Under the circumstances described below, is the deduction by a member of an affiliated group that files a consolidated return of a payment to a partnership in which the member is not a partner a “partnership item” within the meaning of § 6231(a)(3) or an “affected item” within the meaning of § 6231(a)(5)?

P is the common parent of an affiliated group of corporations, including S, that files a consolidated return for the calendar year 2006. S is a partner in PRS, a partnership that also uses the calendar year as its taxable year. PRS is subject to the unified audit and litigation procedures set forth in §§ 6221 through 6234 of the Internal Revenue Code (TEFRA partnership procedures).

In 2006, P makes a payment to PRS in the ordinary course of P’s business. The payment by P is not made in P’s capacity as agent for the affiliated group under the consolidated return regulations; nor is the payment by P made on behalf of S. PRS treats the payment from P as income for services provided by PRS.

P deducts the payment on the group’s 2006 consolidated return as a business expense. The Service determines that P’s deduction should be disallowed because P’s payment is actually a loan from P to PRS.

Section 6221 provides that, except as otherwise provided in §§ 6221 through 6234, the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) shall be determined at the partnership level.

Section 301.6221-1 of the Procedure and Administration Regulations provides that a partner’s treatment of partnership items on the partner’s return may not be changed except as provided in §§ 6222 through 6231 and the regulations thereunder. Thus, for example, if a partner treats an item on the partner’s return consistently with the treatment of the item on the partnership’s return, the IRS generally cannot adjust the treatment of that item on the partner’s return except through a partnership-level proceeding. Similarly, the partner may not put partnership items in issue in a proceeding relating to nonpartnership items.

Section 6222(a) provides that a partner shall, on the partner’s return, treat a partnership item in a manner which is consistent with the treatment of such partnership item on the partnership return.

Section 6226(c)(1) provides that each person who was a partner at any time during the taxable year shall be treated as a party to an action under § 6226(a) or (b).

Section 6231(a)(2) provides that the term “partner” means (A) a partner in the partnership and (B) any other person whose tax liability under subtitle A is determined in whole or in part by taking into account directly or indirectly partnership items of the partnership. The corporate parent of a subsidiary C corporation is not a partner in a partnership merely because the subsidiary is a partner in that partnership. Section 301.6231(a)(2)-1(b). Each person who is jointly or severally liable for the income tax liability attributable to partnership items, however, is treated as a partner under § 6231(a)(2)(B) for purposes of determining the tax attributable to those partnership items. See, for example, section 1.1502-6, which generally provides that the common parent corporation and each subsidiary that was a member of the group during any part of the consolidated return year shall be severally liable for the tax for such year computed in accordance with the regulations under § 1502.

Section 6231(a)(3) provides that the term “partnership item” means, with respect to a partnership, any item required to be taken into account for the partnership’s taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that, for purposes of this subtitle, such item is more appropriately determined at the partnership level than at the partner level. Section 301.6231(a)(3)-1 provides a list of items that are more appropriately determined at the partnership level than at the partner level.

Section 6231(a)(4) provides that the term “nonpartnership item” means an item that is (or is treated as) not a partnership item.

Section 6231(a)(5) defines an “affected item” as any item to the extent the item is affected by a partnership item. Affected items are adjusted and assessed after the determination of partnership items. See §§ 301.6231(a)(5)-1 and 301.6231(a)(6)-1; GAF v. Commissioner, 114 T.C. 519 (2000) (affected item notices of deficiency cannot be issued until after the determination of partnership items). Affected items must be determined consistently with the prior determination of partnership items. N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 746-747 (1987). Generally, affected items have a partnership item component that subchapter K of the Code requires a member of the partnership to take into account in computing that member’s tax liability. See section 702.

In the situation described above, each member of P’s affiliated group that filed a consolidated return (including P) is severally liable for the tax for the 2006 consolidated return year. Section 1.1502-6(a). Thus, P is severally liable for the income tax liability attributable to partnership items that are allocated by PRS to S, including PRS’s receipt of payments from P for services. Under § 6231(a)(2)(B), P is treated as a partner in PRS for purposes of the TEFRA partnership procedures.

The TEFRA partnership procedures only apply to the specific items that the partnership must determine under subtitle A of the Internal Revenue Code. Section 6231(a)(3). If the TEFRA partnership procedures apply, the definition of partner under § 6231(a)(2) may bring a person into a partnership proceeding, and bind that person to the outcome of the partnership proceeding with respect to those partnership items. Section 6226(c). It will also bind the partner to the direct flow-through effects of partnership item adjustments on other items on the partner’s return, i.e., “affected items.”

If the TEFRA partnership procedures do not otherwise apply to the adjustment of an item, § 6231(a)(2)(B) does not operate to make that item subject to the TEFRA partnership procedures. Nor does § 6231(a)(2)(B) require that nonpartnership items that are not affected items be treated consistently with the partnership’s reporting of the items, or with the determination of partnership items. Thus, in the situation described above, P’s deduction on the consolidated return for P’s payment to PRS will not be subject to the TEFRA partnership procedures unless the deduction is a partnership item or an affected item.

P’s deduction of the payment to PRS is not a partnership item, as defined in § 301.6231(a)(3)-1. P’s status as a partner for purposes of section 6231(a)(2)(B) does not make P a partner in PRS for purposes of Subchapter K. Although the underlying facts and circumstances of the transaction between P and PRS should independently result in consistent treatment of the transaction by both PRS and P’s affiliated group, nothing in subtitle A requires PRS to account for how P characterizes the transfer of the payment to PRS. Nor is P’s deduction an affected item within the meaning of § 6231(a)(5). The manner in which PRS characterizes the receipt of the payment (whether as gross income for services or loan proceeds) is a separate item from, and does not affect, P’s characterization of the transfer of the payment to PRS (whether as a business expense or as a loan). Although section 702 requires that P’s affiliated group account for S’s distributive share of the receipt of the payment from P to PRS, S’s distributive share does not, in turn, “affect” the treatment of P’s payment to PRS. Accordingly, P’s deduction for its payment to PRS will not be subject to the TEFRA partnership procedures.

The tax treatment by a member of an affiliated group on a consolidated return of a payment to a partnership in which the member is not a partner is not a “partnership item” within the meaning of § 6231(a)(3) or an “affected item” within the meaning of § 6231(a)(5), even if another member of the group is a partner in the partnership.

The principal author of this revenue ruling is William Heard of the Office of the Associate Chief Counsel (Procedure & Administration), Administrative Provisions and Judicial Practice Division. For further information regarding this revenue ruling, contact Mr. Heard at (202) 622-7950 (not a toll-free call).