A partnership does not pay income tax to the U.S. Treasury. Unlike a corporation, which is subject to tax on its earnings, partnerships report items of income, deduction, gain, loss, and other tax attributes on a partnership income tax return, but these tax items flow through to the partners of the partnership. The partners report their allocable share of the partnership items and are ultimately responsible for the payment of any tax arising from the activities of the partnership.

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), 26 U.S.C. §§ 6221-6234 (2000) provides for a unified partnership proceeding, meaning, the IRS can examine the items of income, deduction, gain, loss, and other tax attributes reported on a partnership tax return by conducting an examination of the partnership itself, rather than having to examine each and every partners' income tax return separately. At the conclusion of the partnership examination, the partners are notified of any changes made by the IRS that flow from the partnership return through to the partners' income tax returns.

There are generally three types of adjustments that the IRS makes during the examination of the partnership. First, adjustments are made to items of income, deduction, gain, loss, and other tax attributes on the partnership return, these are referred to as "partnership items." Once adjustments to partnership items are made at the partnership level, these items are next reflected on each partners' income tax return.

The tax items at the partner level are considered to be either "computational adjustments," which are purely mathematical changes to each partner's return reflecting the partnership item changes, or "affected items," which are items that appear on each partner's income tax return that are impacted or "affected" by changes made to a partnership item, but require more than a simple mathematical adjustment at the partner level to determine the appropriate amount of tax liability owed by the partner.

A partner's outside basis, which represents the partner's investment in the partnership adjusted yearly to reflect activity of the partnership, has been held to be an "affected item." Accordingly, a partner's outside basis in a partnership is only adjusted if there is a change to a "partnership item" that flows through to the partner. If there is no change to the partnership income tax return, there is no flow through adjustment impacting outside basis, thus the partner's affected item remains unchanged.

Notwithstanding the Ninth Circuit's acknowledgement that the U.S. Tax Court determined that outside basis is an affected item, it did not concur. Rather, it held that because the partner here was itself a partnership, outside basis was a "partnership item" of the partner and not an "affected item." This is contrary to U.S. v. Woods, 571 U.S. 31 (2013), and the other Circuits addressing this issue.

Further, one of the partners in the partnership agreed to extend the statute of limitations for assessing tax against it. The extension was limited to that partner's items of income, deduction, gain, loss, and other tax attributes, but did not extend the statute of limitations for any of the partner's "affected items."

The question presented is whether a partner's outside basis is a "partnership item" of the partner or (and thus covered by the parties' extension agreement) as held by the Ninth Circuit or whether the partner's outside basis is properly characterized as an "affected item" (and thus outside the extension agreement) consistent with Woods and every other circuit to have considered the issue.

Whether a partner's outside basis is a 'partnership item' or an 'affected item'