IRS Can Adjust Partnership's Outside Basis for Excess Losses from Closed Tax Year

(Parker Tax Publishing November 2024)

The Tax Court held that the IRS could use a 2017 Notice of Final Partnership Administrative Adjustment (FPAA) to adjust a partnership's outside basis to account for improperly deducted losses in 2014 and 2015. The court (1) rejected the partnership's argument that the IRS's only recourse was to issue an FPAA for 2014 and 2015, years which are now closed to IRS assessments, and (2) concluded that events from prior closed years may be considered to calculate outside basis for the year at issue. Surk, LLC, Syrkadian Ventures, LLC v. Comm'r, T.C. Memo. 2024-99.

Background

Surk, LLC (Surk), a partnership, improperly deducted passthrough losses from a lower tier partnership, Outerknown, LLC (Outerknown) for 2014 and 2015. Those losses were in excess of its outside basis in Outerknown in violation of the loss limitation rule of Code Sec. 704(d). The Code Sec. 704(d) loss limitation rule provides that a partner's distributive share of a partnership loss is allowed only to the extent of the partner's adjusted basis in his partnership interest, which is calculated at the end of the partnership tax year in which the loss occurs. Thus, the partner's outside basis is not allowed to fall below zero. A partner's outside basis is the partner's basis in the partner's partnership interest. Any excess of such loss over such basis is allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership.

Because Surk's 2014 and 2015 tax years were closed to assessment, the IRS did not disallow the excess loss deductions but instead issued a Notice of Final Partnership Administrative Adjustment (FPAA) for 2017. The FPAA determined that Surk had to decrease its outside basis in Outerknown for 2017 to account for the excess losses. In the FPAA, after accounting for the excess losses, the IRS disallowed part of Surk's passthrough loss deduction from Outerknown for 2017 on the basis of the Code Sec. 704(d) loss limitation rule.

Both the IRS and Surk agreed that Surk was entitled to increase its outside basis in Outerknown in 2017 to account for a cash distribution that Surk made in 2016 but previously failed to account for. As a result, Surk had sufficient outside basis to deduct the entire 2017 Outerknown loss. The IRS conceded that Surk was entitled to the loss deduction that the IRS disallowed in the FPAA. However, the IRS continued asserting that Surk had to decrease its 2017 year-end outside basis by the 2014 and 2015 excess losses that the IRS determined in the FPAA (the outside basis issue).

One of Surk's partners, Syrkadian Ventures, LLC, (Syrkadian) moved for a decision in Surk's favor on the basis that the IRS had conceded all the adjustments in the FPAA. Syrkadian also argued that the IRS's method of computing Surk's 2017 outside basis in Outerknown was a new matter that was not properly at issue in the case. The court disagreed, noting that the IRS raised the proper calculation of Surk's outside basis in the FPAA by asserting that Surk's losses in the 2014 and 2015 closed tax years had to be taken into account for computing basis for the 2017 tax year. And, the court noted, it was the exact issue presented for decision when the parties agreed to submit the case fully stipulated to the court.

Thus, the question before the Tax Court was how excess loss deductions factor into the annual outside basis calculation. According to Surk, the IRS could not use an FPAA for 2017 to adjust Surk's outside basis to account for the 2014 and 2015 excess losses. Surk argued that the IRS's only recourse was to issue an FPAA for 2014 and 2015 to disallow the excess loss deductions.

Analysis

Ruling in the IRS's favor, the Tax Court held that Surk was required to decrease its 2017 year-end outside basis by the excess losses determined in the FPAA. Code Sec. 722 provides that a partner's outside basis equals its monetary contributions to the partnership plus its adjusted basis in any other property that it contributes and Code Sec. 705(a) provides the general rules for calculating outside basis thereafter. Code Sec. 705(a) requires that partners calculate their outside bases on an annual basis to account for the partnership's activities during the year. The court observed that, when calculating their bases each year, Code Sec. 705(a) provides that partners account for their annual distributive shares of partnership income and/or loss since the partnership began. Specifically, the court stated, Code Sec. 705(a) provides that a partner's outside basis increases by the sum of its distributive share of taxable income "for the taxable year and prior taxable years" and decreases by the sum of its distributive share of partnership loss "for the taxable year and prior taxable years." Thus, the court said, the plain wording of the statute requires that a partner decrease its outside basis by the sum of all current and prior losses, but in their annual calculation partners cannot reduce their outside bases below zero.

The court found that Code Sec. 705(a) required Surk to decrease its outside basis by the excess losses and that the IRS's calculation was consistent with Code Sec. 705(a). The one caveat, the court said, is that outside basis cannot be reduced below zero. But, the court added, the IRS was not recalculating Surk's outside basis for 2014 or 2015 and improperly reducing it below zero. Rather, the IRS was calculating Surk's 2017 year-end basis to account for current-year and prior-year losses. Surk, the court noted, reduced its outside basis below zero when it claimed the excess loss deductions for 2014 and 2015.

Under Reg. Sec. 1.705-1, a partner is required to calculate its outside basis only when necessary to determine its tax liability and the calculation of outside basis is ordinarily made at the end of a partnership year. The Code Sec. 704(d) loss limitation rule is one example of when it is necessary to calculate outside basis and the regulations under Code Sec. 704(d) rely on the basis calculation rules of Code Sec. 705. However, the court observed, specific rules are provided for computing outside basis for purposes of Code Sec. 704(d) and those rules differ from Code Sec. 705(a) as they distinguish between allowed or disallowed losses.

Reg. Sec. 1.704-1(d)(2) provides an ordering rule, first to make positive basis adjustments under Code Sec. 705(a)(1) and then negative adjustments under Code Sec. 705(a)(2) "except for losses of the taxable year and losses previously disallowed." The Tax Court interpreted the regulation's exclusion of "losses previously disallowed" to mean that a partner must decrease its outside basis by all previously allowed losses in the first step of the calculation. Citing several of its prior decisions, the court noted that it has defined an "allowed deduction" as a deduction actually claimed on a return and allowed by the IRS. On its 2014 and 2015 returns, Surk deducted over $3.3 million of excess losses which the IRS did not disallow. In such an instance, the court concluded, the returns provide the final tax treatment, and Surk is bound by the reporting on the returns. Accordingly, the court found that the 2014 and 2015 excess losses were previously allowed losses, and Surk had to decrease its outside basis by the excess losses for its annual calculation of outside basis for purposes of Code Sec. 704(d).

The court rejected Surk's argument that the IRS cannot use an FPAA for 2017 to adjust its outside basis to account for the 2014 and 2015 excess losses. Under Code Sec. 705(a), a partner must calculate outside basis annually and must decrease its outside basis for the current-year loss as well as all prior-year losses since the partnership began. Reg. Sec. 1.704-1(d)(2) adopts the Code Sec. 705 basis adjustment rules although it limits the negative basis adjustment to allowed losses. Thus, the court said, it was immaterial that the IRS did not issue an FPAA for 2014 and 2015 or that those years are closed because the IRS was calculating Surk's outside basis for its 2017 year end. For this same reason, the court also rejected the argument that the IRS's position decreases Surk's outside basis below zero. The IRS's calculation of Surk's 2017 year-end outside basis, the court noted, did not result in an outside basis below zero.

Finally, the court said, Surk improperly deducted the excess losses for 2014 and 2015 and was now seeking to disregard its own reporting to claim future tax benefits. If Surk were not required to decrease its outside basis by the previously allowed excess losses, the court concluded, its outside basis would be overstated and would permit loss deductions in excess of Surk's investment in its Outerknown partnership interest.

For a discussion of the calculation of the partnership loss limitation rules, see Parker Tax ¶20,550. For a discussion of calculating a partner's basis in a partnership interest, see Parker Tax ¶24,610.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com