Is the Suspense (Account) Over?

         Determining a partner’s basis in a partnership is a requirement that has existed since partnership tax rules were implemented. As a result, many would not expect it to be an area open to novel litigation. However, our recent case, Surk, LLC v. Commissioner, T.C. Memo. 2024-99, has shed a new light, or at least a new Tax Court interpretation, on this issue.

         Section 704(d) only allows a partner to take losses to the extent of their “outside” basis in the partnership. Surk held an interest in a partnership (the “Partnership”). Due to a computational error, Surk claimed losses from the Partnership in excess of Surk’s outside basis in the Partnership. IRS audited Surk in the year the excess losses were claimed but did not adjust these excess losses. As a result, the losses in excess of basis remained claimed and not disallowed. Based on the literal language of §705(a)(2), however, Surk’s basis in the Partnership could not be reduced below zero, so Surk argued a zero basis (not a “negative basis”) carried over to the next year.

         In a later year, the IRS sought to correct their slip-up and attempted to reduce Surk’s outside basis in the Partnership to account for the prior excess losses. IRS initially argued that the earlier losses in excess of basis did not create negative basis but were captured in a “suspense account” until they could be offset in later years when there were increases in basis. This “suspense account” concept had appeared previously in partnership treatises and been used by IRS, but it had never been subject to serious litigation, and for good reason. As this case progressed, it became apparent there was little support in the Code for the “suspense account” concept.

         Realizing this lack of support, IRS changed course for the first time in IRS’s opening brief. IRS completely abandoned the suspense account argument and presented an entirely new theory. IRS argued that a partner’s outside basis was in fact a cumulative calculation going back to the partnership’s very formation. IRS did not dispute or disallow the losses claimed in excess of basis in the prior year, but instead argued that those losses needed to be taken into account in a cumulative calculation in a later year by reducing basis. We argued the basis computation was a sequential annual computation. Since §705(a)(2) clearly precludes reducing basis below zero, we argued the prior year error could not be corrected after expiration of the statute of limitations for the year in which the error occurred.

The Tax Court agreed with IRS and stated that this new IRS position was consistent with the basis calculation rules of §705(a). The Tax Court reasoned that §705(a) was not implicated because the cumulative computation did not result in negative basis in the year before the Court. The Tax Court further stated that not accounting for these prior year excess losses would allow Surk to receive a tax benefit in excess of Surk’s investment in the Partnership.

         Because Surk had more than enough basis in the year at issue, there was no actual tax consequence in our case. Still, this ruling may have large practical effects. IRS seems to have no desire to pursue the “suspense account” concept any longer. Instead, the new IRS position adopted by the Tax Court allows IRS to adjust a partner’s outside basis all the way back to the partnership’s formation. The statute of limitations is never closed on an issue to the extent it involves computation of a partner’s outside basis. IRS now seems to be able to make taxpayers account for prior year excess losses (and potentially verify every other cumulative component of the basis computation) in later open years. Only time will tell how successful IRS will be.  

— James and Steven Mather