Whoever your partner might be. No, not Historic Boardwalk Hall; see my blogpost “Honor Your Partner?”, 9/3/12. This time it’s Jimastowlo Oil, LLC, et al., John J. Petito, Tax Matters Partner, 2013 T. C. Memo. 195, filed 8/26/13*, a day to keep us bloggers blogging far into the night.

Judge Halpern is seeking the source, not Perrier, but the source partner, the partnership whence cometh all the FPAAs that Jimastowlo and its buddy Oil Coming We Are Humming LLC are fighting about. IRS hit Jim and Hum with FPAAs, claiming Section 469 passivity and imposing accuracy penalties.

But Jim and Hum were themselves owners of a couple of working interests in oil leases, the chief worker of which was Energytec, Inc., who sold Jim and Hum “income programs” in some played-out Texas wells.

After fighting through the FPAAs, Judge Halpern thinks maybe the real partnership is among Energytec, Jim and Hum, and so he has no jurisdiction because Energytec, the “source” partner, isn’t in the mix.

For those of us who don’t do oil deals, a working interest has been defined by Hank Black, the law dictionarian, as “(T)he rights to the mineral interest granted by an oil-and-gas lease, so called because the lessee acquires the right to work on the leased property to search, develop, and produce oil and gas, as well as the obligation to pay all costs.” 2013 T. C. Memo. 195, at p. 7, footnote 3.

OK, but were Energytec, Jim and Hum partners? Now usually in these deals there’s an operating agreement, spelling out who does what and who gets what and who pays what. But here there was none; the wells were worked by Energytec or its designee, who drilled, collected, sold, kept the books and distributed the net. Neither Hum nor Jim could do anything, take any oil or sell any oil. And when Energytec finally got around to proffering operating agreements, Hum and Jim refused to sign, for the reasons hereinafter in the next succeeding paragraph set forth, as the high-priced lawyers say.

At first Jim and Hum got paid based on the projected yields from the leases, but the projections were wildly optimistic, the payments got cut, and Jim and Hum wound up owing Energytec money. Jim and Hum yelled “Ponzi scheme” and sued. And claimed theft losses. Energytec filed chapter (what else?), and so far no decision on the fraud claims.

But was it a partnership? No, says IRS, so nail Jim and Hum on the FPAAs we gave them. Yes it was, say Jim and Hum, so toss the case for no jurisdiction.

Energytec never filed a 1065. Their 1120 said they were in the oil business, but made no reference to any passthroughs. Jim and Hum each filed their own 1065s, but said nothing about source partnerships; they were simply in what my daughter the Texan calls the “awl bizniz”.

So Judge Halpern checks out the statute and regulations. A simple expense-sharing arrangement is not a partnership, but when two or more are gathered together in a business entity, and aren’t a trust or corporation, they are a partnership.

And that means TEFRA, and FPAAs, and partnership-level and partner-level computations. And affected items, those that show up on partners’ returns but are passed through from the partnership.

Judge Halpern: “Because affected items depend upon partnership-level determinations with respect to partnership items, any issuance of notice of deficiency or FPAA regarding affected items, and any resulting litigation, must await the outcome of the partnership proceeding or the expiration of the time to initiate one. That rule applies equally to affected items reported by a ‘pass-thru’ partner that were derived from a lower tier or ‘source’ partnership.” 2013 T. C. Memo. 195, at p. 23. (Citations omitted, but Judge Halpern cites the Rawls case, the subject of two of my blogposts “Finishing the Play”, 3/26/12, and “Hail, All Hail Cornell!”, 12/5/12).

And it doesn’t matter that none of the partners knew they were partners, filed returns as partners, and even that IRS never claimed they were partners. “The principle… that we lack jurisdiction to redetermine affected items attributable to a source partnership before the source partnership-level proceedings have been completed, applies even when the members of the source partnership have failed to recognize that they have created a separate entity (i.e., a partnership) for Federal income tax purposes and have not, therefore, filed a partnership return on its behalf, and the Commissioner has neither conducted a source partnership-level audit nor issued an FPAA to it.” 2013 T. C. Memo. 195, at p. 24. (Citations omitted).

The Section 469 passivity and the penalties are partnership-level items for the source partnership, and that partnership, if it is a partnership, isn’t before Tax Court. And even economic substance and sham transaction, challenging whether there even was a partnership, are partnership-level issues. See Petaluma.

Guess what? It is a partnership. Even though some assignments of working interests were recorded late or not recorded at all, as among themselves Energytec, Jim and Hum were co-tenants. And some business was being done, however minimal. Some oil was recovered, collected, sold, and some bills were paid.

It was more than co-ownership or expense-sharing. “Each LLC was, thus, a coowner with Energytec (and others) of a working interest in an oil and gas leasehold, which working interest entitled the coowners thereof to find and extract oil and gas. To exploit the working interest, the coowners had to cooperate. During the audit years, Energytec, acting as common agent, operated the wells on a cooperative basis for the working interest owners. No working interest owner could take his share of production in kind or sell it independently of the other owners. The coowners were not merely sharing expenses. They were jointly carrying on a trade or business and dividing the proceeds therefrom.” 2013 T. C. Memo. 195, at p. 40.

Out go the FPAAs, and out goes the petition.

*jimastowlo oil 2013-195