                             T.C. Memo. 2013-195



                        UNITED STATES TAX COURT



    JIMASTOWLO OIL, LLC, ET AL.,1 JOHN J. PETITO, TAX MATTERS
                      PARTNER, Petitioner v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 11316-08, 11332-08,            Filed August 26, 2013.
                  21586-09, 22706-09,
                  11263-10.



             J and OC (LLCs) each purchased a 7.93% working interest in
      an oil and gas leasehold. Each deducted expenses on its returns for
      the audit years (2004-06 for J, 2004 and 2005 for OC) that were
      allegedly associated with its working interest. R issued notices of
      final partnership administrative adjustment (FPAAs) to the LLCs
      denying the deductions, treating reported losses as passive activity


      1
       The following cases are consolidated herewith: Oil Coming We Are
Humming LLC, John J. Petito, Tax Matters Partner, docket No. 11332-08;
Jimastowlo Oil, LLC, John J. Petito, Tax Matters Partner, docket No. 21586-09;
Oil Coming We Are Humming, LLC, John J. Petito, Tax Matters Partner, docket
No. 22706-09; and Jimastowlo Oil LLC, John J. Petito, Tax Matters Partner,
docket No. 11263-10.
                                 -2-

[*2] losses under I.R.C. sec. 469, and asserting accuracy-related
penalties under I.R.C. sec. 6662. After a trial addressing the issues
raised in the FPAAs (substantive issues), we issued an order directing
the parties to address our concern that the so-called income programs
purchased by the LLCs constituted partnerships for Federal income
tax purposes so that we were without jurisdiction to consider the
merits of what would then be the LLCs' pass-through deductions from
a source partnership (i.e., computational adjustments) at the LLCs'
(partner) level, before the propriety of those deductions had been
decided at the source partnership level, citing Sente Inv. Club P'ship
of Utah v. Commissioner, 95 T.C. 243, 248 (1990); Maxwell v.
Commissioner, 87 T.C. 783, 788 (1986); and Alhouse v.
Commissioner, T.C. Memo. 1991-652, aff'd sub nom. Bergford v.
Commissioner, 12 F.3d 166 (9th Cir. 1993). Both parties moved to
reopen the record, which we did, and we conducted a second trial to
address the jurisdictional issue. R argues that the income programs
did not constitute partnerships for Federal tax purposes and that,
therefore, we have jurisdiction to decide the substantive issues. P
argues that the LLCs were members of "de facto" partnerships so that
we lack jurisdiction to decide the substantive issues.

       1. Held: Each LLC, together with the other working interest
owners in the leasehold, joined together to conduct an unincorporated
business, which, for Federal income tax purposes, must be classified
as a partnership.

       2. Held, further, the FPAAs issued to the LLCs, to the extent
that they make adjustments only with respect to the substantive issues
(partnership items), are invalid because there have been no source
partnership-level proceedings.

       3. Held, further, we will, therefore, on our own motion dismiss
these consolidated cases for lack of jurisdiction insofar as the
individual FPAAs pertain to computational items.
                                        -3-

[*3] John J. Petito, pro se.

      Theodore Robert Leighton, Diane R. Mirabito, Andrew Ira Ouslander, and

Deborah Aloof, for respondent in docket Nos. 11316-08, 11332-08, 21586-09, and

22706-09.

      Theodore Robert Leighton, Diane R. Mirabito, Andrew Ira Ouslander,

Deborah Aloof, and Joshua Nachman, for respondent in docket No. 11263-10.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      HALPERN, Judge: These consolidated cases are partnership-level actions

based upon petitions filed pursuant to section 6226.2 Jimastowlo Oil, LLC

(Jimastowlo), and Oil Coming We Are Humming, LLC (Oil Coming), the two

      2
      Unless otherwise indicated, all section references are to the Internal
Revenue Code as amended.

       Sec. 6226 is one of a group of provisions (currently comprising secs. 6221-
6234) entitled "Tax Treatment of Partnership Items" that was added to the Internal
Revenue Code by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),
Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648 (TEFRA partnership provisions).
In general, those provisions establish special procedures for auditing partnership
returns whereby the return is subject to a single audit in which one partner acts for
the partnership but all partners are bound by the results of the audit. The audit
results may be contested in court in a unified proceeding the results of which are
also binding upon all partners. See Boris I. Bittker & Lawrence Lokken, Federal
Taxation of Income, Estates and Gifts, para. 112.3.1, at S112-88 (Cum. Supp. No.
2, 2013).
                                         -4-

[*4] entities involved in these consolidated cases (together, LLCs), are New York

limited liability companies that, pursuant to section 301.7701-3(b)(1)(i), Proced. &

Admin. Regs., constitute partnerships for Federal income tax purposes. The

petitioner in each case is John J. Petito, presently tax matters partner, who resided

in New York when he filed the petitions.

      Consistent with their tax classification as partnerships, both Jimastowlo and

Oil Coming filed Forms 1065, U.S. Return of Partnership Income, for the audit

years (2004-06 for Jimastowlo and 2004-05 for Oil Coming). The petitions were

filed in response to respondent's notices of final partnership administrative

adjustment (FPAAs) issued to the tax matters partner for each LLC for each of the

audit years. Respondent's FPAAs (1) disallow deductions claimed by the LLCs in

connection with their percentage shares in working interests in oil and gas

leaseholds and (2) determine accuracy-related penalties, under section 6662, with

respect to partnership items of the LLCs. In addition, in the FPAA issued to

Jimastowlo for 2006 and in his answer to the petition filed on behalf of Oil

Coming with respect to 2005, respondent asserts that the passive activity loss

limitation rules of section 469 apply; i.e., that the exception to those rules afforded

by section 469(c)(3) for working interests in oil and gas property is inapplicable to

Jimastowlo for 2006 and to Oil Coming for 2005. Petitioner defends the
                                        -5-

[*5] challenged deductions, denies that section 469 applies, denies that the section

6662 accuracy-related penalty applies, and asserts, presumably as an alternative to

the challenged deductions, that, because both of the LLCs invested in what was

discovered, in 2006, to be a "Ponzi scheme", each is entitled to a 2006 theft loss

deduction for its entire investment under section 165(e). We conducted a trial

(first trial) in September 2010, after which the parties submitted briefs addressing

the foregoing issues (substantive issues).

      During our consideration of the substantive issues, we became concerned

that certain so-called income programs purchased by the LLCs (which gave rise to

the disputed deductions) constituted partnerships for Federal income tax purposes.

As will be more fully explained below, the term "income program" was used by a

company named Energytec, Inc. (Energytec), to identify a group of oil and gas

wells, and the percentage working interest therein, purchased by a particular

purchaser from Energytec. If our concern was borne out, the substantive issues

would, within the meaning of section 6231(a)(3), constitute "partnership items",

determinable, pursuant to section 6221, at the partnership level. In that event, we

would be without jurisdiction to decide the substantive issues in the partner-level

proceeding before us. We ordered supplemental briefing addressing (1) whether

the income programs in which the LLCs had invested constituted partnerships
                                         -6-

[*6] subject to the TEFRA partnership provisions and (2) if so, whether we should

dismiss these consolidated cases on our own motion for lack of jurisdiction. We

also directed that, should either party consider it necessary to introduce additional

evidence in order to properly address those issues, that party should move to

reopen the record for that purpose. Both parties so moved, we granted the

motions, and we conducted a further trial (second trial), at which the parties

introduced testimony and documentary evidence. After the second trial, the

parties submitted the supplemental briefs that we had ordered. Respondent argues

that the LLCs were not, on account of their oil and gas investments, partners in

any partnerships, and so we should not dismiss these cases for lack of jurisdiction.

Petitioner argues that the investments were in "de facto" partnerships and we

should dismiss.

      It is within our authority to raise the issue of jurisdiction. E.g., Gould v.

Commissioner, 139 T.C. 418 (2012). As the party alleging jurisdiction,

respondent bears the burden of proving jurisdictional facts by a preponderance of

the evidence. See Zunamon v. Brown, 418 F.2d 883, 886 (8th Cir. 1969) (citing

McNutt v. Gen. Motors Acceptance Corp., 298 U.S. 178, 189 (1936)).

      We find that, on account of each LLC's purchase of an income program,

each was a member of a partnership for Federal income tax purposes. We are
                                         -7-

[*7] therefore precluded by section 6221 from considering the substantive issues,

including the additional issues raised by respondent of whether, if partnerships do

exist, those partnerships should be disregarded on account of a lack of economic

substance or on account of some other antiabuse doctrine. We will dismiss for

lack of jurisdiction insofar as the individual FPAAs pertain to computational

items.

                                FINDINGS OF FACT

The LLCs' Investments in the Schuyler and J.B. Milstead Oil Leases

         Energytec, a Nevada corporation, was organized in 1999 to engage in oil-

and gas-producing activities through the acquisition of oil and gas leaseholds that,

previously, had been the object of exploration and producing activity and that no

longer were producing or operating because of abandonment or neglect.

Energytec's rights in those leaseholds constituted what are known as "working

interests".3

         Each LLC paid $102,720 for its 7.93% share of Energytec's working interest

in certain leaseholds. The working interest in which Jimastowlo shared involved

         3
        Black's Law Dictionary 1745 (9th ed. 2009) defines a working interest in
oil and gas as: "The 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."
                                        -8-

[*8] 11 oil wells on the Schuyler leasehold, Rusk County, Texas (Schuyler

leasehold). The working interest in which Oil Coming shared involved nine oil

wells on the J.B. Milstead leasehold, Rusk County, Texas (Milstead leasehold).

Each LLC obtained its share of Energytec's working interest pursuant to an

"Assignment, Bill of Sale and Conveyance" from Energytec dated April 26, 2005,

in Jimastowlo's case, and April 4, 2005, in Oil Coming's case. The assignment to

Jimastowlo stated that it was "to be effective as of December, 2004, at 7:00 a.m.",

and the one to Oil Coming stated that it was "to be effective as of September,

2004, at 7 a.m." Both assignments were executed on behalf of Energytec by Don

Lambert, Assistant to the President, Energytec, Inc. The assignment to Jimastowlo

was not recorded under Texas law until November 6, 2006, and there is no

evidence that the assignment to Oil Coming was ever recorded.

      Before receiving the foregoing assignments, the LLCs received evaluation

reports (evaluation reports) with respect to the oil wells included in the working

interests in which they would share. The evaluation reports, dated December 2004

in the case of the Schuyler leasehold and September 2004 in the case of the

Milstead leasehold, were prepared for Energytec by Frank W. Cole Engineering

(Cole Engineering). The evaluation report with respect to the Schuyler leasehold

referenced Income Program No. 105, and the evaluation report with respect to the
                                         -9-

[*9] Milstead leasehold referenced Income Program No. 70. As stated, the term

"income program" was used by Energytec to identify the wells, and the percentage

share in the working interest therein, offered by it to a particular purchaser. For

example, Income Program No. 105 identified the 11 wells on the Schuyler

leasehold and the 7.93% working interest therein that Jimastowlo purchased from

Energytec, and Income Program No. 70 identified the 9 wells on the Milstead

leasehold and the 7.93% working interest therein that Oil Coming purchased from

Energytec. Other persons, or groups of persons, identified in the record purchased

percentage working interests in both the Schuyler leasehold and the Milstead

leasehold. Income Program No. 107 identified More in Oil LLC as the owner of a

7.93% working interest in the 11 wells on the Schuyler leasehold, and Income

Program No. 70 identified Robert Ackerman as the owner of a 7.93% working

interest in the 9 wells on the Milstead leasehold. Energytec retained a 6.575%

working interest in the wells on each of those leases.

      Each evaluation report describes the history of the field of which the

leasehold in question was a part (e.g., number of wells, total production to date)

and the geological features of the leasehold area. Each recites that Energytec

acquired the leasehold in question and operates the wells on it. Each then states

that "Energytec is offering to sell a Program of 16 units for a total price of
                                         - 10 -

[*10] $102,720, with the Program having a 7.93% working interest in each of the

* * * [11 wells, in the case of the Schuyler lease, or 9 wells, in the case of the

Milstead lease]." Each evaluation report contains projections of the monthly pro

rata gross income, operating expenses, and net operating income for each

"Program" (investor), together with a table showing the projected "'turn-key' costs

of acquiring and reworking the * * * [11 or 9 wells]." The evaluation reports

project monthly net operating income of $3,440 for each investor in the Schuyler

leasehold wells and $3,600 for each investor in the Milstead leasehold wells. The

evaluation report with respect to the Schuyler leasehold states: "Effective date of

the Assignment is December 30, 2004 and the first disbursement will be made in

Mid-April 2005." The evaluation report with respect to the Milstead leasehold

states an effective date-of-assignment of September 1, 2004, and an initial

disbursement date of "Mid-November 2004." Each evaluation report concludes

with a "summary" stating: "This is an old producing lease with a long history of

satisfactory oil production. These wells should produce economically for the next

10 to 15 years with a modest decline rate. This should be an excellent long term

investment."
                                        - 11 -

[*11] Operation of the Wells

      Usually, the arrangement among the owners of working interests in the same

well or wells is governed by the terms of a joint operating agreement agreed to by

all of the owners, which sets forth the rights, duties, and obligations of each party

to the agreement. Among other things, the operating agreement designates an

operator, who conducts and controls operations of the well (i.e., producing the oil

and gas from the well, billing the nonoperators for costs incurred, and distributing

the profits, if any). During the audit years, Energytec operated the wells on the

Schuyler and Milstead leaseholds on a cooperative basis (i.e., as an economic

activity collectively owned and cooperatively exploited) for the working interest

owners, but it did so without benefit of a joint operating agreement executed by

the working interest owners. To carry out the actual operation of the wells during

the audit years, Energytec employed, first, Cole Engineering (until April 1, 2006),

and, thereafter, Commanche Well Service Corp. (Commanche), a wholly owned

subsidiary of Energytec. Each collected oil from the wells in tanks, sold the

collected oil, offset operating expenses against sale proceeds, and apportioned

what proceeds remained among the working interest owners in proportion to their

percentage interests. No working interest owner could take in kind or sell on its

own its share of any oil production.
                                        - 12 -

[*12] In May 2006, Energytec presented the LLCs and the other working interest

owners in the Schuyler and Milstead leaseholds with draft joint operating

agreements formally designating Commanche as operator of the wells on the

respective leaseholds. Many of the leasehold owners, including the LLCs, would

not execute the draft agreements.

Payments to Working Interest Owners

      The predictions in the evaluation reports regarding oil well production

turned out to be wildly optimistic. From the inception of their interests until

March 2006, Energytec did make monthly payments to the LLCs as stated in the

evaluation reports: $3,440 to Jimastowlo and $3,600 to Oil Coming.4 But, as

stated in the evaluation reports, those payments were based on "projected" net

income from drilling operations, not actual net income, and the income projections

were based on projected production, which was substantially in excess of actual

production. As of May 15, 2006, Energytec categorized many of the wells

included in both the Schuyler and Milstead leases as "Non Producing Operational

Hold".




      4
       The March 2006 and April 2006 payments to Oil Coming were $1,532.43
and $1,242.27, respectively.
                                        - 13 -

[*13] As a result of the imbalance between net income from production and

payments to working interest owners involved in Energytec's various drilling

operations, including those with respect to the Schuyler and Milstead leaseholds,

Energytec sent a "Working Interest Report", dated May 22, 2006, to the LLCs and

the other working interest owners. The working interest reports advise of

Commanche's replacement of Cole Engineering as operator of Energytec's oil and

gas interests, and exhibit A attached to each report sets forth each LLC's

investment in its respective drilling program, the total amount, as of March 31,

2006, paid to each, and each's pro rata share of the actual net revenue to that date

from the program. Those pro rata shares were the amounts each LLC would have

received had it been paid only its 7.93% working interest share of net revenues.

The excess of the payments to each over its pro rata share of net revenue is

denominated an amount due Energytec. The working interest report explains that,

normally, in oil and gas operations of the kind in which the LLCs were involved

(which the report calls "Joint interest operations, sometimes referred to as Joint

Ventures"), the operator bills the working interest owners for their pro rata shares

of the monthly expenditures and, monthly, remits to them their pro rata shares of

the net revenues from operations after expenses. The report then notes that, in the

case of Energytec's jointly owned oil and gas drilling operations,
                                       - 14 -

      [*14] the majority of the working interest owners were receiving
      recurring payments that did not fluctuate regardless of production, oil
      and gas prices, or lease operating expenses * * * [L]ease operating
      expense and capital expenditures on the majority of the leases held by
      working interest owners has been paid by Energytec with no
      provision for * * * [joint interest billings]. The effect of these
      recurring payments and the costs borne by Energytec was the
      acceleration of the return on the investment by working interest
      owners to the detriment of the cash position and earnings of
      Energytec.

After reiterating that "[i]n many cases, the recurring payments * * * have exceeded

the net revenue that was due to the working interest owners", the report states: "If

this situation applies to you, subsequent revenue distributions will be applied

against the outstanding balance due to Energytec until the balance is collected in

full." As an alternative, the affected working interest owners were offered the

right to "pay the outstanding balance due Energytec and subsequently receive

revenue distributions based upon actual revenues less applicable lease operating

expenses."

      Exhibit A attached to the working interest report sent to Jimastowlo lists

amounts paid to Jimastowlo, as of March 31, 2006, of $37,840 and net revenue, as

of that date, from actual production (gross revenue of $2,549 less actual expenses

of $1,565) of $984, resulting in an amount due Energytec of $36,856. The

corresponding figures for Oil Coming, as of March 31, 2006, were payments of
                                        - 15 -

[*15] $59,132 and net revenue from actual production (gross revenue of $26,762

less actual expenses of $6,762) of $20,000, resulting in $39,132 due Energytec.

      Thereafter, both Jimastowlo and Oil Coming began receiving monthly

statements of "Amount Due To Energytec" from Energytec showing a "Balance

Forward" of the amount due reduced by each's pro rata share of the net revenue

from "Current Month Activity", resulting in an "Ending Balance" of the amount

due to be carried over to the subsequent month. Statements of account sent to

Jimastowlo show an amount due Energytec of $36,856 as of November 30, 2009

(the same amount due as set forth on exhibit A of the May 22, 2006, working

interest report sent to Jimastowlo), indicating that there was no net revenue from

production associated with the Schuyler leasehold wells between May 22, 2006,

and November 30, 2009. Statements of account sent to Oil Coming show that, by

December 31, 2009, Oil Coming's amount due Energytec had been reduced from

$39,132 to $26,101 by its pro rata share ($13,031) of net revenue from production

associated with the Milstead leasehold wells.

Litigation Instituted by the Working Interest Owners

      Many of the working interest owners (other than Energytec) were unhappy

with the state of affairs described in the working interest reports. They sent letters

to Energytec objecting and demanding to be paid on the basis of monthly projected
                                        - 16 -

[*16] production rather than actual net revenues from production, the former being

consistent with what they believed to be their agreement or understanding with

Frank W. Cole (representing both Cole Engineering and Energytec and who,

before March 18, 2006, was the chairman of the board, chief executive officer, and

chief financial officer of Energytec) as to the nature of their working interests.

      Thereafter, on October 23, 2007, Jomar Oil, LLC (Jomar), a working

interest owner involved in one of Energytec's oil well drilling programs, instituted

suit against Energytec, Frank W. Cole, and other individuals in the U.S. District

Court for the Northern District of Texas seeking rescission of the investment and

monetary damages for alleged misrepresentation, fraud, violation of Federal and

State securities laws, breach of contract, and conversion of funds on the part of the

defendants (Jomar litigation). Jomar was joined in that suit by numerous other

working interest owners involved in Energytec drilling programs, including the

LLCs, by the filing of an "Amended Consolidated Complaint" in June 2008 and a

"Consolidated Complaint" in November 2008. Jimastowlo alleged, with respect to

"Income Program 105" (consisting of its share of the working interest in the

Schuyler leasehold wells), that Energytec's evaluation report and the purchase

agreement knowingly or recklessly "made material misrepresentations and false

statements". In addition, Jimastowlo incorporated allegations common to all of
                                        - 17 -

[*17] the consolidated plaintiffs that Energytec omitted material facts, including

the fact that "the true nature of the Income Programs was a 'Ponzi' scheme, or part

of a 'Ponzi' scheme being perpetrated by * * * [Energytec] whereby * * * the

investment returns promised to the Plaintiffs were illusory". Oil Coming made

essentially identical allegations with respect to "Income Program 70" (consisting

of its share of the working interest in the Milstead leasehold wells). In its answer,

dated December 17, 2008, Energytec denied the allegations of the various

plaintiffs, including those of Jimastowlo and Oil Coming, sought rejection of all

claims, and asserted counterclaims for unreimbursed amounts paid in excess of net

revenues.

      On June 26 and July 10, 2009, the court denied motions by two of the

individual defendants in the Jomar litigation to dismiss the consolidated

complaint. See Jomar Oil, LLC v. Energytec, Inc., No. 3:07-CV-1782-LECF,

2009 WL 1856582 (N.D. Tex. June 26, 2009); Jomar Oil LLC v. Energytec, Inc.,

No. 3:07-CV-1782-L, 2009 WL 2002918 (N.D. Tex. July 10, 2009).

Subsequently, in its order dated February 19, 2010, the court, having considered

the parties' status report and having stayed the claims against Energytec on

account of its chapter 11 bankruptcy, determined that "it is appropriate to stay the

remaining claims brought by Plaintiffs and * * * Third-Party Plaintiffs", and it
                                        - 18 -

[*18] further determined that the case "should be, and is hereby, administratively

closed." The court directed the parties to move to reopen the case within 30 days

of the end of bankruptcy proceedings or upon the lift of the bankruptcy stay. To

date, there has been no decision on the merits in the Jomar litigation.

LLCs' Returns

      None of the Forms 1065 that the LLCs filed for the audit years indicates that

either was a member of any partnership or joint venture, nor do those returns

identify any gross receipts or deductions attributable to another (source)

partnership. On line 3 of Schedule B, Other Information, of each of those returns,

each LLC answered no to the question whether it owned any interest in another

partnership, nor did those returns contain entries derived from a Schedule K-1,

Partner's Share of Income, Deductions, Credits, etc., issued to the LLCs by any

source partnership. Most, if not all, of the LLCs' deductions that respondent

challenges herein (e.g., "oil & gas expenses-IDC", "oil depletion exp", "oil & gas

production expenses", "qual production activities") relate to the production (or

attempted production) of oil. All of the Forms 1065 for the audit years state the

LLCs' principal business activity to be manufacturing and state its principal

product or service to be oil and gas production.
                                        - 19 -

[*19] Energytec's Returns

      The Forms 1120, U.S. Corporation Income Tax Return, filed by Energytec

for 2004-06 state its principal business activity as oil and gas exploration. The

Form 1120 for 2004 reports gross receipts of over $16 million attributable to

"Disposition of various working interests". None of those returns reports any

income from U.S. partnerships or "pass-through" entities or (for 2006) from

"nonincludible [in its consolidated return] U.S. entities." No Schedules K-1 are

attached to any of those returns.

                                     OPINION

I.    Applicable Principles of Law

      A.     Definitions of Partnership and Partner

      In pertinent part, section 761(a) defines a partnership, for purposes of

subtitle A (income taxes) as including a "syndicate, group, pool, joint venture, or

other unincorporated organization through or by means of which any business

* * * or venture is carried on". See also section 1.761-1(a), Income Tax Regs.,

which provides: "The term partnership means a partnership as determined under

§§ 301.7701-1, 301.7701-2, and 301.7701-3 of this chapter." In pertinent part,

section 301.7701-1(a)(1), Proced. & Admin. Regs., provides: "Whether an

organization is an entity separate from its owners for federal tax purposes is a
                                        - 20 -

[*20] matter of federal tax law and does not depend on whether the organization is

recognized as an entity under local law." In pertinent part, section 301.7701-

1(a)(2), Proced. & Admin. Regs., adds: "A joint venture or other contractual

arrangement may create a separate entity for federal tax purposes if the

participants carry on a trade, business, financial operation, or venture and divide

the profits therefrom." It cautions, however: "Nevertheless, a joint undertaking

merely to share expenses does not create a separate entity for federal tax

purposes." Id. Section 301.7701-2(a), Proced. & Admin. Regs., defines a

business entity as "any entity recognized for federal tax purposes * * * that is not

* * * a trust * * * or otherwise subject to special treatment". In pertinent part,

section 301.7701-2(c)(1), Proced. & Admin. Regs., states: "The term partnership

means a business entity that is not a corporation * * * and that has at least two

members." See also Commissioner v. Culbertson, 337 U.S. 733, 740 (1949), in

which the Supreme Court defined a partnership as "an organization for the

production of income to which each partner contributes one or both of the

ingredients of income-capital or services." A domestic business entity with two or

more members that is not formed as a corporation under State or Federal law (a per

se corporation) and that has not elected to be classified as a corporation is
                                        - 21 -

[*21] classified as a partnership. See sec. 301.7701-3(a) and (b)(1), Proced. &

Admin. Regs.

      Section 6231(a)(1)(A) generally defines "the term 'partnership'", for

purposes of the TEFRA provisions, as "any partnership required to file a return

under section 6031(a)." Section 6031(a) applies to partnerships "as defined in

section 761(a)".

      Section 6231(a)(2)(A) defines a partner as "a partner in the partnership"

and, in pertinent part, section 6231(a)(9) defines a "pass-thru partner" as "a

partnership * * * through whom other persons hold an interest in the partnership

with respect to which proceedings under this subchapter [the TEFRA provisions]

are conducted." Should we find that the operation of the wells on the Schuyler

and Milstead leaseholds (sometimes, well operations) for the benefit of Energytec

and the other working interest owners, including the LLCs, created separate

entities classified as partnerships for Federal income tax purposes (with the LLCs

as partners therein), it is clear that, as LLCs taxable as partnerships, the LLCs

would constitute "pass-thru" partners under section 6231(a)(9).
                                        - 22 -

[*22] B.     Jurisdiction Over and Definitions of Partnership Items and Affected
             Items

      Section 6221 provides:

      SEC. 6221. TAX TREATMENT DETERMINED AT
                 PARTNERSHIP LEVEL.

            Except as otherwise provided in this subchapter, [e.g., sections
      6223(e)(2), 6227(d)(1), and 6231(b), involving special circumstances
      in which partnership items are treated as nonpartnership items] the tax
      treatment of any partnership item (and the applicability of any
      penalty, addition to tax, or additional amount which relates to an
      adjustment to a partnership item) shall be determined at the
      partnership level.

      In pertinent part, section 6231(a)(3) defines a "partnership item" as: "any

item required to be taken into account for the partnership's taxable year * * * to

the extent [IRS] regulations * * * provide that * * * such item is more

appropriately determined at the partnership level than at the partner level."

      Section 301.6231(a)(3)-1(a), Proced. & Admin. Regs., includes as

partnership items "more appropriately determined at the partnership level than at

the partner level * * * [t]he partnership aggregate and each partner's share of" a

number of listed items including "[i]tems of income, gain, loss, deduction, or

credit of the partnership" and also including "[t]he depletion allowance under

section 613A with respect to oil and gas wells". Sec. 301.6231(a)(3)-1(a)(1)(i),

(vi)(D), Proced. & Admin. Regs.
                                        - 23 -

[*23] Section 6231(a)(5) defines the term "affected item" as "any item to the

extent such item is affected by a partnership item." The existence of an affected

item normally results in a "computational adjustment", defined as "the change in

the tax liability of a partner which properly reflects the treatment * * * of a

partnership item." Sec. 6231(a)(6). In the case of a computational adjustment that

does not require a partner-level determination, the Commissioner is not required to

issue a notice of deficiency before assessing the resulting tax deficiency against

each partner. See sec. 6230(a)(1); sec. 301.6231(a)(6)-1(a)(2), Proced. & Admin.

Regs. A computational adjustment that does require a partner-level determination

is subject to the deficiency procedures (sections 6211-6216). See sec. 6230(a)(2);

sec. 301.6231(a)(6)-1(a)(3), Proced. & Admin. Regs.

      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. See

Maxwell v. Commissioner, 87 T.C. 783, 792 (1986). That rule applies equally to

affected items reported by a "pass-thru" partner that were derived from a lower tier

or "source" partnership. See Sente Inv. Club P'ship of Utah v. Commissioner, 95

T.C. 243, 248 (1990). See also Rawls Trading, L.P. v. Commissioner, 138 T.C.
                                        - 24 -

[*24] 271 (2012), wherein the Commissioner simultaneously issued FPAAs to two

lower tier "source" partnerships and one upper tier or "interim" ("pass-thru")

partnership. We held, on our own motion, that, because the FPAA issued to the

interim partnership reflected only computational adjustments resulting from

adjustments to the source partnership returns, the FPAA issued to the interim

partnership was "invalid" and did "not confer jurisdiction on us." Id. at 288-289.

      The principle enunciated in Maxwell, Sente Inv. Club P'ship of Utah, and

Rawls Trading, 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. See Alhouse v. Commissioner, T.C. Memo. 1991-

652, aff'd sub nom. Bergford v. Commissioner, 12 F.3d 166, 170 (9th Cir. 1993).

      Section 6229(c)(3) provides that, if a partnership fails to file a return for any

taxable year (which would be the case herein should we determine that the well

operations created separate entities classified as partnerships), "any tax
                                         - 25 -

[*25] attributable to a partnership item (or affected item) arising in such year may

be assessed at any time."

      C.     Treatment of the Section 469 Issue

      Section 469 provides rules limiting passive activity losses and credits.

Section 469(c)(3) provides that a working interest in any oil or gas property is, per

se, not a passive activity, provided that the interest is not held through an entity

that limits the interest holder's liability with respect to that interest. Assuming the

well operations did, in fact, create separate entities classified as partnerships for

Federal income tax purposes, the issue of whether the members of the LLCs could

avoid application of the passive activity loss rules pursuant to section 469(c)(3)

should be considered an affected item. That conclusion is based upon the

similarity between that issue (i.e., applicability of the limited liability proviso) and

the issue of whether partnership losses exceed the amounts for which the partners

are at risk under section 465, which we have held to constitute an affected item.

See Roberts v. Commissioner, 94 T.C. 853, 861 (1990).

      D.     Treatment of the Penalty Issue

      The accuracy-related penalties respondent imposed against the LLCs

are described as applying "to all under-payments of tax attributable to

adjustments of partnership items." Therefore, should we determine that the
                                        - 26 -

[*26] alleged underpayments herein relate to partnership items attributable to

source partnerships in which the LLCs are partners, the applicability of those

alleged penalties would have to be determined at that source partnership level

pursuant to section 6221. See also sec. 6226(f) (granting a reviewing court in a

TEFRA proceeding jurisdiction to "determine * * * the applicability of any

penalty, addition to tax, or additional amount which relates to an adjustment to a

partnership item").

      Section 301.6221-1(d), Proced. & Admin. Regs., states that partner-level

defenses to any penalty or addition to tax, such as the reasonable cause exception

of section 6664(c)(1) (in these cases, petitioner's claim that he reasonably relied on

"supporting documentation"), "may not be asserted in the partnership-level

proceeding, but may be asserted through separate refund actions following

assessment and payment." Section 301.6221-1(c), Proced. & Admin. Regs., also

states that "[p]artner-level defenses to such items can only be asserted through

refund actions following assessment and payment." See also sec. 6230(c)(1)(C),

(4) (together providing that a partner may file a claim for refund asserting the

Commissioner's improper imposition of any penalty or addition to tax at the

partnership level, including the assertion of "any partner level defenses that may

apply"); New Millennium Trading, LLC v. Commissioner, 131 T.C. 275, 284
                                         - 27 -

[*27] (2008) ("When considering the determination of penalties at the partnership

level, the Court can consider the defenses of the partnership but not partner-level

defenses of individual partners."). Courts have deemed it appropriate, however,

under certain circumstances, to consider partner-level defenses to the imposition

of penalties and additions to tax in the partnership-level proceeding. See, e.g.,

Tigers Eye Trading, LLC v. Commissioner, T.C. Memo. 2009-121, 2009 WL

1475159, at *19 (partnership-level defenses "include all defenses that require

factual findings that are generally relevant to all partners or a class of partners");

Santa Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005-104, 2005

WL 1111792, at *94-*112; Klamath Strategic Inv. Fund, LLC v. United States,

472 F. Supp. 2d 885, 903-904 (E.D. Tex. 2007), aff'd, 568 F.3d 537 (5th Cir.

2009). In any event, for reasons explained above, partner-level defenses to the

imposition of the section 6662 accuracy-related penalty may not be tried in a

partner-level proceeding before the application of that penalty to the partnership

has been determined in a partnership-level proceeding.

      E.     Disregarding a Partnership

      Assuming the well operations did, in fact, create separate entities classified

as partnerships for Federal income tax purposes, the determination of whether the

partnerships should be disregarded for tax purposes under a legal doctrine such as
                                        - 28 -

[*28] sham or economic substance is a partnership item. Petaluma FX Partners,

LLC v. Commissioner, 131 T.C. 84, 93, 97 (2008), aff'd on this issue, 591 F.3d

649, 653-654 (D.C. Cir. 2010); see also RJT Invs. X v. Commissioner, 491 F.3d

732, 737-738 (8th Cir. 2007).

      F.     Theft Loss Deduction

      Likewise, petitioner's alternative claim--that because it was discovered in

2006 that the LLCs had invested in a Ponzi scheme, each LLC is entitled to a theft

loss deduction for that year for its entire investment under section 165(e)--

involves a partnership item. In Marine v. Commissioner, 92 T.C. 958, 967-977

(1989), aff'd without published opinion, 921 F.2d 280 (9th Cir. 1991), a pre-

TEFRA case, we stated that, when a general partner embezzles limited partners'

cash contributions, he is not acting in this capacity as a partner, since he has no

authority to steal. The partnership and not, directly, the individual partners, is able

to deduct the theft loss as if a nonpartner had committed the embezzlement. Id. In

Midcontinent Drilling Assocs. v. Commissioner, T.C. Memo. 1994-119, 1994

WL 91170, at *5, a TEFRA case, we stated (on the authority of Marine): "A

partnership may be entitled to deduct an embezzlement loss." We found, however,

that, although the parties had stipulated that the general partner had embezzled

sums from the partnership, the partnership failed to prove sufficient details to
                                         - 29 -

[*29] justify its claimed theft loss. Implicit in our discussion is the assumption

that the general partner's misappropriation of the limited partners' capital

contributions was a partnership item. Were it not, we would have dismissed that

portion of the petition for lack of jurisdiction.5

      5
        Respondent argues that, "should petitioner's Ponzi scheme allegations
eventually be proved correct, then the Income Programs and the alleged source
partnerships are not partnerships for federal income tax purposes." Respondent's
argument about allegations that might eventually be proved correct is an argument
that a genuine issue of material fact remains that should preclude a decision at this
time. We reject that argument. We reopened the record and conducted the second
trial so that the parties could introduce additional evidence as to whether the
income programs constituted partnerships. Respondent has, thus, had adequate
opportunity to present evidence of fraud and to argue (presumably) that fraud in
the inducement to become partners negates the partnership. We have neither
adequate evidence of fraud nor a fleshed-out argument on brief. The record is
again closed, and we will decide the existence-of-a-partnership issue on the record
and arguments in front of us.

        In passing, we note that respondent's lawyers have, perhaps inconsistently,
dealt with a similar argument administratively. In an IRS Field Service Advisory,
1997 WL 33314338 (June 3, 1997) (FSA), the Chief Counsel reconsidered a
previous FSA, 1994 WL 1865988 (June 3, 1994). The two FSAs addressed
procedures for resolving theft loss deductions claimed by victims of the Ponzi
schemes perpetrated by the operators of TEFRA partnerships. In the first FSA, the
Chief Counsel's National Office took the position that the TEFRA partnership
provisions would govern the theft losses only if the partnership entities directly
incurred the losses (which would be passed through to the partners under the
provisions of subch. K (the partnership provisions of the Internal Revenue Code)).
If, on the other hand, the individual investors were defrauded into investing in the
partnerships, the FSA held, the TEFRA procedures would not apply. Whether the
general partners had, in fact, participated in the fraud by inducing innocent
partners to invest in the "sham" partnerships had not been determined, and the
                                                                        (continued...)
                                        - 30 -

[*30] II.    Analysis

      A.     Whether Well Operations Created Entities Classified as Partnerships

             1.     Introduction

      Whether we are precluded from deciding the substantive issues in these

consolidated cases and, therefore, must dismiss the cases for lack of jurisdiction

depends on whether for Federal tax purposes the well operations created entities

separate from the coowners (including LLCs) of the working interests. If they did,

and the entities are properly classified as partnerships, then the substantive issues

involve partnership items or affected items, and all partnership items (including

whether the partnerships are to be disregarded, e.g., as shams or for lack of


      5
        (...continued)
issue in the second FSA was whether the IRS must issue protective statutory
notices of deficiency for deficiencies attributable to theft losses claimed by
TEFRA partners on their own returns. The second FSA concluded that the IRS
need not issue the protective statutory notices "because, irrespective of whether
the general partner participated in the fraud, the resulting loss is either a
partnership item or an affected item and is thus properly determinable at the
partnership level." The second FSA relies principally on Marine v. Commissioner,
92 T.C. 958, 967-977 (1989), aff'd without published opinion, 921 F.2d 280 (9th
Cir. 1991), and Midcontinent Drilling Assocs. v. Commissioner, T.C. Memo.
1994-119, in reaching that result. The second FSA appears to contradict
respondent's position here that, if the Ponzi scheme allegations prove correct
(which has not yet been determined), there are no partnerships. Respondent does
not in his argument here address the question of "as of when" there would be no
partnerships: ab initio or when the Ponzi scheme was discovered or proved. Cf.
sec. 165(e).
                                        - 31 -

[*31] economic substance) must be determined first in a partnership-level

proceeding, before the consequences of any partnership-level determinations may

be applied to the LLCs (i.e., to the partners). It is true that, had someone at or

acting on behalf of Energytec determined that the well operations did create

partnerships for its many joint drilling ventures (including those to which the

LLCs were parties) and, on account of that determination, did file partnership

returns on behalf of those relationships, then the question of whether the well

operations did, in fact, give rise to partnerships for Federal income tax purposes

would appropriately be determined in partnership-level proceedings directed at the

putative partnerships. See sec. 6233(a); sec. 301.6233-1(a), Proced. & Admin.

Regs. There are, however, no partnership returns for such putative partnerships

(nor any FPAAs), and we must make that determination in this non-partnership-

level proceeding. See Alhouse v. Commissioner, T.C. Memo. 1991-652 ("Since

no partnership return was filed and no notice of final partnership administrative

adjustment (FPAA) issued, if we find that a partnership existed we must dismiss

for lack of jurisdiction insofar as the individual notices of deficiency pertain to

partnership items or (affected items).").
                                         - 32 -

[*32]         2.    Respondent's Argument

        In his opening brief, respondent argues:

              Thus, for 2004 and 2005, while Jimastowlo and Oil Coming
        nominally held working interests, received cash payments, and
        claimed expenses, the whole arrangement lacked any real economic
        connection to an actual business enterprise. The cash payments were
        unrelated to production, and the expenses claimed were unrelated to
        operations. * * * [W]hile the arrangements between Jimastowlo, Oil
        Coming, and Energytec nominally involved joint ownership of
        working interests, in substance there was never a coming together to
        share profits and losses.

We understand respondent's argument to be that, notwithstanding that each LLC

was among the coowners of a working interest that entitled those coowners to

explore for and extract oil and gas, in neither case did the coowners actually join

together to exploit their rights, and, therefore, their status as coowners was

insufficient to create an entity (a business entity) classified as a partnership for

Federal tax purposes. We disagree that the coowners did not actually join together

to exploit their rights, and we further disagree that they failed to create an entity

classified as a partnership. Our reasons follow.

              3.    Coowners of a Working Interest

        Consistent with the dictionary definition of a working interest quoted supra

note 3, we have said: "Generally, * * * a working interest in an oil field is a

leasehold interest granted by the fee simple owner of the land to explore for and
                                       - 33 -

[*33] extract oil from the land." Cokes v. Commissioner, 91 T.C. 222, 223 (1988).

Energytec had working interests in the Schuyler and Milstead leaseholds, and it

assigned 7.93% interests in those working interests to the LLCs. Respondent

argues that the assignment to Jimastowlo was not valid until recorded in 2006 and

that the assignment to Oil Coming was not valid since never recorded.

Respondent overstates the case. There were written assignments of percentage

working interests to the LLCs, executed by an officer of Energytec, which, even

though unrecorded, were valid, under Texas law, as between the LLCs and

Energytec. See Tex. Bus. & Com. Code Ann. sec. 26.01 (West 2009); Tex. Prop.

Code Ann. sec. 13.001(b) (West 2004). Each LLC was, thus, a cotenant (i.e.,

coowner) with Energytec (and others) of the respective leasehold. See Glover v.

Union Pac. R.R. Co., 187 S.W.3d 201, 213 (Tex. App. 2006) ("Owners of

undivided portions of oil and gas interests are tenants in common.").6


      6
        Respondent also agues that, because the assignments were not executed
until 2005, then, even if valid under Texas law, they could not have been effective
for 2004. As noted supra, however, each assignment stated that it was "to be
effective" as of 2004, and evidence in the record indicates that the LLCs invested
in the drilling programs and at least Oil Coming began receiving distributions in
2004. Evidence of 2004 investments by both Jimastowlo and Oil Coming is also
furnished by Energytec's 2004 return, which reports gross receipts of over $16
million attributable to "Disposition of various working interests". No amount is so
denominated on either its 2005 or 2006 return. We find on those facts that the
LLCs effectively received their percentage working interests in 2004.
                                         - 34 -

[*34]         4.    Carrying On a Trade or Business Cooperatively

        Mere coownership of property, even if it is maintained, kept in repair, and

rented or leased, does not constitute an entity separate from the coowners for tax

purposes. See sec. 301.7701-1(a)(2), Proced. & Admin. Regs. Nevertheless, as

stated supra: "A joint venture or other contractual arrangement may create a

separate entity for federal tax purposes if the participants carry on a trade,

business, financial operation, or venture and divide the profits therefrom." Id.

(emphasis added).

        During the audit years, Energytec operated the wells on the Schuyler and

Milstead leaseholds, and, while both production and sales of oil were minimal,

there were both production and sales. Indeed, during the second trial, one of

respondent's counsels conceded that, during the audit years, there was a business

in existence with respect to each of the Schuyler and Milstead leaseholds: a

"business consisting of drilling for oil and selling it". Counsel added: "Energytec

owned the business or was conducting the operations of the business activity."

Counsel's statements about the existence of businesses with respect to each

leasehold are consistent with our findings. The business in question was

exploiting the rights coowned by the working interest owners (including the

LLCs) to explore for and extract oil from each leasehold. During the years,
                                           - 35 -

[*35] Energytec did not itself directly operate the wells on the Schuyler and

Milstead leaseholds. It employed first Cole Engineering and then Commanche to

do so. We have found that, during those years, each collected oil from the wells in

tanks, sold the collected oil, offset operating expenses against sale proceeds, and

apportioned what proceeds remained among the working interest owners in

proportion to their percentage interests. We have further found that no working

interest owner could take in kind or sell on its own its share of any oil production.

We have not made those findings primarily on the basis of the evaluation reports

or other documents in evidence, but we have made them primarily on the basis of

testimony of respondent's witness, Paul Willingham, who, beginning in Spring

2005, was, first, employed by Energytec as controller and, then, as vice

president/controller. He was a credible witness, familiar with Energytec's

operating procedures. He testified that the oil produced in connection with any

one of Energytec's drilling programs "went into a tank and it was sold as a load

and then, once the revenue came in, it would be distributed amongst whoever was

the owner based upon its ownership percentage." He testified that neither LLC

could take its share of the oil in kind.

      Mr. Willingham's description of the drilling, sales, and apportionment-of-

proceeds process is indicative that Energytec operated the wells on the Schuyler
                                        - 36 -

[*36] and Milstead leaseholds on a cooperative basis for the working interest

owners, and, indeed, we have so found. In so finding, we recognize that, during

the audit years, no written joint operating agreement governed operation of the

wells on either the Schuyler or the Milstead leasehold. That Energytec would

operate the wells on a cooperative basis without a written joint operating

agreement was, however, prefigured by the evaluation reports, which the LLCs

had received before receiving assignments of their percentage working interests.

The reports describe Energytec as operating the wells on the leaseholds; they state

that Energytec is offering to sell programs consisting of 7.93% working interests

in the wells, and they project the monthly net return to each program. It is implicit

in the evaluation reports that Energytec would, directly or indirectly, operate the

wells and share the net proceeds proportionately among the working interest

owners.

      That Jimastowlo understood that it was in a cooperative relationship as

regards the Schuyler lease drilling program was certainly the understanding of

another of respondent's witnesses, Steven D. White, petitioner's predecessor as tax

matters partner for Jimastowlo. When asked by respondent's counsel about his

decision to "invest in * * * Income Program 105", Mr. White responded: "I would

say I didn't invest. I became partners with them [Energytec]." Mr. White further
                                       - 37 -

[*37] testified that he came away from a meeting with an Energytec representative

with the understanding that Jimastowlo would be participating in a partnership in

that it would be "owning part of a well that other people would have shares in.

The oil would be produced, and I would get my allotted I guess return back." On

the basis of the testimony of Messrs. Willingham and White, we think that

Energytec may accurately be described as the common agent of the coowners of

each working interest for the purpose of exploiting the appurtenant leasehold.

      Although it is true that, until March 2006, the LLCs received fixed

payments in excess of their shares of actual net revenues from production, in May

2006 Energytec initiated the originally intended arrangement by requiring each

LLC's future share of actual net revenue from production to offset the excess

portion of what Energytec has been treating as prior advance payments based upon

projected net revenue. Moreover, as Mr. Willingham testified, the coowners

(including the LLCs) were credited with their shares of whatever net income the

wells did produce. Jimastowlo's net revenue from its share of the working interest

in the Schuyler leasehold as of March 31, 2006, was minimal: gross revenue of

$2,549, actual expenses of $1,565, net revenue of $984. Oil Coming fared

somewhat better as of that date from its share of the working interest in the

Milstead leasehold: gross revenue of $26,762, actual expenses of $6,762, and net
                                        - 38 -

[*38] revenue of $20,000. After March 2006, when Energytec ceased making

payments to the LLCs based on projected net income, and through November

2009, there was no net revenue from production associated with the Schuyler

leasehold wells, and Jimastowlo was credited with none. On the other hand,

through that period Oil Coming was credited with $13,031, its pro rata share of net

revenue from production associated with the Milstead leasehold wells. Thus,

while it is undoubtedly true that, at least in major portion, the cash payments that

the LLCs received were unrelated to production, and while it may be true (we have

no evidence) that an equally major portion of the claimed expenses was unrelated

to operations, it is nonetheless true that, during the audit years, each of the LLCs

was the owner of 7.93% of a working interest in oil and gas wells that were

producing at least minimal amounts of oil in which each owned a share.

Moreover, the evidence indicates that Energytec intended the fixed payments to be

reflective of actual, anticipated well production. As noted supra, however,

because the revenue and profit projections upon which those payments were based

proved to be overly optimistic, it was necessary to stop payments in March 2006

and attempt to carry out the original intent to have the coowners receive no more

than their pro rata shares of the actual profits from well production.
                                         - 39 -

[*39] The LLCs were, thus, because of their coownership of working interests in

the Schuyler and Milstead leaseholds, and by virtue of the common agency of

Energytec, participants in "actual" oil drilling and sales businesses. Those actual

oil drilling and sales businesses undoubtedly incurred expenses and other

deductible items, and, because, as stated in the evaluation reports, each working

interest owner's share of drilling proceeds was only net of its share of expenses,

each LLC's share of proceeds was burdened by its share of those expenses

(notwithstanding that, at least initially, distributions did not reflect those net

shares). Each LLC claimed deductions for what it says is its share of those items,

which respondent disallowed and which are at issue in these cases (e.g., "oil & gas

expenses-IDC", "oil depletion exp", "oil & gas production expenses", "qual

production activities"). Respondent's argument, set forth above, that the LLC's

"lacked any real economic connection to an actual business enterprise" is that

"[t]he cash payments were unrelated to production, and the expenses claimed were

unrelated to operations." That argument ignores the testimony of respondent's

witness (Mr. Willingham) about the actual functioning of well operations. It also

ignores the fact that fixed payments stopped in May 2006 in favor of a "truing up"

consistent with a characterization of the prior cash payments as advance payments

against actual revenues. Indeed, respondent concedes on brief that the LLCs
                                        - 40 -

[*40] "nominally held working interests". Moreover, by the FPAA in

Jimastowlo's case and by the answer in Oil Coming's case, respondent would limit

to passive loss status any losses resulting from the LLCs' deductions not because

the losses did not result from working interests in an oil and gas property, but

because the losses did result from working interests, which were held through the

LLCs. See sec. 469(c)(3).

      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.

             5.    Classification for Tax Purposes

      Because the coowners of the working interests in each of the Schuyler and

Milstead leaseholds jointly carried on a trade or business, dividing the proceeds

therefrom among themselves, each trade or business constituted for Federal tax
                                        - 41 -

[*41] purposes an entity separate from the coowners of the appurtenant working

interest. See sec. 301.7701-1(a)(2), Proced. & Admin. Regs. There being no

argument that the resulting entity should be classified as a trust (or otherwise

specially classified), the entity is within the meaning of the regulations a business

entity, classified as either a partnership or a corporation. See sec. 301.7701-2(a),

Proced. & Admin. Regs. Since it is a domestic business entity with more than two

members that is not a per se corporation (and not electing to be classified as a

corporation), it is, by default, classified as a partnership. See sec. 301.7701-3(a)

and (b)(1), Proced. & Admin. Regs.

      We need not at this time get into an extended discussion of whether

promulgation of the so-called check-a-box regulations, sections 301.7701-1,

301.7701-2, and 301.7701-3, Proced. & Admin. Regs., effective in 1997, can be

reconciled with the prior caselaw defining partnerships, since we see no conflict in

these cases. Our conclusion that the coowners of each working interest were

jointly carrying on a trade or business and dividing the proceeds therefrom would

be sufficient to satisfy the multifactor test for determining partnership

classification that we emphasized in Luna v. Commissioner, 42 T.C. 1067, 1077-

1078 (1964), and subsequent cases. E.g., Superior Trading, LLC v.

Commissioner, T.C. Memo. 2012-110, 2012 WL 1319748, at *4 n.9 ("The import
                                        - 42 -

[*42] of these so-called Luna factors has not dissipated any after the promulgation

of sec. 301.7701-3(a), Proced. & Admin. Regs."); WB Acquisition, Inc. v.

Commissioner, T.C. Memo. 2011-36, 2011 WL 477697, at *9; Comtek

Expositions, Inc. v. Commissioner, T.C. Memo. 2003-135, 2003 WL 21078102, at

*6, aff'd, 99 Fed. Appx. 343 (2d Cir. 2004); Alhouse v. Commissioner, T.C.

Memo. 1991-652.

      We also note that the question of whether the joint exploitation of a working

interest in an oil and gas leasehold creates an entity has a long, contentious

history, culminating in a series of cases that conclude that working interest owners

and well operators create a pool or joint venture for operation of the wells. In

Bentex Oil Corp. v. Commissioner, 20 T.C. 565 (1953), the taxpayer (Bentex) had

joined with two other coowners of an oil and gas leasehold to exploit it. They

operated under an oral agreement providing that each coowner would separately

take and sell his share of the lease production. The operation, identifying itself as

a joint venture, filed partnership returns for 1937 through 1939, in which it elected

to expense, rather than capitalize, intangible drilling costs. Later, because it was

to its advantage, Bentex attempted to disavow the IDC election made by the

organization, arguing that the organization was not a partnership or a joint venture

and had no right to make the election. We summarily dispensed with that
                                       - 43 -

[*43] argument, stating that, on the facts before us, "we entertain no doubt" that

the organization "was a joint venture or partnership within the broad definition of

that term in * * * [what is now section 7701(a)(2)]". And while it may be that the

underlying rationale for our conclusion was that, because the organization filed a

partnership return, the members were estopped from denying partnership status, in

Cokes v. Commissioner, 91 T.C. at 230, without any mention of the partnership

return, we said:

             In 1953, in a unanimous Court-reviewed opinion, we held that
      a taxpayer who held a one-quarter interest in an oil and gas lease was
      a participant in a partnership or joint venture, and so an election to
      currently deduct or to capitalize certain expenditures could be made
      only by the partnership or joint venture, and could not be made
      separately by the taxpayer. Bentex Oil Corp. v. Commissioner, 20
      T.C. 565 (1953).

In Perry v. Commissioner, T.C. Memo. 1994-215, involving self-employment tax,

the taxpayer owned percentage working interests in numerous wells under

agreements providing that, in proportion to their respective percentage interests,

the working interest owners owned the oil and gas produced by the wells and the

equipment and the materials to operate the wells. The taxpayer's liability for self-

employment tax turned on whether he was a member of a partnership carrying on a

trade or business. There was no partnership agreement, although the taxpayer's

percentage working interests in each well were subject to a standard form
                                        - 44 -

[*44] operating agreement. Relying on Bentex and Cokes, we concluded: "[T]he

working interest owners and well operators created a pool or joint venture for

operation of the wells. Accordingly, petitioner's income from the working

interests was income from a partnership of which he was a member, under the

broad definition of 'partnership' found in section 7701(a)(2)."

      There were here no written partnership agreements among the coowners of

the working interests in either the Schuyler or the Milstead leasehold, nor had the

coowners executed joint operating agreements. Nevertheless, during the audit

years Energytec operated the wells on both leaseholds on a cooperative basis for

benefit of the working interest owners. The working interest coowners and

Energytec (in its role as common agent for the coowners) thereby created pools or

joint ventures (without distinction, joint ventures) for operation of the wells that

would, on the authority of cases particular to the classification of arrangements for

the exploitation of working interests in oil and gas properties, like Bentex, Cokes,

and Perry, be classified as partnerships for Federal tax purposes.

             6.     Conclusion

      To summarize: Jimastowlo and Oil Coming were partial owners of working

interests in the Schuyler and Milstead leaseholds; the well operations (carried out

by Energytec on those leaseholds for the benefit of the owners of the working
                                         - 45 -

[*45] interests) created separate entities (joint ventures) classified as partnerships

for Federal tax purposes, and, by virtue of their shares of the working interests, the

LLCs were members of those joint ventures (i.e., partners in partnerships).

Respondent may still argue that, for lack of economic substance or on account of

some other antiabuse doctrine, the classification of those joint ventures as

partnerships must be disregarded. We do not, and may not, under RJT Invs. X v.

Commissioner, 491 F.3d at 737-738, and Petaluma FX Partners, LLC v.

Commissioner, 131 T.C. 84, address that issue in this partner-level proceeding.

Respondent must make that argument in proceedings against the two drilling

program partnerships.

      B.     Application of Section 6231(g)(1)

      Section 6231(g)(1) provides in its entirety:

           SEC. 6231(g). Partnership Return to be Determinative of
      Whether Subchapter Applies.--

               (1) Determination that subchapter applies.--If, on the
           basis of a partnership return for a taxable year, the Secretary
           reasonably determines that this subchapter applies to such
           partnership for such year but such determination is
           erroneous, then the provisions of this subchapter are hereby
           extended to such partnership (and its items) for such taxable
           year and to partners of such partnership.
                                        - 46 -

[*46] Respondent, citing the lack of any reference to or indicium of a joint venture

in the LLCs' and Energytec's returns (and the effective denial, in those returns, that

such partnerships existed), argues that he "reasonably relied on the Forms 1065

filed by * * * [the LLCs] in determining that the TEFRA partnership provisions

applied only at their level and not to any alleged source partnerships."

Respondent's reliance on section 6231(g)(1) is misplaced.

      Section 6231(g)(1) was added to the TEFRA partnership provisions by the

Taxpayer Relief Act of 1997, Pub. L. No. 105-34, sec. 1232(a), 111 Stat. at 1023.

Both the statutory language and the House Ways and Means Committee Report7

make clear that the intent of the provision was to alleviate the Commissioner's

difficulties in determining "whether to follow the TEFRA partnership procedures

or the regular deficiency procedures", a problem generally caused by the inability

to ascertain with certainty whether the partnership in question had 10 or fewer

partners and, therefore, was a "small partnership" exempt from the TEFRA

partnership provisions. See H.R. Rept. No. 105-148 (1997), 1997-4 C.B. (Vol. 1)

319, 909-910. That is not respondent's problem in these consolidated cases, as it

is undisputed that the TEFRA partnership provisions apply to the LLCs, i.e., that


      7
       The provision originated in the House and was adopted, verbatim, by the
Senate and the House-Senate conference committee.
                                         - 47 -

[*47] respondent properly issued FPAAs to the LLCs, which, pursuant to section

301.7701-2(c)(1), Proced. & Admin. Regs., are taxable as partnerships.

Respondent's problem is that all of the adjustments in those FPAAs represent

flow-through items from source partnerships over which we lack jurisdiction in

what would then be a partner-level proceeding. See Rawls Trading, L.P. v.

Commissioner, 138 T.C. at 288-289; Sente Inv. Club P'ship of Utah v.

Commissioner, 95 T.C. at 248.

      C.   Respondent's Authority To Issue FPAAs to the Joint Ventures

      Respondent argues that, even though the ostensible joint ventures' failures

to file partnership returns permit respondent to assess tax liabilities against their

partners (and, therefore, to issue FPAAs to the ostensible drilling program

partnerships) "at any time", see sec. 6229(c)(3), as a practical matter, the issuance

of FPAAs to the joint ventures would be impossible. In reaching that conclusion,

respondent points to the absence of (1) joint venture returns resulting in the failure

to identify a tax matters partner, as defined in section 6231(a)(7), or, indeed, any

of the partners, and (2) information "as to the name, EIN, address, or principal

place of business of either alleged source partnership." Respondent also posits

that, if he issues FPAAs to the LLCs as partners in the alleged source partnerships,

the legitimacy of those FPAAs "more than likely * * * will be contested in this
                                        - 48 -

[*48] Court." Respondent also fears that the issuance of "additional FPAAs to any

alleged source partnerships * * * could expose respondent to a charge that * * *

[they] are * * * arbitrary and capricious and thus invalid", citing Scar v.

Commissioner, 814 F.2d 1363 (9th Cir. 1987), rev'g 81 T.C. 855 (1983).

      Like all courts, we are a court of limited jurisdiction. As we stated in Rawls

Trading, L.P. v. Commissioner, 138 T.C. at 292, "in determining the outer limits

of the ambit of our subject matter jurisdiction, we cannot consider the

consequences, howsoever harsh they may be, that our decision inflicts upon one of

the parties." Moreover, as in that case, we believe respondent's concerns are

overblown. There are exhibits in the record identifying the coowners of both the

Schuyler and Milstead leaseholds and enough evidence of joint ventures to

preclude a successful argument that the FPAAs should be considered arbitrary and

capricious and, therefore, invalid under Scar. We also note that, pursuant to

section 6231(a)(7) and section 301.6231(a)(7)-1(p) and (q), Proced. & Admin.

Regs., respondent may be able to select as the tax matters partner any one of a

number of working interest owners, including Mr. Petito on behalf of each of the

joint-venturer LLCs, for purposes of serving the FPAAs.
                                         - 49 -

[*49] D. Application of Section 6222

      We have also considered, on our own motion, the possible application of

section 6222, which requires consistency between how a partner treats a

partnership item on his return and how the partnership treats it on its return. See

sec. 6222(a). The consequence of any inconsistency between how a partner treats

a partnership item on his return and how the partnership treats it on its return is

that, unless the partner notifies the Secretary of the inconsistency, section 6225,

which requires a partnership-level proceeding before assessment of a deficiency,

does not apply to computational adjustments necessary to bring the partner's

treatment of the partnership items on his return into consistency with the

partnership's treatment of the items on its returns. See secs. 6222(c), 6225. The

LLCs did not notify the Secretary of any inconsistencies with the joint ventures, so

that there is at least the potential for respondent, on the authority of section

6222(c), to bypass section 6225 and to immediately assess deficiencies in tax

resulting from computational adjustments necessary to bring consistency.

      Respondent's authority to bypass partnership-level proceedings against the

joint ventures and to make immediate assessments attributable to computational

adjustments at the LLC (partner) level is limited to the circumstances described in

section 6222(b)(1)(A)(i), i.e., where "the partnership has filed a return but the
                                         - 50 -

[*50] partner's treatment * * * [of a partnership item] is * * * inconsistent with the

[partnership's] treatment of the item", and the partner has failed to notify the

Commissioner of the inconsistency. See sec. 6222(c). As one commentator has

suggested, that authority does not exist in the case of a partner's failure to file a

notice of inconsistent treatment arising (under section 6222(b)(1)(A)(ii)) solely

from the partnership's failure to file a return. Steven R. Mather, Audit Procedures

for Pass-Through Entities, 624-2d Tax Management (BNA) at A-29 ("[T]here is

no apparent consequence within the scope of the TEFRA provisions for an

inconsistency arising from the failure of the partnership to file a partnership

return.")8

       We find section 6222 to be inapplicable herein.

III.   Conclusion

       The joint ventures of which each of the LLCs was a member were

partnerships required to file partnership returns and, thus, subject to the TEFRA

partnership provisions. The substantive issues all involve partnership items of the

       8
        Sec. 6222(b) clearly contemplates a partner's filing a notice of
inconsistency with respect to any partnership item if the partnership has not filed a
return. See sec. 6222(b)(1)(A)(ii). Since the partnership may file a delinquent
return after the partner has filed his return, a partner filing a notice of
inconsistency will in that case be excused from the consistency requirement
pursuant to sec. 6222(b)(1), flush language ("subsection (a) shall not apply to such
item").
                                       - 51 -

[*51] joint ventures. The LLCs were pass-thru partners and, with respect to them,

the substantive issues all involve what would be computational adjustments if the

substantive issues (partnership items) were decided adversely to the joint ventures.

See sec. 6231(a)(6); Rawls Trading, L.P. v. Commissioner, 138 T.C. at 285; Sente

Inv. Club P'ship of Utah v. Commissioner, 95 T.C. at 248. The fact that the joint

ventures failed to file partnership returns and that the Commissioner has neither

initiated nor completed partnership proceedings does not change that analysis.

See Alhouse v. Commissioner, T.C. Memo. 1991-652. The FPAAs issued to

Jimastowlo and Oil Coming appear to reflect only computational adjustments.9 If

that is true, the FPAAs are invalid and do not confer jurisdiction on us. Rawls

Trading, L.P. v. Commissioner, 138 T.C. at 289. We will confer with the parties

to determine whether there are any issues (other than computational adjustments)

properly addressed in this proceeding. We must dismiss for lack of jurisdiction

insofar as the individual FPAAs pertain to computational items.

      To reflect the foregoing,


                                                An appropriate order will be issued.

      9
        There are other items on some of the FPAAs respondent issued with respect
to the LLCs. Those items make no adjustments to the LLCs' returns. Thus,
eliminating the adjustments that appear to be computational adjustments, the
FPAAs appear to make no changes to the LLCs' returns.
