IRS Can Assess Partnership, but Collect from Partners

In Galletti, S.Ct., 3/23/04, the Supreme Court decided that the IRS could collect a partnership tax liability from the general partners without first assessing the tax against them. This result is not the boon to the IRS that it may appear; however, it does create several potential problems for practitioners and their clients.

Under Sec. 6501(a), generally, “the amount of any tax…shall be assessed within 3 years after the return was filed…and no proceeding in court without assessments for the collection of such tax shall be begun after the expiration of such period.” Sec. 6203 requires the assessed liability to be recorded “in the office of the Secretary [of the Treasury] in accordance with rules or regulations prescribed by the Secretary.” According to Sec. 6303(a), notice of the assessment must be given within 60 days to “each person liable for the unpaid tax, stating the amount and demanding payment thereof.” Assuming all this is properly done, Sec. 6502 provides that if tax is properly assessed within three years, the limitations period is extended by 10 years from the assessment date.

Facts

The taxpayers in Galletti, Abel and Sarah Galletti, and Francesco and Angela Briguglio, were general partners in Marina Cabrillo Company, a California partnership. During the years 1992–1995 inclusive, the company incurred large Federal payroll tax liabilities that it failed to pay. The failure continued even after the IRS timely assessed the taxes against the partnership. The assessment gave the IRS an additional 10 years to collect the unpaid taxes, under Sec. 6502.

On Oct. 20, 1999, and Feb. 4, 2000, the Gallettis and the Briguglios, respectively, filed joint petitions for relief under Chapter 13 of the Bankruptcy Code. The IRS filed proofs of claim against the Gallettis for $395,179.89 and against the Briguglios for $403,264.06 for Marina Cabrillo’s unpaid payroll taxes.

The taxpayers acknowledged their liability for the taxes under California law and agreed that the taxes had been properly assessed against the partnership. However, the taxes had never been assessed against them individually, as general partners. The taxpayers claimed that, because the three-year statute of limitations under Sec. 6501 had expired, the Service could no longer attempt to collect the tax from them.

The taxpayers asserted that the Service had to assess them individually because, as individual general partners, they were primarily liable for the partnership’s payroll taxes. This flows both from the fact that the taxpayers are the taxpayers referred to in Sec. 6203 (which requires the recording of the liability of “the taxpayer” following assessment) and because the taxpayers are liable for the partnership’s debts under California law.

The Bankruptcy Court for the Central District of California, the Central California District Court and the Ninth Circuit all accepted the taxpayers’ arguments. However, the Supreme Court rejected their arguments and found for the IRS.

Supreme Court’s Reasoning

First, the Court found that the taxpayer under Sec. 6203 was the partnership, because the partnership incurred the payroll tax liabilities, not the individual partners. The partnership and the individual partners are separate entities. The Court then rejected the idea that separate tax assessments were required. An assessment, the Court determined, was merely the calculation and recording of a tax liability. Certain consequences may flow from that assessment, but the assessment is the recording. Hence, taxpayers are not assessed—taxes are. Those who are, “by reason of state law, liable for payment of” taxes, do not have to be individually assessed.

This appears to be a significant victory for the IRS, perhaps because of the tremendous effort the Service expended in litigating this matter through four courts. The Service does not have to ascertain the individuals who are secondarily liable for taxes under state law when it assesses taxes against an entity. However, to actually collect the taxes from those individuals, the Service must still determine who and where they are and then follow all of the Code’s collection procedures—notice, due process, etc. Further, if the Service chooses to litigate the matter, it must follow all of the rules and procedures of the court in which the suit is litigated. Thus, in this case, the Service still had to go to the Bankruptcy Court, file its claims and follow the court’s procedures.

Conclusion

This decision creates problems for tax advisers and their clients. First, several different types of individuals may be liable for taxes under state law—general partners (as in Galletti), but also beneficiaries of estates and fiduciaries, among others. Second, a taxpayer who is liable for paying taxes under state law may not receive notification that he or she is liable for such taxes until relatively late in the proceedings. This can put the taxpayer in a disadvantageous position.

Third, the taxpayer may not have been aware of the tax controversy at all, if he or she was not part of the entity’s administration and had no knowledge of the facts. Thus, the taxpayer may not be aware of available defenses. Moreover, the taxpayer may not have knowledge of the existence, or whereabouts, of other individuals secondarily liable, who may be able to bear the cost of defense and, ultimately, pay the overdue taxes. In short, the taxpayer may be confronted with a sudden blow, with no available defense. This is most likely to occur when either there has been a falling out among the individuals involved or one individual has moved away.

Tax advisers should watch for these situations, which may become more common because of the Supreme Court’s decision in Galletti. They can be difficult because they arise out of nowhere.

From Jim Lynch, CPA, Sobel & Co., LLC, Livingston, NJ