The Tax Court in Brief – October 10th – October 14th, 2022
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Tax Litigation: The Week of October 10th, 2022, through October 14th, 2022
- Scheider v. Comm’r, T.C. Memo. 2022-104 | October 11, 2022 | Urda, J. | Dkt. No. 4048-20
- Cochran v. Comm’r, 159 T.C. No. 4 | October 12, 2022 | Greaves, J. | Dkt. No. 21002-16
Clark Raymond & Company, PLLC v. Comm’r, T.C. Memo. 2022-105 | October 13, 2022 | Gustafson, J. | Dkt. No. 2265-19 (partnership intangible assets, substantial economic effect, capital accounts, distributions, tests for economic effect and Treas. Reg. § 1.704-1)
Summary: This 56-page opinion regards a partnership-level action under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which was repealed for returns filed for partnership tax years beginning after December 31, 2017. The case regards, basically, a partnership agreement of Clark Raymond & Company, PLLC (CRC) (an accounting firm) and tax liabilities of CRC and its partners arising from a withdrawal of various partners and fact-specific (and intensive) transactions involving CRC and its partners from the period 2006 through 2018. The tax year in issue is 2013. The partners of CRC included professional liability companies, professional services corporations, and a professional limited liability company.
In 2011 through 2013, the CRC partners negotiated a buyout of a partner (or partners) and the CRC partnership agreement was restated. Shortly thereafter, two partners withdrew and certain clients of CRC retained the withdrawn partners’ new partnership. A tax quagmire arose when the tax matters partner for CRC reported, via Form 1065, U.S. Return of Partnership Income, (1) the value of the defecting clients to the partnership formed by the partners who withdrew and (2) otherwise made allocations to the withdrawn partners’ capital accounts. Because the issues were ultimately narrowed by concessions, the Tax Court focused on specific defined terms used in the partnership agreement and how those terms applied to provisions for (1) determining and allocating Net Profit and Loss among the partners, (2) computing retirement payments for a retiring partner, (3) calculating contributions to the partners’ capital accounts, and (4) calculating distributions for non-cash assets, such as clients.
For tax year 2013, CRC filed its 2013 Form 1065 and issued Schedules K-1 to the former partners-now-withdrawn. Those former partners filed Forms 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request with respect to CRC’s 2013 issued Schedules K-1. So, the IRS issued a Tax Matters Partner (TMP) Notice of Beginning of Administrative Proceeding. In December 2018, the IRS issued the TMP a determination of adjustments to CRC’s 2013 Form 1065. With regard to property distributions, the IRS determined, among other things, that reported “client distributions” (i.e., “client assets” or “book of business” assets) were not distributions and should be disregarded, or, in the alternative, CRC failed to substantiate the identities and the values of the clients distributed (and it failed to show that CRC was capable of valuing the clients distributed), and therefore the distributions should be disregarded. The Tax Court dived into these issues in great detail.
Key Issues:
- Whether CRC made distributions of client-based intangible assets to CRC partners during 2013?
- Whether CRC’s ordinary income allocations reported on its Form 1065 had substantial economic effect under 26 U.S.C. § 704(b)?
Primary Holdings: The Tax Court did not sustain the IRS’s determinations.
- The ultimately agreed-upon transfer of the client-based intangibles was treated as a distribution. CRC failed to prove its adjusted basis in the client-based intangibles distributed to the withdrawing partners, so the Tax Court assigned zero-dollar bases to those assets. The unrealized gain applicable to those assets were properly allocated among all three partners in issue (as set out in the partnership agreement) so that the capital accounts of all three were increased. But, because the agreed-upon distribution was made only to the withdrawing partners, only their capital accounts should have been reduced. Thus, the withdrawing partners’ capital accounts did go negative, a qualified income offset was triggered, and CRC’s 2013 income should be allocated to the withdrawing partners’ accounts to bring them up to zero. The parties were ordered to submit computations under Rule 155 to determine the exact amount of the now-withdrawn partners’ capital account balance deficiencies (after applicable adjustments to their capital accounts) and the amounts of income allocable to the partners’ capital accounts as a result.
- CRC’s special allocation of income to the withdrawn partners in 2013 lacked substantial economic effect because the partnership failed to maintain capital accounts in accordance with the requirement of Treasury Regulation § 1.704-1(b)(2)(iv) that CRC must allocate the unrealized gain inherent in the client-based intangibles across the partners’ capital accounts before decreasing the withdrawing partners’ capital accounts by the value of the distribution.
Key Points of Law:
Intangible Assets. Business entities may own intangible assets. See, e.g., Tomlinson v. Commissioner, 58 T.C. 570, 580 (1972), aff’d, 507 F.2d 723 (9th Cir. 1974); Topeka State J., Inc. v. Commissioner, 34 T.C. 205, 215, 221 (1960). Intangible assets are generally included in the valuation of a partnership (and partnership interest). See, e.g., Watson v. Commissioner, 35 T.C. 203, 208, 214 (1960); Tolmach v. Commissioner, T.C. Memo 1991-538. A “client-based intangible” asset (such as a customer list or “book of business”) is one example of an intangible asset, and it may be capable of valuation, distribution, and sale to third parties. See, e.g., Newark Morning Ledger Co. v. United States, 507 U.S. 546, 570 (1993); JHK Enters., Inc. v. Commissioner, T.C. Memo. 2003-79, 85 T.C.M. (CCH) 1032, 1032 (client files, a client list, going concern value (goodwill), and equipment); Holden Fuel Oil Co. v. Commissioner, T.C. Memo. 1972-45, 31 T.C.M. (CCH) 184, 187–89 (customer lists and amortization deduction for a portion of the amount paid), aff’d, 479 F.2d 613 (6th Cir. 1973).
Good Will of an Accounting Firm. “The goodwill of a public accounting firm can generally be described as the intangibles that attract new clients and induce existing clients to continue using the firm. These intangibles may include an established firm name, a general or specific location of the firm, client files and workpapers (including correspondence, audit information, financial statements, tax returns, etc.), a reputation for general or specialized services, an ongoing working relationship between the firm’s personnel and clients, or accounting, auditing, and tax systems used by the firm.” Rudd v. Commissioner, 79 T.C. 225, 238 (1982). Client lists and other client-based intangibles have value. This value can exist even where the client is not contractually bound to keep bringing his business. See Aitken v. Commissioner, 35 T.C. 227, 230–31 (1960).
Substantial Economic Effect. 26 U.S.C. § 704(a) provides that the partnership agreement generally determines a partner’s distributive share of partnership income, gain, loss, deductions, or credits of the partnership. However, the partners’ ability to allocate partnership items on a basis other than the partners’ interests in the partnership (i.e., a non-pro rata “special allocation”) is not unrestricted. Special allocations must have substantial economic effect (as opposed to the mere avoidance of tax). Otherwise, the partners’ distributive shares of partnership items “shall be determined in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances)”. Id. at § 704(b).
Economic Effect. A special allocation of partnership items is deemed to have economic effect if, in the event there is an economic benefit or burden that corresponds to an allocation, the partner to whom the special allocation is made receives a corresponding benefit or bears a corresponding burden. See Treas. Reg. § 1.704-1(b)(2)(ii)(a). A determination to this effect is made as of the end of the partnership taxable year to which the allocation relates. Id. at § 1.704-1(b)(2)(i). The economic effect of the special allocation must be substantial. This requires “a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.” Id. at § 1.704-1(b)(2)(iii)(a). Determinations of substantial economic effect, as well as determinations of a partner’s interest in the partnership, depend upon an analysis of the partners’ capital accounts. See id. at § 1.704-1(b)(2)(iv)(a).
Partner’s Capital Account. Generally, a partner’s capital account represents the partner’s equity investment in the partnership. The capital account balance is determined by adding (1) the amount of money that the partner contributes to the partnership, (2) the fair market value of other property the partner contributes (net of liabilities to which the property is subject or which are assumed by the partnership), and (3) any allocations of partnership income or gain. Treas. Reg. § 1.704-1(b)(2)(iv)(b). A partner’s capital account is decreased by (1) the amount of money distributed to him by the partnership, (2) the fair market value of property distributed to the partner (net of any liability that the partner assumes or to which the property is subject), and (3) the amounts of partnership losses and deductions allocated to the partner. Id. An allocation of partnership items can have substantial economic effect only if the partnership maintains capital accounts of the partners in accordance with these rules. Id.
Tests for Economic Effect. The regulations governing special allocations provide three tests for economic effect. Special allocations of items to a partner are deemed to have economic effect if they meet the requirements of any one of these alternative tests.
Test 1 – Basic Test of Economic Effect. Treasury Regulation § 1.704-1(b)(2)(ii)(b). The test provides, in general, that a special allocation has economic effect if it is made pursuant to a partnership agreement that contains provisions requiring: (1) the determination and maintenance of partners’ capital accounts in accordance with the rules of Treas. Reg. § 1.704- 1(b)(2)(iv); (2) upon liquidation of the partnership, the proceeds of liquidation be distributed in accordance with the partners’ positive capital account balances; and (3) upon liquidation of the partnership, any partner with a deficit capital account balance is unconditionally obligated to restore the amount of the deficit balance to the partnership by the end of the taxable year (a “deficit restoration obligation” or “DRO”). Treas. Reg. § 1.704-1(b)(2)(ii)(b).
Test 2 –Alternate Test of Economic Effect. Partnership agreements may provide for specific limits upon the amount the limited partners are required to contribute to the partnership. These limits on liability, however, are inconsistent with the requirement in the basic test that each partner must agree to repay the deficit balance (if any) in that partner’s capital account upon liquidation. Thus, the regulations include an “[a]lternate test for economic effect”, which provides that special allocations of partnership items may have economic effect even in the absence of a deficit restoration obligation. The alternate test begins by incorporating the first two parts of the basic test. (That is, the partnership agreement must (1) provide for properly maintained capital accounts and (2) provide that the proceeds of liquidation will be distributed in accordance with the partners’ positive capital account balances.) However, instead of a negative capital account makeup requirement, the alternate test mandates a hypothetical reduction of the partners’ capital accounts. The alternate test requires that capital accounts be reduced, as of the end of the year, for any allocation of loss or deduction or distributions that, at that time, are reasonably expected to be made, to the extent that such allocations or distributions exceed reasonably expected increases to the partners’ capital account. See Treas. Reg. § 1.704-1(b)(2)(ii)(d).
Qualified Income Offset for Test 2. The alternate test also requires that the partnership agreement provide for a QIO. A QIO provision automatically allocates partnership income (including gross income and gain) to a limited partner who has an unexpected negative capital account, either as a result of partnership operations or as a result of making the adjustment for reasonably expected reductions. The QIO must operate “in an amount and manner sufficient to eliminate such deficit balance as quickly as possible.” Treas. Reg. § 1.704-1(b)(2)(ii)(d) (flush text).
Test 3 – Economic Equivalence Test. Treasury Regulation § 1.704-1(b)(2)(ii)(i) provides that, if an allocation would produce the economic equivalent of meeting the basic test for economic effect, it will be deemed to have economic effect even if it does not otherwise meet the formal requirements of the basic test.
Partner’s interest in the partnership Section 704(b) provides that an allocation of partnership income, gain, loss, deductions, or credit (or item thereof) that does not have substantial economic effect will be “determined in accordance with the partner’s interest in the partnership”. A “partner’s interest in the partnership” is defined as the “manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated.” Treas. Reg. § 1.704-1(b)(3)(i)-(ii).
Partnership Distributions. The basic capital accounting rules in Treasury Regulation § 1.704-1(b)(2)(iv)(b) require that partners’ capital accounts be decreased by the fair market values of property distributed to them by the partnership. Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1). If property is distributed, then these rules must be applied even if the partners and the partnership overlook the distribution or attempt to impose another characterization on it. See, e.g., Seay v. Commissioner, T.C. Memo. 1992-254, 63 T.C.M. (CCH) 2911, 2913 (holding that the taxpayer received a distribution of partnership assets when he withdrew cash from the partnership, despite claiming that his withdrawals were loans from the partnership). To satisfy this requirement, the capital accounts of the partners first must be adjusted to reflect how any unrealized income, gain, loss, and deduction inherent in the property (not already reflected in the capital accounts) would be allocated among the partners if there were a taxable disposition of the property for its fair market value (colloquially referred to as a “book-up”). Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1). The fair market value assigned to property contributed to, distributed by, or otherwise revalued by a partnership will be regarded as correct, provided that (1) the value is reasonably agreed to among the partners in arm’s-length negotiations and (2) the partners have sufficiently adverse interests. Treas. Reg. § 1.704-1(b)(2)(iv)(h)(1). The determination of fair market value is a question of fact. S. Tulsa Pathology Lab’y, Inc. v. Commissioner, 118 T.C. 84, 101 (2002).
Insight: This opinion provides tremendous detail on allocation of distributions based on client-based intangible assets of a partnership. Maintenance (or lack thereof) of records (and proper calculation of) partners’ capital accounts, distributions, and other matters that ultimately affected the partnership’s and withdrawing partners’ tax liabilities proved to be both critical and problematic for the parties in issue (including the IRS and the Tax Court). See, e.g., 26 U.S.C. § 197 (Amortization of good will and other intangibles), and for requiring the inclusion of intangible assets in the valuation of a transferred business interest (for federal gift tax purposes), see Treas. Reg. §§ 1.197-2, 25.2512-3.
