General Practice, Solo & Small Firm DivisionMagazine
Taxation Without Notice: Due Process And Other Notice Shortcomings With The Partnership Audit Rules
By Don R. Spellmann
This article analyzes the operation, effectiveness, and constitutionality of the notice requirements that Congress mandated as an integral component of the Partnership Audit Rules (Rules).
Summary of Partnership Audit Rules. Under the Rules, the taxation of all partnership items is generally determined at the partnership level. The Service must notify every partner of the beginning and completion of any partnership administrative proceedings. Each partner has the right to participate in these proceedings. At the end of the proceeding, the Service issues a final partnership administrative adjustment (FPAA) setting forth the Service’s proposed changes to the income and loss items determined at the partnership level. Prior to the issuance of an FPAA, any partner may file a request for an administrative adjustment of partnership items (AAR) and sue for a refund if such AAR is denied. Only the tax matters partner (TMP) and certain other partners may petition for judicial review of any FPAA, although any partner may participate in any judicial proceedings, and all of the partners are treated as parties to (and are bound by) those proceedings. When the partnership proceedings are completed, the Service immediately assesses a partner for any deficiencies attributable to partnership items without sending a notice of deficiency.
Notice Requirements. Section 6223 requires the Service to send notice of the beginning of a partnership administrative proceeding (NBAP), and the FPAA resulting from that NBAP, to each partner (Notice Partner). If a partnership (Direct Partnership) has another partnership as one of its partners (PassThru Partner) and the names of the partners of the PassThru Partner (Indirect Partners) are set forth on the Direct Partnership’s returns, the Service must send notification to the Indirect Partners in lieu of the PassThru Partner.
The TMP must keep each partner informed of all administrative and judicial proceedings regarding the adjustment of partnership items, and must send a copy of the NBAP and the FPAA to each NonNotice Partner. If the Service mails an NBAP to the partnership, the TMP must furnish to the Service the name, address, profits interest, and taxpayer identification number of each person who was a partner at any time during the tax year to which the NBAP relates. The Service satisfies its notice obligations if it mails the NBAP or FPAA to the addresses it receives by operation of the Rules, including the addresses of the partners set forth on the partnership return for the year at issue.
Constitutional Issues. A Notice Partner will not generally be bound by a judicial proceeding if the Service fails to provide timely notice of an FPAA, unless the Notice Partner otherwise elects to be bound. Notice to the TMP is, however, sufficient to make a NonNotice Partner a party to a proceeding. Accordingly, all partners may be bound by a partnership-level judicial proceeding and judgment if the Rules and Notice Requirements comport with due process standards.
The Due Process Clause requires that any adjudication which deprives a person of property must be preceded by notice and an opportunity to be heard. The means for providing notice must be "reasonably certain to inform those affected" and "must afford a reasonable time for those interested to make their appearance." Actual notice is not essential in the case of persons "missing or unknown" or whose interests are "conjectural or future." Constructive notice does not constitute adequate notice if an affected person’s address is reasonably ascertainable, unless the affected person is in privity with a party that received actual notice. Because merely complying with the minimum notice requirements of a remedial statute may be insufficient for due process purposes, Service compliance with the Notice Requirements alone will not necessarily comport with due process. The inquiry is whether the Rules ensure constitutionally adequate notice to partners. The Supreme Court has recognized that written notice sent by mail is an inexpensive and efficient means "reasonably calculated to provide actual notice."
Judicial Decisions on Constitutionality of Notice Requirements. Because a taxpayer has a constitutionally recognized property interest to protect in the assessment and collection of taxes, the Service’s assessment and collection activities pursuant to the Rules are subject to the Due Process Clause.
To date, no court has held that the Rules denied a taxpayer’s right to due process. Kaplan v. United States and Walthall v. United States are the first partnership cases to confront fact patterns in which partners neither received notice nor the opportunity to present their claim in court. In Kaplan, the only notice a limited partner received was a demand for payment from the Service almost ten years after he had filed his return. The Seventh Circuit rejected Kaplan’s argument that the Service’s failure to provide him actual notice violated his due process rights.
Walthall involved plaintiffs who invested in partnerships (constituting PassThru Partners) which invested in Direct Partnerships. The Service audited the Direct Partnerships and sent NBAPs and FPAAs to the direct partners of the Direct Partnerships, including the PassThru Partners. The Walthalls did not receive any of the notices. Upon completion of the partnership-level proceedings, the Service sent the Walthalls a notice and demand for payment with respect to their interest in the Direct Partnerships. The Walthalls sued, claiming that their due process rights had been denied because they did not receive notice. The Ninth Circuit held that the Notice Requirements were "reasonably calculated to provide sufficient notice to indirect partners such as the Walthalls."
Due Process Analysis of the Notice Requirements. The Notice Requirements must provide each partner with adequate notice and an opportunity for a hearing. Although the Rules explicitly entitle each partner, including NonNotice Partners, to file an AAR and to participate in any administrative or judicial proceeding, the right to participate is only meaningful if the partner has been notified that the partnership proceedings are pending.
The Notice Requirements require the Service to mail personally addressed NBAPs and FPAAs to each Notice Partner (including identified Indirect Partners). If it fails to do so, these Notice Partners may opt out of the partnership-level proceedings. With respect to Notice Partners, the Notice Requirements comport with due process. However, a NonNotice Partner may be taxed under the Rules without either the benefit of personal notice or even a pre or postpayment hearing. Facially, these cases present clear contraventions of the Due Process Clause. The question presented is whether the Notice Requirements provide NonNotice Partners with "notice reasonably calculated to apprise interested" partners of the partnership proceedings. The Rules depend on constructive notice to the NonNotice Partners, which is accomplished by mailing notice to the TMP and delegating to the TMP the responsibility for forwarding that notice to the NonNotice Partners. The constitutional dilemma for the Notice Requirements is that the Supreme Court has ruled in several cases that, when the names and addresses of affected parties are readily available, these parties must be mailed personal notice, even when their numbers are voluminous.
Based on the likelihood that the Notice Requirements may violate a NonNotice Partner’s due process rights the Service should consider mailing (or Congress should amend the Rules to require the Service to mail) NBAPs and FPAAs to all reasonably identifiable NonNotice Partners.
Don R. Spellmann is an associate at Latham & Watkins, New York, New York.
- This article is an abridged and edited version of one that originally appeared on page 133 in The Tax Lawyer, Fall 1998 (52:1).