo. 1993-480 ("Appellants cannot reasonably rely for professional advice on someone they know to be burdened with an inherent conflict of interest"); Marine v. Commissioner, 92 T.C. 958, 992-93 (1989), aff'd without published opinion, 921 F.2d 280 (9th Cir. 1991).  Such reliance is especially unreasonable when the advice would seem to a reasonable person to be "too good to be true."  Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993), aff'g Donahue v. Commissioner, T.C. Memo. 1991-181; Gale v Commissioner, T.C. Memo. 2002-54; Elliot v Commissioner, 90 T.C. 960, 974 (1988), aff'd without published opinion, 899 F.2d 18 (9th Cir. 1990).  See Treas. Reg. § 1.6662- 3(b)(2).

Similarly, the fact that a taxpayer consulted an independent tax advisor is not, standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable.  Edwards v. Commissioner, T.C. Memo. 2002-169; Spears v. Commissioner, T.C. Memo. 1996-341, aff'd. 98-1 USTC 50,108 (2d Cir. 1997).  For example, a taxpayer may not rely on an independent tax adviser if the taxpayer knew or should have known that the tax adviser lacked sufficient expertise, the taxpayer did not provide the advisor with all necessary information, or the information the advisor was provided was not accurate.  Baldwin v. Commissioner, T.C. Memo. 2002-162; Spears v Commissioner, T.C. Memo. 1996- 341, aff'd 98-1 USTC   50,108 (2d Cir. 1997).

In most cases, Investor does not analyze the facts and authorities of these transactions associated with his investment in order to determine the correct tax treatment.  Generally, Investor has no direct experience in the oil and gas industry, and instead places complete trust in Promoter in deciding to invest significant amounts.  There is generally no indication that Investor sought tax advice with respect to the Investment in Partnership or deductions arising therefrom.  Although, in some cases, Investor is the only partner in Partnership (other than the Promoter-affiliated Managing Partner) and holds the majority interest in Partnership capital and profits, the Partnership return is prepared by a preparer selected by Promoter or the Managing Partner. 

E. Penalties and Partnerships

Many of the Partnerships are subject to the unified partnership audit and litigation procedures of Sections 6221 through 6234 (“TEFRA partnership procedures”).  Special rules apply to determine the applicability of penalties to a partnership subject to the TEFRA partnership procedures.  For taxable years ending after August 5, 1997, the applicability of any penalty which relates to the adjustment of a partnership item is determined at the partnership level.  Section 6221.  Treasury Regulation § 301.6221-1 provides as follows:

(c) Penalties determined at partnership level.  Any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item shall be determined at the partnership level.  Partner-level defenses to such items can only be asserted through refund actions following assessment and payment.  Assessment of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item shall be made based on partnership-level determinations.  Partnership-level determinations include all the legal and factual determinations that underlie the determination of any penalty, addition to tax, or additional amount, other than partner-level defenses specified in paragraph (d) of this section.

Following prior partnership law with respect to partnership items, relevant inquiries into tax motivation and negligence are made with respect to the general partner.  See Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993) (focusing on the general partner's objective in determining profit motive); Fox v. Commissioner, 80 T.C. 972, 1008 (1983), aff'd 742 F.2d 1441 (2d Cir. 1984), aff'd sub nom., Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984); Zemel v. Commissioner, 734 F.2d 5-9 (3d Cir. 1984).  Such inquires may include, for example, whether the general partner acted with reasonable cause and good faith with respect to any portion of underpayment otherwise subject to accuracy-related penalty.  The good faith actions of an individual partner in claiming items on his individual return are not considered.  Long Term Capital Holdings v. United States, 330 F.Supp.2d 122 (D.Conn. 2004); Santa Monica Pictures, LLC v. Commissioner, T.C. Memo 2005-104.

Treas. Reg. § 301.6221-1(d) provides that partner-level defenses to any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item may not be asserted in the partnership-level proceeding, but may be asserted through separate refund actions following assessment and payment.  See Section 6230(c)(4).  Partner-level defenses are limited to those that are personal to the partner or dependent upon the partner’s separate return and cannot be determined at the partnership level.  Examples of these determinations are whether any applicable threshold underpayment of tax has been met with respect to the partner, or whether the partner has met the criteria of § 6664(b) (penalties applicable only where return is filed).

Another example of a partner-level defense to the imposition of a penalty is the reasonable cause exception.  A partner may be able to raise a reasonable cause defense if the individual partner has circumstances personal to it that are distinct from the actions of the partnership, subject to partnership-level determinations as to the applicability of § 6664(c)(2).  However, to the extent Investor effectively acted as the general partner and the reasonable cause and good faith of the general partner are determined at the partnership level, it is likely that such partnership-level determinations will also dispose of such partner-level defenses.  The same would be true for a partnership-level determination of whether the general partner reasonably believed that the tax treatment of an item was more likely than not the proper treatment under § 6662(d)(2)(C)(i)(II).

Page Last Reviewed or Updated: 27-Nov-2013