Tigers Eye Trading, LLC, Sentinel Advisors, LLC, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 138 T.C. 67

OPINION Beghe, Judge: Following entry of a stipulated decision on December 1, 2009, this Son of BOSS case remains before this Court on a motion to revise the decision. The motion was filed by participating partner A. Scott Logan Grantor Retained Annuity Trust I, A. Scott Logan, Trustee, a partner other than the tax matters partner. We refer to the trustee in his individual capacity as Mr. Logan and to the trust as Logan Trust I or participating partner. Participating partner argues that the stipulated decision upholds adjustments in the final partnership administrative adjustment (FPAA) and applies accuracy-related penalties that exceed this Court’s jurisdiction under

section 6226(f), thereby overstepping the jurisdictional limits under the TEFRA statute and regulations, as established by the Court of Appeals for the D.C. Circuit in Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649 (D.C. Cir. 2010) (Petaluma II), aff’g in part, rev’g in part and remanding on penalty issues 131 T.C. 84 (2008) (Petaluma I). On December 15, 2010, this Court responded to the remand on penalty issues with its reviewed Opinion (7-5, with two dissenting opinions), Petaluma FX Partners, LLC v.

Commissioner, 135 T.C. 581 (2010) (Petaluma III), and on March 8, 2011, the Commissioner filed a notice of appeal. Participating partner argues that under the Golsen rule the Court’s jurisdiction to decide the issues in dispute in this partnership-level proceeding is controlled by Petaluma II, so that the Court must vacate and revise the stipulated decision to conform to the jurisdictional limits imposed by Petaluma II. We observe that the limiting holdings in Petaluma II were the result of a concession by the Government that the Court of Appeals accepted without any discussion of the applicable regulations.

In an opinion issued after Petaluma II was filed, Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. _, 131 S. Ct. 704 (2011), the Supreme Court emphatically reminded lower courts that they must defer to regulations that satisfy the two-step Chevron standard. More recently, in Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 650 F.3d 691 (D.C. Cir. 2011), rev’g and remanding 134 T.C. 211 (2010), supplementing T.C. Memo. 2009-195, the Court of Appeals for the D.C. Circuit held that the deference given to regulations under Mayo Found. required the Court to apply the

definitions of statutory terms provided in valid TEFRA regulations rather than follow earlier caselaw. In accordance with Mayo Found, and Inter-mountain, this Court must apply the TEFRA regulations, unless we hold them to be invalid, rather than follow the holding in Petaluma II in which the Court of Appeals did not specifically consider and apply the regulations.

Under the assumption that this Court was bound by the holdings of the Court of Appeals in Petaluma II, in respondent’s response to participating partner’s motion to vacate and revise the decision, respondent made the same concession as the Government made in Petaluma II. Subject-matter jurisdiction relates to a court’s statutory or constitutional power to hear a given type of case. United States v. Cotton, 535 U.S. 625, 630 (2002); United States v. Morton, 467 U.S. 822, 828 (1984); Alikhani v. United States, 200 F.3d 732, 734 (11th Cir. 2000).

The Supreme Court has held that “subject-matter jurisdiction, because it involves a court’s power to hear a case, can never be forfeited or waived.” Cotton, 535 U.S. at 630. “[S]ubject matter jurisdiction is an unwaivable sine qua non for the exercise of federal judicial power”. Curley v. Brignoli, Curley & Roberts, Assocs., 915 F.2d 81, 83 (2d Cir. 1990). Moreover, courts have an independent obligation to determine whether subject matter jurisdiction exists, even in the absence of a challenge from any party. Ruhrgas AG v. Marathon Oil Co., 526 U.S. 574, 583 (1999).

Whether a court has subject matter jurisdiction to adjudicate the merits of a controversy is a question of law. Taylor v. Voss, 271 U.S. 176, 186 (1926) (“a petition for revision will lie to bring up for review the question of law whether the court of bankruptcy has jurisdiction to adjudicate the merits of such controversy in a

summary proceeding”); Adkison v. Commissioner, 592 F.3d 1050, 1052 (9th Cir. 2010) (“Whether the Tax Court has subject matter jurisdiction is a question of law and thus reviewed de novo”), aff’g 129 T.C. 97 (2007); United States v. Moore, 443 F.3d 790, 793 (11th Cir. 2006). The meaning of a statutory term is also a question of law. Crane v. Commissioner, 331 U.S. 1, 15 (1947) (Tax Court’s determinations of statutory terms “announced rules of general applicability on clear-cut questions of law”).

Neither the Supreme Court nor an appellate court is bound to accept the Government’s concession that the court below erred on a question of law. Orloff v. Willoughby, 345 U.S. 83, 88 (1953). Similarly, the Tax Court need not accept a party’s concession on a question of law, particularly when to do so would strip the Court of its jurisdiction. See Charlotte's Office Boutique, Inc. v. Commissioner, 121 T.C. 89, 102 (2003), aff’d, 425 F.3d 1203 (9th Cir. 2005). The Golsen rule does not apply where the precedent from the Court of Appeals constitutes dicta or contains distinguishable facts or law. See, e.g., Hefti v.

Commissioner, 97 T.C. 180, 187 (1991) (dictum not controlling), aff’d, 983 F.2d 868 (8th Cir. 1993); Metzger Trust v. Commissioner, 76 T.C. 42, 72-74 (1981) (factual distinctions render Golsen rule not squarely on point), aff’d, 693 F.2d 459 (5th Cir. 1982); Kueneman v. Commissioner, 68 T.C. 609, 612 n.4 (1977) (distinct legal question not governed by the Golsen rule), aff’d, 628 F.2d 1196 (9th Cir. 1980). As we stated in Lardas v. Commissioner, 99 T.C. 490, 493-495 (1992), the Golsen rule applies only where the “clearly established” position of a Court of Appeals signals “inevitable” reversal upon appeal.

In Petaluma II the Government conceded that outside basis was an affected item but argued that the Tax Court had jurisdiction to decide an affected item where its elements consisted entirely of partnership items. The Court of Appeals agreed that outside basis was an affected item but rejected the Government’s elements argument. The Court of Appeals did not decide (1) whether under

section 301.6231(a)(3)-1(a)(4) and (c)(3)(iii), Proced. & Admin. Regs., outside basis is a partnership item because it is an item related to contributions and distributions necessary for maintaining its books and records and providing information to the purported partners; (2) whether outside basis was an entity item under

section 301.6233-lT(

a) and (c), Temporary Proced. & Admin. Regs., 52 Fed. Reg. 6779, 6795 (Mar. 5, 1987); (3) whether the basis in the property distributed by an entity that is disregarded as a partnership for Federal income tax purposes is an entity item under

section 301.6233-lT(

a) and (c), Temporary Proced. & Admin. Regs., supra; or (4) whether

section 301.6231(a)(3)-1(a)(4) and (c)(3)(iii), Proced. & Admin. Regs., and

section 301.6233-1T(

a) and (c), Temporary Proced. & Admin. Regs., supra, are valid. The Court of Appeals for the D.C. Circuit recognizes its “obligation to explore any promising avenue to * * * [the inferior court’s] jurisdiction, whether or not suggested by the parties”. Ass’n of Am. Med. Colleges v. Califano, 569 F.2d 101, 111 (D.C. Cir. 1977); see also Da Silva v. Kinsho Int’l Corp., 229 F.3d 358, 361 (2d Cir. 2000) (“the issue of subject matter jurisdiction is one we are required to consider, even if the parties have ignored it or, as here, have switched sides on the issue”).

Because the Court of Appeals did not consider the precise issue we decide herein, Golsen does not apply. See Read v. Commissioner, 114 T.C. 14 (2000), aff’d without published opinion sub nom. Mulberry Motor Parts, Inc. v. Commissioner, 273 F.3d 1120 (11th Cir. 2001); Estate of Branson v. Commissioner, 113 T.C. 6, 34 (1999), aff’d, 264 F.3d 904 (9th Cir. 2001).

Accordingly, we reject respondent’s concession and apply the applicable regulations, authorized by sections 6231(a)(3) and 6233, and hold that this Court has jurisdiction to enter the stipulated decision as written, even to the extent it adjusts outside basis to zero and applies the 40% gross basis misstatement penalty under

section 6662(

h) to the deficiency that results from the overstatement of the purported partners’ bases in distributed property. Therefore we shall deny participating partner’s motion to vacate and revise the decision. Background Entry of the stipulated decision in this 1999 taxable year Son of BOSS case was preceded by our opinion in Tigers Eye Trading, LLC v. Commissioner, T.C. Memo. 2009-121 (Tigers Eye I).

Tigers Eye I was preceded by extensive discovery and motion practice, the lodging of expert reports on the actual and expected financial consequences of the transaction, and the lodging and later filing of two extensive stipulations of fact. The undisputed factual material thereby made available enables us to describe the operative facts of the transaction. The extensive and detailed facts set forth in Tigers Eye I are incorporated herein by this reference. In addressing the pending motion, we take account of additional indisputable facts and repeat only the most pertinent facts set forth in Tigers Eye I.

The subject transaction was one of a number of such transactions promoted by Sentinel Advisors, LLC (Sentinel), the tax matters partner, using a limited liability company— Tigers Eye Trading, LLC (Tigers Eye), in the case at hand— treated as a partnership for income tax purposes, as the vehicle needed to create the claimed basis step-ups that were the transaction’s reason for being. During 1999 Mr.

Logan realized a multimillion-dollar long-term capital gain on his sale to a large Canadian financial services holding company of his stock interest in a corporation he had cofounded to act as a distributor of variable annuities. Tigers Eye was a Delaware limited liability company formed in late September 1999, ostensibly to engage in foreign currency trading but in reality to generate paper losses to offset taxpayers’ otherwise taxable capital gains.

On October 1, 1999, the Logan Trusts each acquired a pair of offsetting long and short foreign currency options through AIG, which they then contributed along with cash to become partners in Tigers Eye on October 9, 1999. The Logan Trusts inflated their adjusted bases in Tigers Eye to reflect their contributions of the long options without reducing those bases to reflect Tigers Eye’s assumption of their obligations under the short options.

The basis inflation is premised on (1) treating each purchased option separately from each sold option, (2) each purchased option’s having a basis equal to the gross premium in the hands of both the Logan Trusts and Tigers Eye, (3) treating the assignment to and assumption by Tigers Eye of the contingent obligation to satisfy the sold option separately from the purchased option for purposes of

section 752, and (4) disregarding the contingent obligation to satisfy the sold option in determining outside basis in the partnership under the authority of Helmer v. Commissioner, T.C. Memo. 1975-160. An unrelated entity, the Batts Group, also acquired interests in offsetting foreign currency options through AIG that were transferred to Tigers Eye and also received other property in liquidation of its interest in Tigers Eye.

We refer to participants in offsetting options transactions with partnerships such as the offsetting option transactions of the Logan Trusts and the Batts Group with Tigers Eye as option partners. In addition to Sentinel, the tax matters partner, which contributed $3,000 cash, Tigers Eye also had as a partner a foreign entity, Banque Safra-Luxembourg (Banque Safra), which contributed $58,000 cash. Neither Sentinel nor Banque Safra had any financial interest in the option transactions, and neither has a stake in the outcome of this proceeding.

During December 1999 Sentinel caused Tigers Eye to unwind or terminate the paired options at a net loss. Sentinel through Tigers Eye used the remaining cash contributions to purchase foreign currency (euro) and shares of listed stock (Xerox Corp.) that were purportedly distributed to the Logan Trusts in liquidation of their purported partnership interests. The Logan Trusts claimed that they had hugely inflated bases in Tigers Eye that attached to the foreign currency and stock Tigers Eye transferred to them (sometimes referred to herein as the distributed property).

They sold the currency and stock before yearend 1999 and claimed huge losses that flowed through to Mr. Logan’s 1999 Federal income tax return. Mr. Logan used the claimed losses on the sales of the foreign currency to offset his ordinary income, and he used the claimed short-term losses on the sales of the Xerox Corp. stock to offset most of the multimillion-dollar long-term capital gain he realized on the sale of his stock interest in the annuity distribution business. On April 14, 2000, Tigers Eye filed a Form 1065, U.S. Partnership Return of Income, for its 1999 taxable year.

On March 7, 2005, respondent issued an FPAA to the Tigers Eye partners. The FPAA comprises

(1) Letter 1830, Notice of Final Partnership Administrative Adjustment,

(2) Form 870-PT, Agreement for Partnership Items and Partnership Level Determinations as to Penalties, Additions to Tax, and Additional Amounts, including a

Schedule of Adjustments, and (3) an “Exhibit A — Explanation of Items”, setting forth respondent’s other adjustments or determinations. The

Schedule of Adjustments adjusted to zero the following five items: A. Capital Contributions (Sched. M-2, line 2) $698,595 B. Distributions of Property other than Money (Sched. M-2, line 6b) 365,446 C. Outside Partnership Basis 24,500,059 D. Other Deductions (Sched. K, line 11) 11,314 E. Ordinary Income, Other Income (Loss) (Sched. K, line 7) (242,186) Items A, B, D, and E are each identified as the adjustment of a line item on the Tigers Eye 1999 Form 1065. Item C (Outside Partnership Basis) is not such an item and does not correspond to any line item on the partnership return.

Unlike the item A, B, D, and E amounts, each of which is identified as the adjustment of a line item on the Tigers Eye 1999 Form 1065, the item C amount does not appear on the partnership return or on the Schedules K-l, Partner’s Share of Income, Credits, Deductions, etc., of the partnership return and sent to the partners. Only two of the foregoing adjustments were to items appearing on the partnership return that directly flowed through to the returns of the Logan Trusts and thence to Mr. Logan’s individual return. These two adjustments change to zero two items that appeared on

Schedule K of the partnership return: “Other Deductions” of $11,314 (appearing on line 11,

Schedule K, page 3, of the partnership return) and the negative amount “($242,186)” reported for “Ordinary Income, Other Income (Loss)” (on line 7,

Schedule K, Partners’ Shares of Income, Credits, Deductions, etc., page 3, of the partnership return). These line items were described in greater detail in Statements 1 and 2 of the return, reproduced below. Statement 1, which attributes the negative figure -257,857 to “ordinary loss from sec. 988 transactions”, thereby indicates that this negative figure included the net loss claimed by Tigers Eye on the termination or unwinding of the contributed paired options, as well as the results of other foreign currency transactions. The partnership return Schedules K-l for the Logan Trusts show that their respective shares of the entries on lines 7 and 11 of

Schedule K were a loss of $52,583 and other deductions of $2,136, respectively, for a total loss of $157,749 and total other deductions of $6,408 that flowed from the partnership return through the returns of the Logan Trusts to Mr. Logan’s 1999 Federal income tax return. Indeed, the Form 1041, U.S. Income Tax Return for Estates and Trusts, for each of the Logan Trusts reports a $55,278 nonpassive loss from partnerships, which is within $600 of the $54,719 sum of the items allocated to each Logan Trust on lines 7 and 11. Mr.

Logan’s 1999 individual Federal income tax return, in three separate schedules entitled “1999 income from passthroughs”, shows a loss of $55,278 from “schedule E ACTIVITY INCOME (LOSS)” for each of the Logan Trusts ($55,279 loss for Logan Trust II) for total “SCHEDULE E INCOME OR (LOSS) FROM ESTATES OR TRUSTS STATEMENT 21 NONPASSIVE LOSS OF” $165,835. Statement 6 on the partnership return, “partners’ capital account

summary”, shows “Capital Contributed” and “Withdrawals” (the latter is identical to “Distributions of Property Other Than Money”) totaling $698,595 and $365,446, respectively, that were also adjusted to zero by the FPAA. The “Capital Contributions” of $698,595 shown by the partnership return and zeroed out by the FPAA (and the stipulated decision) was the sum of the cash contributed by all the partners plus the net value of the paired options that the Logan Trusts and the Batts Group had ostensibly contributed to the partnership; this net value was arrived at by netting the premiums on the long and short options.

This partnership return reporting differed from the inflated bases claimed by the Logan Trusts through the tax shelter in that the option partners claimed bases in their partnership interests that included the premiums on the long options (amounting to more than $27 million, see supra note 17) without reduction or offset for the liabilities represented by the premiums on the short options.

The “Withdrawals” (“Distributions of Property Other Than Money”) of $365,446 zeroed out by the FPAA was the book value (the aggregate purchase price/cost) of the foreign currency and corporate shares purchased by Sentinel through Tigers Eye on behalf of the Logan Trusts and the Batts Group for distribution to them. The Logan Trusts’ share of this cost amounted to approximately $230,000. See supra note 17.

The aggregate inflated “outside” bases claimed by the Logan Trusts on the sales of foreign currency and Xerox Corp. stock were more than 118 times greater than (11,800% of) the withdrawals/distribution amounts reported on the partnership return. The “exhibit A — Explanation of Items” made the following additional adjustments or determinations:

(1) Tigers Eye’s existence as a partnership had not been established as a fact;

(2) Tigers Eye had no business purpose other than tax avoidance, lacked economic substance, and was an economic sham so that Tigers Eye and the transactions in which it claimed to have participated should be disregarded in full; and

(3) Tigers Eye had been formed or availed of, within the meaning of

section 1.701-2, Income Tax Regs., for a principal purpose of improperly reducing the partners’ Federal income tax liabilities. The Explanation of Items went on to make alternative adjustments or determinations premised on regarding Tigers Eye as a partnership that had received the paired foreign currency options as contributions and assignments from the option partners (the Logan Trusts and the Batts Group) and thereafter distributed foreign currency and listed shares of stock to them in liquidation of their partnership interests. In that regard, the Explanation of Items determined that (1) the partners “have not established [under

section 723] adjusted bases in their respective partnership interests in amounts greater than zero”; (2) “the purported partners of Tigers Eye did not enter into the option positions and Tigers Eye did not purchase the foreign currency or [listed] stock with a profit motive for purposes of

section 165(c)(2)”; and (3) the obligations under the sold options should be netted against the purchased options so that “any * * * claimed increases in the outside bases in Tigers Eye resulting from the contributions of the sold [sic “purchased”] options should be disallowed”. The alternative adjustments described in this paragraph have been rendered inapplicable by the stipulated decision’s adoption of the primary adjustments disregarding the partnership described in the immediately proceeding paragraph.

Finally, the Explanation of Items determined at the partnership level that accuracy-related penalties to be imposed at the individual taxpayer level apply “to all underpayments of tax attributable to adjustments of partnership items of Tigers Eye Trading, LLC”. The Explanation of Items went on to state: The penalty shall be imposed on the components of underpayment as follows: A. a 40 percent penalty shall be imposed on the portion of any underpayment attributable to the gross valuation misstatement as provided by Sections 6662 (a), 6662(b)(3), 6662(e), and 6662(

h) of the Internal Revenue Code. B. a 20 percent penalty shall be imposed on the portion of the underpayment attributable to negligence or disregard of rules and regulation as provided by Sections 6662(a), 6662(b)(1), 6662(

c) of the Internal Revenue Code. C. a 20 percent penalty shall be imposed on the underpayment attributable to the substantial understatement of income tax as provided by sections 6662(a), 6662(b)(2), and 6662(

d) of the Internal Revenue Code. D. a 20 percent penalty shall be imposed on the underpayment attributable to the substantial valuation misstatement as provided by Sections 6662(a), 6662(b)(3), and 6662(

e) of the Internal Revenue Code. Sentinel, the tax matters partner, filed the petition in this case but claims to have no direct financial interest in its outcome. Mr. Logan, as trustee of Logan Trust 1, sought and was granted leave to participate in this proceeding as participating partner. Mr. Logan, through his counsel, has wielded the laboring oar and called the shots for the taxpayer interests in this proceeding.

Within a week before the scheduled trial, the Court was gratified to receive the stipulated decision document signed by respondent’s counsel, by Sentinel, through Ari Bergmann, trustee of the Bergmann Revocable Trust, tax matters partner of Sentinel, tax matters partner of Tigers Eye, and by Sentinel’s counsel. Participating partner through counsel indicated no objection to entry of the decision.

The decision provides as follows: ORDERED AND DECIDED: That the following statement shows the adjustments to the partnership items of Tigers Eye Trading, LLC, for the taxable year 1999: As Determined Partnership Item As Reported Ordinary Income, Other Income (Loss) ($242,186) Cfl-ó Deductions, Other Deductions $11,314 CO c> Partnership Item As Reported As Determined Distributions of Property other than Money $365,446 o c/b Capital Contributions $698,595 o c/b It is determined that the notice of final partnership administrative adjustment dated March 7, 2005, which is the subject matter of this case, is correct.

It is determined that a 40 percent gross valuation misstatement penalty under I.R.C. § 6662(a); (b)(3), (

e) and (

h) applies to any underpayment of tax attributable to overstating the capital contributions claimed to have been made to the purported partnership. It is determined that a 20 percent penalty applies to any additional underpayment of tax attributable to the foregoing partnership item adjustments other than the capital contributions claimed to have been made to the purported partnership, as such underpayment is attributable to negligence or disregard of rules or regulations under I.R.C. § 6662(a), (b)(1) and (

c) or a substantial understatement of income tax under I.R.C. § 6662(a), (b)(2) and (d). On November 25, 2009, the Court issued an order striking the case from the November 30, 2009, Washington, D.C., special trial session. On December 1, 2009, the Court entered the stipulated decision. The Court’s gratification from receipt and entry of the stipulated decision was short lived. On January 12, 2010, the Court of Appeals for the D.C. Circuit issued Petaluma II.

One week later, on January 19, 2010, participating partner filed the motion for leave to file a motion to revise the stipulated decision and lodged the motion to revise decision. On November 30, 2010, the Court granted leave and the motion to revise decision was filed. Participating partner asserts that the Court must vacate and revise the stipulated decision because it exceeds the jurisdictional limitations imposed by Petaluma II. Discussion I. Introduction: Complexity of Income Tax Treatment of Partners and Partnerships A.

Overview of Subchapter K A partnership is not taxed as an entity, and its items of income and loss flow through to its partners. Sec. 701. Partnerships are required to file annual information returns reporting the partners’ distributive shares of income, deductions, and other partnership items. Sec. 6031. The individual partners report their distributive shares of the partnership items on their Federal income tax returns. Secs. 701-704. The substantive law governing the income taxation of partners is in subchapter K of

chapter 1 of the Code (subchapter K). Subchapter K creates a detailed and complex system of rules for characterizing transactions between the partnership and the partners, computing and/or characterizing partnership income, assets, and liabilities, allocating those items among the partners, and determining and making adjustments to a partner’s basis (cost for tax purposes under

section 1012 except as otherwise provided in subchapter

K) in the partnership for his share of those items. The purpose of subchapter K is “to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax.” Sec. 1.701-2(a), Income Tax Regs. B. TEFRA 1. In General The unified audit and litigation procedural rules applicable to partnerships and their partners were enacted by Congress in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402, 96 Stat. at 648, and amended by Congress in the Taxpayer Relief Act of 1997 (TRA 1997), Pub. L.

No. 105-34, sec. 1238, 111 Stat. at 1026. The TEFRA procedures are set forth in subchapter C of

chapter 63 of the Code. Under the TEFRA procedures all partnership items, the proper allocation of those partnership items among the partners, and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item are determined in a single partnership-level proceeding. Sec. 6226. The determinations of partnership items in partnership-level proceedings are binding on the partners and may not be challenged in subsequent partner-level proceedings. See secs. 6230(c)(4), 7422(h). 2.

TEFRA Penalty Litigation Structure Before TRA 1997 Before Congress enacted TRA 1997, any penalty, addition to tax, or additional amount (collectively, penalty) related to adjustment of a partnership item or items in a TEFRA proceeding at the partnership level was generally treated as an affected item that required a factual determination in a subsequent proceeding at the partner level. See N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 744 (1987); sec. 301.6231(a)(5)-1T(d), Temporary Proced. & Admin. Regs., 52 Fed. Reg. 6790 (Mar. 5, 1987).

Before Congress enacted TRA 1997, the Tax Court lacked jurisdiction in a partnership-level proceeding to decide the applicability of partnership-item penalties. See N.C.F. Energy Partners v. Commissioner, 89 T.C. at 744. Rather, partnership-item penalties were determined at the partner level as affected items in a deficiency proceeding after the related partnership-level proceeding had been completed. Procedurally, this made sense, inasmuch as the ultimate liability of each individual partner depended, almost invariably, upon his ability to sustain his individual reasonable cause/good faith defenses under

section 6664(c), irrespective of whether the application of the penalty originated from misconduct or failure of care at the partnership or individual level. 3. TEFRA Penalty Litigation Structure After TRA 1997 TRA 1997 sec. 1238 made a comprehensive set of procedural amendments to the regime for the determination of penalties under TEFRA:

(1) By amending

section 6221, TEFRA’s introductory jurisdictional provision, to require the applicability of any partnership-item penalty to be determined at the partnership level (“Except as otherwise provided in this subchapter, the tax treatment of any partnership item (and the applicability of any penalty * * * which relates to an adjustment to a partnership item) shall be determined at the partnership level” (emphasis added)); (2) by amending and expanding

section 6226(f), on the scope of judicial review by the Tax Court, the Court of Federal Claims, or Federal District Courts with which a petition to review an FPAA is filed, i.e., in a partnership-level proceeding, to provide that such court “shall have jurisdiction to determine” not only all partnership items and their allocations among partners but also “the applicability of any penalty * * '* which relates to an adjustment to a partnership item” (emphasis added); (3) by amending

section 6230(a)(2)(A)(

i) to deprive the Tax Court of jurisdiction to determine partnership-item penalties in a partner-level deficiency proceeding (“(

A) Subchapter B [sections 6211-6216 titled “Deficiency Procedures in the Case of Income, Estate, Gift and Certain Excise Taxes”] shall apply to any deficiency attributable to — (

i) affected items which require partner-level determinations (other than penalties * * * that relate to adjustments to partnership items)”); (4) by adding

section 6230(c)(1)(C), which allows a partner to file a claim for refund on the ground that “the Secretary erroneously imposed any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item”; and (5) by amending

section 6230(c)(4) to make conclusive the partnership-level determination regarding the applicability of any partnership-item penalty, but allowing the partner to assert any “partner-level” defenses in the refund claim. This amendment was added to and continued the provision of

section 6230(c)(4) that makes conclusive partnership-level adjustments of partnership items that result in computational adjustments without the need for an affected items notice of deficiency, but also allows those adjustments to be challenged in a refund suit. In its report underlying the amendments, the House Committee on Ways and Means provided the following explanation: Present Law Partnership items include only items that are required to be taken into account under the income tax subtitle. Penalties are not partnership items since they are contained in the procedure and administration subtitle.

As a result, penalties may only be asserted against a partner through the application of the deficiency procedures following the completion of the partnership-level proceeding. Reasons for Change Many penalties are based upon the conduct of the taxpayer. With respect to partnerships, the relevant conduct often occurs at the partnership level. In addition, applying penalties at the partner level through the deficiency procedures following the conclusion of the unified proceeding at the partnership level increases the administrative burden on the IRS and can significantly increase the Tax Court’s inventory.

Explanation of Provision The bill provides that the partnership-level proceeding is to include a determination of the applicability of penalties at the partnership level. However, the provision allows partners to raise any partner-level defenses in a refund forum. [H.R. Rept. No. 105-148, at 594 (1997), 1997-4 C.B. (Vol. 1) 319, 915-916.] The foregoing recitation of these TRA 1997 amendments to TEFRA and their legislative history displays the common theme that unites them.

The recitation makes clear that the applicability of the accuracy-related penalty or penalties that relate to the adjustment of partnership items would henceforth be determined in the partnership-level proceeding to determine the validity of the adjustments to partnership items by the fpaa. No longer would application of accuracy-related penalties be determined at the partner level by the resolution of a partner-level affected-items deficiency proceeding.

Nevertheless, for all the reasons discussed in the Afterword to Tigers Eye I, see supra two concluding paragraphs of note 10, the TRA 1997 changes have spawned many controversies concerning proper application of the TEFRA procedural rules, particularly in Son of BOSS cases, including the case at hand. C. Attempted Exploitation by Tax Shelter Promoters of Complex Interactions and Disconnects of Subchapter K Substantive Rules and TEFRA Procedural Rules The substantive and procedural rules applicable to the income taxation of partners and partnerships are “distressingly complex and confusing”.

Rhone-Poulenc Surfactants and Specialties, L.P. v. Commissioner, 114 T.C. 533, 539-540 (2000) (citing Foxman v. Commissioner, 41 T.C. 535, 551 n.9 (1964), aff’d, 352 F.2d 466 (3d Cir. 1965)). That complexity has proven to be easily exploited, and consequently, entities classified as partnerships have become the vehicles of choice in creating and operating abusive tax shelters.

The difficulty of applying the TEFRA partnership provisions in tax shelter cases is evidenced — in addition to Petaluma and the case at hand — by the opinions of the various trial courts and the Courts of Appeals to which the cases were appealed. See, e.g., Jade Trading, LLC v. United States, 598 F.3d 1372, 1379—1380 (Fed. Cir. 2010) (Jade Trading II), aff’g in part, rev’g in part and remanding on penalty issues 80 Fed. Cl. 11 (2007) (Jade Trading I), remanded to 98 Fed. Cl. 453 (2011) (Jade Trading III), aff’d, 451 Fed. Appx. 954 (Fed. Cir. 2012); LKF X Invs. LLC v.

Commissioner, 106 A.F.T.R. 2d (RIA) 2010-5003, 2010-1 U.S. Tax Cas. (CCH) para. 50,488 (D.C. Cir. 2010), aff’g in part, rev’g and remanding on penalty issues T.C. Memo. 2009-192; RJT Invs. X v. Commissioner, 491 F.3d 732 (8th Cir. 2007); Desmet v. Commissioner, 581 F.3d 297 (6th Cir. 2009), aff’g in part and remanding Domulewicz v. Commissioner, 129 T.C. 11, 22 (2007), remanded to T.C. Memo. 2010-177; New Millennium Trading, LLC v. Commissioner, 131 T.C. 275, 279 (2008); Hambrose Leasing 1984-5 Ltd. P’ship v. Commissioner, 99 T.C. 298 (1992); Alpha I, L.P. v. United States, 93 Fed.

Cl. 280, 326 (2010); Russian Recovery Fund, Ltd. v. United States, 81 Fed. Cl. 793 (2008). Abusive tax shelters are complex financial artifices which exploit two fundamental weaknesses in the federal tax system: (1) the complexity of the internal revenue laws and (2) the government’s inability by conventional means to identify quickly and challenge abusive tax schemes. By exploiting these weaknesses, tax shelter promoters precipitated a proliferation of abusive tax shelters and huge revenue losses to the federal government. ******* * * * Congress could not draft provisions that anticipated every colorable

interpretation for fabricating a tax shelter. New tax shelter techniques continued to develop unhindered by legislative efforts at containment. [D. French Slaughter, “The Empire Strikes Back: Injunctions of Abusive Tax Shelters After TEFRA”, 3 Va.

Tax Rev. 1, 6 (Summer 1983); fn. refs., citations, and quotation marks omitted.] The above quotation was not only an accurate description of past and present ills as of the time it was published — 1983— but also a forecast of future developments, as exemplified by the Son of BOSS transactions that are central to the formation of the limited liability companies of Tigers Eye in the case at hand and Petaluma in the Petaluma case; they are a variation of the “bond and options sales strategy”, which the Commissioner regards as an abusive tax shelter, see Notice 2000-44, 2000 — 2 C.B. 255, 256; supra note 1, and this Court has repeatedly so held, see, e.g., Carpenter Family Invs., LLC v.

Commissioner, 136 T.C. 373, 375 (2011); 3K Invs. Partners v. Commissioner, 133 T.C. 112, 113 n.2 (2009); see also Kligfeld Holdings v. Commissioner, 128 T.C. 192, 194 (2007). Taxpayers attempted to exploit the complexity of partnership substantive tax law by using Son of BOSS transactions to inflate artificially the basis of property ostensibly distributed by a partnership to the purported partners in liquidation of their partnership interests.

Those attempts exploited the complexity of the tefra partnership procedural rules to impede the Government’s ability to identify quickly and challenge abusive Son of BOSS transactions and to avoid the proper imposition of the accuracy-related penalties. As a result of those attempts, a disproportionate number of cases under TEFRA have been devoted to procedural, jurisdictional, and statute of limitations questions. The diversion of resources from the determination and collection of liabilities for taxes, penalties, and interest has been substantial. See supra note 1.

Application of the TEFRA provisions is the most “distressingly complex and confusing” in tax shelter cases such as the case at hand and Petaluma where the Commissioner takes and sustains the primary position in the FPAA (and the parties agree or the taxpayer concedes) that an entity purporting to be a partnership is to be disregarded on grounds of sham or lack of economic substance.

In such cases the entity is not a partnership for Federal income tax purposes, the persons holding interests in the entity are not partners, their interests in the entity are not interests in a partnership, and the transactions between the entity and the interest holders are not transactions between a partnership arid its partners. Consequently, the substantive provisions of subchapter K simply do not apply to the entity, the persons holding interests in the entity, or their transactions with the entity and among themselves. However, pursuant to

section 6233(

a) and (b), the TEFRA procedural provisions applicable to partnerships do apply “to the extent provided by regulations” to an entity that has filed a partnership return and to the persons holding an interest in the entity even if it is not a partnership for Federal income tax purposes or even “if it is determined that there is no such entity”. Sec. 301.6233-lT(c), Temporary Proced. & Admin. Regs., 52 Fed. Reg. 6795 (Mar. 5, 1987). The complexity of the TEFRA provisions in a case where an entity purporting to be a partnership is disregarded as such begins with sections 6226(

f) and 6233, which govern the Tax Court’s jurisdiction in partnership-level proceedings. Our jurisdiction to enter the stipulated decision as written also begins with those statutory provisions. II. Jurisdiction Under TEFRA When Entity Filing Partnership Return Is Not a Partnership or Does Not Exist A. TEFRA Procedures Apply When Entity That Filed Partnership Return Is Not a Partnership or Does Not Exist: Sections 6226(

f) and 6233 Generally, in partnership-level proceedings we have jurisdiction under

section 6226(

f) to determine all partnership items of the partnership for the partnership taxable year to which the FPAA relates, and we are not limited to the partnership items adjusted in the FPAA. Sec. 301.6226(f)-lT, Temporary Proced. & Admin. Regs., 52 Fed. Reg. 6788 (Mar. 5, 1987). We also have jurisdiction to determine the proper allocation of those partnership items among the partners and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item. Sec. 6226(f).

The TEFRA procedures and our jurisdiction in TEFRA proceedings are not limited to partnership items of valid business entities recognized as partnerships for Federal tax purposes. Pursuant to

section 6233 and the regulations promulgated thereunder, if an entity that has filed a partnership return is determined not to be a partnership or not to exist, the TEFRA partnership procedures (statutory and regulatory) will apply to the entity, its items, and persons holding an interest in the entity. Sec. 301.6233-lT(a), (c), Temporary Proced. & Admin. Regs., supra. In such a case, the Court has jurisdiction to make the determinations that the entity is not a partnership and/or that it does not exist as well as determinations with respect to all items of the entity that would be partnership items, as defined in

section 6231(a)(3) and

section 301.6231(a)(3)-l, Proced. & Admin. Regs., if the entity had been a partnership. Sec. 301.6233-lT(a), (c), Temporary Proced. & Admin. Regs., supra. Generally, a valid business entity having two or more owners is taxed as either a corporation or a partnership. However, an entity that merely acts as nominee and agent for its owners may be disregarded as a separate business entity. Cf. Commissioner v. Bollinger, 485 U.S. 340, 344-345 (1988). In such a case, the Court may determine that the entity does not exist and is neither a corporation nor a partnership, but the TEFRA procedures will still apply in accordance with

section 6233(

b) and

section 301.6233-lT(c), Temporary Proced. & Admin. Regs., supra. When Congress enacted the TEFRA procedures and the Secretary first promulgated the temporary regulations, there were frequent controversies over whether an unincorporated business entity with two or more owners (often a limited partnership) was properly classified as a corporation or a partnership for Federal tax purposes under

section 301.7701-2, Proced. & Admin. Regs., in effect at that time.

Section 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra, focuses on the resolution of such controversies and, if the entity is properly taxable as a corporation, gives the Court jurisdiction in the TEFRA proceeding to determine the taxable income of the corporation, which will also “serve as a basis for a computational adjustment reflecting the dis-allowance of any loss of credit claimed by a purported partner with respect to that entity.” However, the procedures under

section 6233 are not limited to controversies regarding the proper classification of an entity as a corporation or as a partnership.

Section 6233(

b) and

section 301.6233-lT(c), Temporary Proced. & Admin. Regs., supra, give the Court jurisdiction in the partnership-level proceeding to determine that an entity that filed a partnership return does not exist. If the Court determines that the entity does not exist or is deemed not to exist, the nonexistent or disregarded entity will be treated as an entity that filed a partnership return, and

section 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra, will apply. The Court must then determine whether the entity is nonetheless a partnership for Federal income tax purposes. If the Court determines that it is not, the Court has jurisdiction to make determinations with respect to all items of the entity that would be partnership items, as defined in

section 6231(a)(3) and

section 301.6231(a)(3)-l, Proced. & Admin. Regs., if the entity had been a partnership. B. Jurisdiction To Determine Items of Disregarded Entity:

Section 301.6233-lT(

a) and (c), Temporary Proced. & Admin. Regs., 52 Fed. Reg. 6779, 6795 (Mar. 5, 1987)

Section 6233 provides that if a partnership return is filed for a taxable year but it is determined that no partnership exists, the TEFRA procedures still apply to the entity, its items, and persons holding an interest in the entity, to the extent provided in the regulations. In such a case, the TEFRA temporary regulations applicable to Tigers Eye’s 1999 taxable year provide that the Court may make determinations with respect to all items of the entity (entity items) that “would be partnership items, as defined in

section 6231(a)(3) and the regulations thereunder [section 301.6231(a)(3) — 1, Proced. & Admin. Regs.], if * * * [it] had been a partnership”. Sec. 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra. Further, the TEFRA temporary regulations provide: Paragraph (

a) of this

section shall apply where a partnership return is filed for a taxable year but it is determined that there is no entity for such taxable year. For purposes of applying paragraph (

a) of this section, the partnership return shall be treated as if it was filed by an entity. [Sec. 301.6233-lT(c), Temporary Proced. & Admin. Regs., supra.} See also sec. 301.6233-1(a), (d), Proced. & Admin. Regs., supra (applicable for taxable years beginning on or after October 4, 2001). A partnership item is an item that is (1) required to be taken into account under any provision of subtitle A, governing income taxes, and (2) identified by the Secretary in the regulations as “more appropriately determined at the partnership level”. Sec. 6231(a)(3). In

section 301.6231(a)(3)-l, Proced. & Admin. Regs., the Secretary identified the items that are “more appropriately determined at the partnership level than at the partner level and, therefore, are partnership items”.

Section 301.6231(a)(3)-l(a)(l)(i), Proced. & Admin. Regs., provides that partnership items include the partnership aggregate and each partner’s share of items of income, gain, loss, deduction, or credit of the partnership. Partnership items also include “the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.” Sec. 301.6231(a)(3)-l(b), Proced. & Admin. Regs. The existence of a valid partnership is a partnership item.

First, it must be taken into account in computing a purported partner’s income taxes. “‘When filling out individual tax returns, the very process of calculating an outside basis, reporting a sales price, and claiming a capital loss following a partnership liquidation presupposes that the partnership was valid.’” Petaluma II, 591 F.3d at 653 (quoting RJT Invs. X v. Commissioner, 491 F.3d at 736). Second, the existence of a valid partnership “is a sine qua non for determining the amount and characterization of all other partnership items.” Id.

The legal and factual determinations underlying the Court’s determination that the entity is not a partnership and/or does not exist will determine the character of the items of income, credit, gain, loss, and deduction of the entity. Thus the legal or factual determination that establishes the existence or nonexistence of a partnership is an item that the Secretary has identified as being more appropriately decided at the partnership level than at the partner level. Id.

The determination that an entity is not a partnership because it is an association taxable as a corporation or because it was merely the nominee or agent for its owners is such a legal or factual determination and is a “partnership item” that the Court has jurisdiction to decide in the partnership-level proceeding. The classification of the entity as a corporation or as a nominee-agent will determine the character of the items of income, credit, gain, loss, and deduction of the entity.

Thus, if the Court determines that the entity that filed a partnership return is not a partnership but is an association taxable as a corporation, entity items would include amounts taxable to the entity as a corporation. Sec. 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra.

If the Court determines that an entity is a nominee-agent for the purported partners, the items of the entity will be directly attributable to them. “[D]etermining whether there is a valid partnership necessarily controls whether there can be partnership income, partnership gain, partnership losses, and so forth.” Petaluma II, 591 F.3d at 653. If the Court has determined that an entity that filed a partnership return is not a partnership and/or does not exist, there is no partnership income, partnership gain, or partnership loss. The items of the entity are not properly characterized as those of a partnership.

The regulations provide that the Court’s determination that an entity that filed a partnership return is not a partnership and is taxable as a corporation “will serve as a basis for a computational adjustment reflecting the disallowance of any loss or credit claimed by a purported partner with respect to that entity”. Sec. 301.6233-1T(a), Temporary Proced. & Admin. Regs., supra. Because that

section of the temporary regulation also applies to entities that do not exist, the determination that the entity is deemed not to exist and is not a partnership for Federal tax purposes will also serve as a basis for a computational adjustment reflecting the disallowance of any loss or credit claimed by a purported partner with respect to that entity.

Notably, the regulation does not limit the computational adjustment to the disallowance of the purported partner’s share of “partnership loss or credit” that flowed through to his return from the partnership return; the regulation extends the permissible computational adjustment to the disallowance of “any loss or credit claimed by a purported partner with respect to that entity”. (Emphasis added.) Such a loss or credit, because it would be “with respect to that entity”, would include a loss claimed on the sale or liquidation of the partner’s purported partnership interest in the entity or on his sale of property purportedly distributed to him in liquidation of his partnership interest in the entity.

Thus the Court has jurisdiction in the partnership-level proceeding to determine that items of the entity that purport to be partnership items do not exist and to adjust all such items to zero so that a computational adjustment can be made to reflect the disallowance of any loss or credit claimed by a purported partner with respect to the entity. C. Jurisdiction To Determine Applicability of Any Penalty That Relates to Adjustment of Entity Item:

Section 6226(

f) If the Court determines that an entity that filed a partnership return is not a partnership, the TEFRA provisions, including

section 6226(f), apply. Sec. 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra. Pursuant to

section 6226(

f) the Court has jurisdiction to determine the applicability of any penalty that relates to an adjustment to a partnership item. III. Jurisdiction To Enter Stipulated Decision as Written With Respect to Partnership Items A. Provisions of the Stipulated Decision The first decision paragraph in the stipulated decision gives specific effect to four of the five scheduled adjustments made by the FPAA: Loss, Other Deductions, Distributions of Property Other Than Money, and Capital Contributions, omitting any reference to “Outside Partnership Basis”.

The $242,186 loss and the $11,314 of other deductions flowed directly through to the purported partners’ returns. The deficiencies resulting from those adjustments do not require any facts to be determined in a partner-level proceeding. Therefore respondent may assess those deficiencies and the penalties applicable thereto without sending a statutory notice of deficiency. The third and fourth decision paragraphs apply accuracy-related penalties to any underpayment of tax attributable to the specified adjustments of partnership items made by the first decision paragraph.

The third decision paragraph applies the 40% gross valuation (basis) misstatement penalty to the portion of any underpayment attributable to the gross valuation misstatement, as provided by

section 6662(a), (b)(3), (e), and (h), attributable to overstating the capital contributions claimed to have been made to the purported partnership. The fourth decision paragraph provides that any additional underpayment of tax that may be attributable to the adjustments to zero of the loss, other deductions, and distributions is attributable to negligence or disregard of rules or regulations under

section 6662(a), (b)(1), and (

c) or a substantial understatement of income tax under

section 6662(a), (b)(2), and (

d) and applies the 20% penalty to that underpayment. By the second decision paragraph stating that the FPAA is correct the parties adopt and incorporate all determinations made in the FPAA, including the initial FPAA determination that Tigers Eye is disregarded for Federal income tax purposes.

Notwithstanding that the first and third decision paragraphs omit any reference to “Outside Partnership Basis”, the parties agree that the second decision paragraph, in determining that the FPAA is correct, implicitly upholds the FPAA’s adjustment of outside partnership basis to zero and the application of the 40% penalty to the portion of any underpayment attributable to the gross valuation misstatement as provided by

section 6662 (a), (b)(3), (e), and (h). Consequently, the 40% penalty will apply to the portion of the underpayment attributable to the gross misstatement of basis in the distributed property (the basis participating partner claimed was its outside basis in its partnership interest in Tigers Eye). B. Disregard of Tigers Eye By the second decision paragraph of the stipulated decision, the parties have agreed and the Court has decided that the FPAA that is the subject matter of this case is correct.

The decision upholds the initial fpaa determination that the partnership is a sham, lacks economic substance, and is disregarded for Federal income tax purposes. Thus, the stipulated decision reflects the parties’ agreement that for Federal income tax purposes Tigers Eye does not exist and is not a partnership. Pursuant to

section 6233 and the regulations thereunder, we have jurisdiction to make those determinations as well as determinations with respect to all items of Tigers Eye that would be partnership items, as defined in

section 6231(a)(3) and

section 301.6231(a)(3)-1, Proced. & Admin. Regs., if it had been a partnership. Pursuant to

section 301.6233-1T(

a) and (c), Temporary Proced. & Admin. Regs., supra, the tefra procedures apply to Tigers Eye, its items, and all persons holding interests in Tigers Eye, and the Court has jurisdiction under

section 6226(

f) to determine the applicability of any penalty that relates to an adjustment to an item of Tigers Eye. That conclusion is consistent with the holding of the Court of Appeals in the Petaluma case. Petaluma II, 591 F.3d at 652-654; Petaluma I, 131 T.C. at 92-97. C. Items of Tigers Eye The Court has jurisdiction to make determinations with respect to all of Tigers Eye’s items, including the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, and deduction related to the transactions conducted by Tigers Eye.

See sec. 301.6233-lT(a), (c), Temporary Proced. & Admin. Regs., supra-, sec. 301.6231(a)(3)-1(b), Proced. & Admin. Regs. The determination that Tigers Eye is a sham and lacks economic substance is a factual determination that underlies the characterization of items of income, gain, and loss related to its transactions. Because Tigers Eye is a sham and had no real business purpose, it merely acted as nominee and agent for the option partners and the items related to the transactions involving the option spreads and purchases and distribution of stock and foreign currency are characterized as such. Cf.

Commissioner v. Bollinger, 485 U.S. at 344-345. We have jurisdiction to make those factual and legal determinations in this partnership (entity)-level proceeding and to determine the items of Tigers Eye that resulted from its acting as nominee or agent for the option partners. We also have jurisdiction to determine that items that purport to be partnership items do not exist and to adjust all such items to zero so that a computational adjustment can be made to reflect the disallowance of any loss or credit claimed by a purported partner with respect to the nonexistent Tigers Eye partnership.

The items reported on the partnership return that were adjusted to zero in the first decision paragraph are such items. D. First Decision Paragraph By the first decision paragraph, the loss, deductions, capital contributions, and distributions reported by Tigers Eye on the partnership return are items adjusted to zero. Tigers Eye’s purported partners claimed their proportionate shares of the loss and deductions on their returns.

The option partners also claimed huge losses on the sale of the distributed property, which they characterized as property distributed to them in liquidation of their interests in a partnership purportedly acquired by contributing property to the purported partnership.

The parties’ agreement to the Court’s determination that Tigers Eye is not a partnership for Federal income tax purposes “will serve as a basis for a computational adjustment reflecting the disallowance of any loss claimed by a purported partner with respect to that entity” (emphasis added), i.e., Tigers Eye, including the loss claimed on the sale of property purported to have been distributed to a purported partner on liquidation of a nonexistent partnership interest in Tigers Eye. See sec. 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra. Pursuant to

section 6233 and its implementing regulation, we have jurisdiction to determine that all items of Tigers Eye purported to be partnership items are adjusted to zero. The loss, other deductions, capital contributions, and distributions are identified in

section 301.6231(a)(3)-l(a)(l)(i), (4), Proced. & Admin. Regs., as partnership/entity items that the Secretary determined are more appropriately decided at the partnership level than at the partner level. 1. Partnership Loss and Deductions The Secretary determined in

section 301.6231(a)(3)-l(a)(l)(i), Proced. & Admin. Regs., that the partnership aggregate and each partner’s share of items of income, gain, loss, deduction, or credit of the partnership are partnership items more appropriately determined at the entity level. The $242,186 partnership loss and the $11,314 partnership other deductions are partnership items. We have jurisdiction to determine that, because Tigers Eye is not a partnership, Tigers Eye did not have any partnership loss or partnership deductions. See sec. 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra.

Thus, we have jurisdiction to adjust to zero the $242,186 loss and the $11,314 deduction, as provided in the first decision paragraph of the stipulated decision. 2. Contributions and Distributions In

section 301.6231(a)(3)-l(a)(4), Proced. & Admin.

Regs., the Secretary decided that items relating to contributions to the partnership and distributions from the partnership are partnership items to the extent that a determination of such items can be made from determinations that the partnership is required to make with respect to an amount, the character of an amount, or the percentage interest of a partner in the partnership, for purposes of the partnership books and records or for purposes of furnishing information to a partner * * * Thus, the Secretary decided that items related to contributions to the partnership and distributions from the partnership that the partnership is required to determine for its books and records or for providing information to its partners are partnership items. a.

Items Related to Contributions In

section 301.6231(a)(3)-l(c)(2), Proced. & Admin. Regs., the Secretary provided the following illustrations of additional determinations the partnership is required to make for purposes of its books and records or for purposes of furnishing information to a partner that relate to contributions:

(2) Contributions. — For purposes of its books and records, or for purposes of furnishing information to a partner, the partnership needs to determine: (

i) The character of the amount received from a partner (for example, whether it is a contribution, a loan, or a repayment of a loan); (ii) The amount of money contributed by a partner; (iii) The applicability of the investment company rules of

section 721(

b) with respect to a contribution; and (iv) The basis to the partnership of contributed property (including necessary preliminary determinations, such as the partner’s basis in the contributed property). To the extent that a determination of an item relating to a contribution can be made from these and similar determinations that the partnership is required to make, therefore, that item is a partnership item.

To the extent that the determination requires other information, however, that item is not a partnership item. * * * Under the regulation, for purposes of keeping its books and records and providing information to the option partners as a purported partnership, Tigers Eye was required to determine (1) the amount of money and (2) the character and basis of the paired options received from the purported partners. Tigers Eye needed to determine its basis in the paired options in order to compute the losses realized on the unwinding of the option spreads, which were part of the loss claimed on the partnership return.

In determining the basis of the paired options, Tigers Eye needed to determine each partner’s basis in the contributed property, including the amount of the liabilities to which the property was subject. Partnership items include the partnership aggregate and each partner’s share of partnership liabilities, including determinations as to the amounts of the liabilities, whether the liabilities are nonrecourse, and increases or decreases during the taxable year. Sec. 301.6231(a)(3) — l(a)(l)(v), Proced. & Admin. Regs.

Tigers Eye was also required to determine the contributions for purposes of determining the partners’ percentage interests in the purported partnership, the partners’ shares of the partnership loss and deductions, and the amounts to which the purported partners were entitled on the purported liquidation of their interests. Tigers Eye was required to make the same determinations for purposes of its books and records and providing information to the option partners with respect to the money arid property it received in conducting the transactions as nominee or agent for the option partners.

Tigers Eye needed to account for expenses it incurred on behalf of the option partners, the amounts received and expended on the unwinding of the paired options, and the costs of the foreign currency and stock purchased on behalf of the option partners. Tigers Eye needed to provide that information to the option partners so that they could report their gain or loss on the unwinding of the paired options and determine their bases in the foreign currency and stock purchased on their behalves. b. Items Related to Distributions In

section 301.6231(a)(3)-l(c)(3), Proced. & Admin. Regs., the Secretary provided the following illustrations of additional determinations the partnership is required to make for purposes of its books and records, or for purposes of furnishing information to a partner that relate to distributions:

(3) Distributions. — For purposes of its books and records, or for purposes of furnishing information to a partner, the partnership needs to determine: (

i) The character of the amount transferred to a partner (for example, whether it is a distribution, a loan, or a repayment of a loan); (ii) The amount of money distributed to a partner; (iii) The adjusted basis to the partnership of distributed property; and (iv) The character of partnership property (for example, whether an item is inventory or a capital asset). To the extent that a determination of an item relating to a distribution can be made from these and similar determinations that the partnership is required to make, therefore, that item is a partnership item.

To the extent that the determination requires other information, however, that item is not a partnership item. Such other information would include those factors used in determining the partner’s basis for the partnership interest that are not themselves partnership items, such as the amount that the partner paid to acquire the partnership interest from a transferor partner if that transfer was not covered by an election under

section 754. Under the regulation, for purposes of keeping its books and records and providing information to the option partners as a purported partnership, Tigers Eye needed to determine the character of the amount distributed to an option partner; i.e., that it was a distribution in liquidation of the partner’s interest in the purported partnership. Having made that determination, Tigers Eye needed to determine the amounts to be distributed to the purported partners on liquidation of their interests.

Tigers Eye needed to select the property to be distributed, determine its basis in the property, and remove it as an asset on its books. Tigers Eye needed to provide that information to the option partners so that they could properly determine their bases in the distributed property. Tigers Eye was required to make the same determinations for purposes of its books and records and providing information to the option partners with respect to the property it distributed to them in conducting the transactions as nominee or agent on their behalves.

Tigers Eye was required to determine the character of property distributed to an option partner; i.e., that it was a distribution of the property Tigers Eye purchased as nominee or agent of the option partners. Having made that determination, Tigers Eye needed to identify the property to be distributed, determine its basis in the property, and account for it on its books. Tigers Eye needed to provide that information to the option partners so that they could properly determine their bases in the distributed property. 3.

Adjustment of Items to Zero Because Tigers Eye is not a partnership for Federal income tax purposes, it had no partnership items, there was no partnership loss, and there were no partnership deductions, no contributions to the purported partnership, and no distributions from a partnership to its purported partners. Adjustment of those items to zero is appropriate. The loss, deductions, capital contributions, and distributions that are adjusted to zero pursuant to the first decision paragraph are partnership items that this Court has jurisdiction to decide under

section 6233 and

section 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra. E. Second Decision Paragraph By the second decision paragraph the parties adopt and incorporate all determinations made in the FPAA, including the disregard of Tigers Eye, the adjustment of outside basis to zero, and the application of the 40% penalty to the underpayment attributable to gross valuation/basis misstatement.

Participating partner asserts that under Petaluma II the Court does not have jurisdiction to decide outside basis or the applicability of the 40% penalty to an underpayment of tax attributable to an overstatement of the basis in the distributed property, which participating partner attributed to its outside basis in the partnership. Participating partner concludes, therefore, that the Court must revise the second decision paragraph accordingly.

However, for the reasons set forth below, we conclude that the option partners’ bases in the distributed property as well as their outside bases (or lack thereof) in their purported partnership interests are partnership/entity items of Tigers Eye that we have jurisdiction under sections 6233 and 6231(a)(3) and their regulations to decide in this partnership/entity-level proceeding. 1. Basis in Property Distributed by Disregarded Entity Pursuant to

section 6233 and its regulation, we have jurisdiction to determine the items of Tigers Eye acting as nominee for the option partners. Tigers Eye was required to make determinations for purposes of its books and records and for providing information to the option partners with respect to the transactions it conducted as nominee or agent on their behalves. An option partner is required to take his basis in the distributed property into account in computing his gain or loss on the sale of the property and computing his income tax taking into account that gain or loss. The Secretary has determined in

section 301.6231(a)(3)-l(a)(4), Proced. & Admin. Regs., that items relating to distributions that the partnership is required to make for purposes of its books and records or for providing information to a partner are “more appropriately determined at the partnership level” and are partnership items. The regulation specifically provides that, for purposes of its books and records and providing information to a partner, the partnership needs to determine “[t]he adjusted basis to the partnership of distributed property”. Sec. 301.6231(a)(3)-l(c)(3)(iii), Proced. & Admin. Regs.

Tigers Eye needed to account for the money it received from the option partners, the expenses it incurred on behalf of the option partners, the amounts received and spent on the receipt and unwinding of the paired options, and the cost of the foreign currency and stock purchased on behalf of the option partners. Tigers Eye needed to provide that information to the option partners so that they could properly report their gain or loss on the unwinding of the paired options and determine their bases in the foreign currency and stock purchased on their behalves.

Tigers Eye was required to determine the character of property distributed to an option partner; i.e., that it was a distribution of the property Tigers Eye purchased as nominee or agent on behalf of the option partners. Tigers Eye needed to identify the property to be distributed, determine its basis in the property (which, in view of its nominee-agent status, is participating partner’s basis in the property) and account for the property on its books.

Because Tigers Eye did not separately account for the transactions on behalf of the various option partners, the items are entity items (partnership items) that we have jurisdiction to decide in this entity/partnership-level proceeding. Although the FPAA

Schedule of Adjustments adjusted partnership distributions to zero, it did not mention or make any specific adjustment to the bases of the foreign currency and stock received by the option partners. However, pursuant to

section 6226(f), regardless of whether the Commissioner specifically made adjustments in the FPAA, the Court has jurisdiction to determine “all partnership items of the partnership for the partnership taxable year to which the notice of FPAA relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item”. Tigers Eye’s basis in the foreign currency and stock (which is participating partner’s basis) is a partnership/entity item we have jurisdiction to decide in this case.

See sec. 301.6231(a)(3)-l(c)(3)(iii), Proced. & Admin. Regs. Participating partner acknowledges that the distributions reported on the partnership return filed by Tigers Eye is Tigers Eye’s cost basis in the distributed property. Thus, the distributions shown on the

Schedule K-l issued to each option partner is Tigers Eye’s cost basis in the property distributed to such partner. 2. Outside Basis Participating partner and petitioner agree that the second decision paragraph, in determining that the FPAA is correct, upholds the fpaa’s adjustment of outside partnership basis to zero. Participating partner asserts that the stipulated decision must be revised because under Petaluma II this Court lacks jurisdiction to make adjustments to outside basis.

However, for the reasons set forth below, we do not believe the holding of the Court of Appeals on that issue in Petaluma II serves as binding precedent under the intervening opinion of the Supreme Court in Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. _, 131 S. Ct. 704 (2011), and the recently filed opinion of the Court of Appeals for the D.C. Circuit, Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 650 F.3d 691 (D.C. Cir. 2011). a.

Petaluma Superseded by Mayo Found, and Inter-mountain: TEFRA Regulations Must Be Applied The adjustments made in the Tigers Eye FPAA are similar to those made in the Petaluma FPAA. In Petaluma I the Tax Court held that (1) the partnership was a sham and was disregarded for Federal tax purposes; (2) the purported partners had no bases in their interests in the disregarded partnership; and (3) a valuation misstatement penalty under

section 6662(b)(3) applied to underpayments related to the gross misstatement of the partners’ outside bases. In deciding the second issue, the Court held that although in some cases a partner’s outside basis may be an affected item, under the regulations defining partnership items the outside basis of the Petaluma partners was a partnership item the Court had jurisdiction in the partnership-level proceeding to decide.

In Petaluma II, the Court of Appeals affirmed the Petaluma I holding that the determination that the partnership is a sham and is disregarded for Federal tax purposes is a partnership item the Tax Court has jurisdiction to decide in the partnership-level proceeding. In so doing, the Court of Appeals held that the Tax Court’s jurisdiction in the case was governed by

section 6233. The Court of Appeals then meticulously applied

section 6231(a)(3) and the regulations thereunder to decide that the existence or nonexistence of a partnership is a partnership item. Next, contrary to the Tax Court’s holding in Petaluma I that under the regulations outside basis was a partnership item, the Government conceded that outside basis was not a partnership item. The Court of Appeals accepted the Government’s concession without any discussion of

section 6233 or 6231 or the regulations under

section 6231 upon which the Tax Court had relied. The Government argued that the Tax Court had jurisdiction in the partnership proceeding to determine the partners’ outside bases as affected items whose elements are determined mainly from partnership items. The Court of Appeals rejected that argument and held that the Tax Court did not have jurisdiction in the partnership proceeding to determine the partners’ outside bases, an affected item, despite the disregard of the partnership.

Consequently, the Court of Appeals agreed with Petaluma that “since the Tax Court lacked jurisdiction to determine outside basis, it also lacks jurisdiction to determine that penalties apply with respect to outside basis because those penalties do not relate to an adjustment to a partnership item”. Petaluma II, 591 F.3d at 655. After Petaluma II was issued, the Supreme Court in Mayo Found., 562 U.S. _, 131 S. Ct. 704, made it clear that Federal courts must defer to regulations interpreting the Code that satisfy the two-step Chevron standard. See Chevron, U.S.A., Inc. v. Natural Res. Def.

Council, Inc., 467 U.S. 837, 842-843 (1984). More recently, in Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 650 F.3d at 691, the Court of Appeals for the D.C. Circuit held that the deference given to regulations under Mayo Found, requires the Court to apply the

definitions of statutory terms provided in valid TEFRA regulations rather than follow earlier caselaw. The jurisdictional holdings of Petaluma II on outside basis and accuracy-related penalties have their genesis in the Government’s concession that outside basis was not a partnership item. The Court of Appeals summarily accepted that concession without any reference to

section 301.6233-1T, Temporary Proced. & Admin. Regs., supra, or

section 301.6231(a)(3) — 1, Proced. & Admin. Regs. In contrast, the Court of Appeals discussed and applied sections 6233 and 6231(a)(3),

section 301.6233-lT(a), Temporary Proced. & Admin. Regs., supra, and

section 301.6231(a)(3)~l, Proced. & Admin. Regs., in affirming our holding in Petaluma I that disregard of the partnership is a partnership item. Because the Court of Appeals did not consider the regulation in concluding in Petaluma II that outside basis is an affected item, we believe that its decision on the outside basis issue in Petaluma II has been superseded by the intervening opinions of the Supreme Court in Mayo Found, and the Court of Appeals in Intermountain.

Intermountain requires us to apply the TEFRA regulations rather than follow any contrary holding in Petaluma II, unless we hold the regulation to be invalid under the two-step Chevron standard as mandated by the Supreme Court in Mayo Found. If, under the applicable regulations, outside basis can be a partnership item, as we believe it to be generally, and more particularly when the entity is disregarded for Federal income tax purposes, acceptance of the Government’s concession effectively invalidates the regulation.

Consequently, we will follow the Supreme Court’s command in Mayo Found. and apply the TEFRA regulations rather than hold them invalid or inapplicable. In determining the validity of a regulation, we are not bound to follow Petaluma II where the Court of Appeals did not specifically consider the applicability of the regulation in deciding the issue. See Inter-mountain Ins. Serv. of Vail, LLC v. Commissioner, 650 F.3d at 702.

We begin by identifying the factors that determine outside basis in a valid partnership, so as to set the stage for the corresponding analysis that applies when the partnership is disregarded. b. Determination of Outside Basis: General Rule Under

Section 705(

a) Section 705(

a) states the general rule for determining the adjusted basis of a partner’s interest in a partnership. In relevant part,

section 705(

a) provides that the adjusted basis of a partner’s interest in a partnership is his original basis as determined under

section 722 (relating to contributions to a partnership) or

section 742 (relating to transfers of partnership interests) increased by (1) the amount of money and his basis in property subsequently contributed to the partnership and (2) his distributable share of the income of the partnership and decreased (but not below zero) by (1) the amount of money and the partnership’s adjusted basis in property distributed to the partner in a nonliquidating distribution to the partner and (2) his distributable shares of partnership losses and expenditures. Secs. 705(a), 722, 732(a).

The original outside basis of a partner who obtains an interest in a partnership by contribution to the partnership is equal to the amount of money contributed plus his adjusted basis in any property contributed. Sec. 722; sec. 1.722-1, Income Tax Regs. The original outside basis of a partner who obtains his interest in the partnership by purchase is his cost basis equal to the purchase price. Sec. 742; sec. 1.742-1, Income Tax Regs. The partnership’s assumption of a partner’s liability and a reduction of a partner’s share of the liabilities of the partnership are treated as distributions of money. Sec. 752(b).

The partner’s assumption of a liability of the partnership and an increase in a partner’s share of the liabilities of the partnership are treated as contributions of money. Id. If, as a result of a single transaction, a partner incurs both an increase and a decrease in his share of partnership liabilities, only the net increase is treated as a contribution or the net decrease is treated as a distribution. Sec. 1.752-l(f), Income Tax Regs.

Thus, if property contributed to the partnership is subject to indebtedness or if liabilities of the partner are assumed by the partnership, the increase and decrease in the partner’s basis from the deemed contributions and distributions of money are netted and the contributing partner’s outside basis is reduced by the portion of the indebtedness allocated to the other partners. Sec. 1.722-1, Income Tax Regs. The provisions governing the determination of outside basis are intended to equate the aggreg

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