According to statistical data released by the IRS earlier this year, the examination rate for partnership tax returns has been increasing significantly over the last couple of years; of course, this includes returns filed by LLCs that are treated as partnerships for Federal income tax purposes. This should come as no surprise given the significant growth in LLC business structures.
However, as the number of partnerships (LLCs) has increased, so has their complexity, such that the IRS has found it increasingly difficult to audit partnerships and to collect any resulting income tax deficiencies. As we previously noted, it was in response to these difficulties that Congress enacted, as part of the Bipartisan Budget Act of 2015, a number of new tax compliance provisions targeted specifically at partnerships.
In light of the IRS’s increased attention on partnerships, next year’s blog posts will include a number of articles that will cover many of the basic principles of partnership taxation.
We end this year with a factually simple partnership case that is nonetheless a head-scratcher, as least insofar as the taxpayer’s behavior is concerned.
The Not-So-Great Recession
Taxpayer was a member of Partnership. Taxpayer alleged that, in the wake of the 2008 recession, other partners at Partnership could not cover their share of the firm’s expenses and that, as a result, the firm had gone into “significant negative capital.” For some reason, Taxpayer felt that it was his fiduciary obligation under New York partnership law to cover other partners’ shares of partnership expenses.
Although New York’s partnership statute prescribes certain fiduciary obligations that partners owe each other, it is not clear why Taxpayer believed that he was obligated to pay other partners’ shares of Partnership expenses. In any event, whether he had an obligation under State law to reinvest some of his income in Partnership was not relevant to the amount of Partnership’s income properly attributable to him for Federal income tax purposes.
Taxpayer claimed that his positive “capital account bore no relationship to the financial condition of the partnership, and what little money was available to” Taxpayer was used to absorb expenses that normally would have been expenses of the firm.
“Don’t Do It”
Because the available money had allegedly not been paid out to Taxpayer, but had been used to pay firm expenses, Taxpayer felt it should not be treated as income to him. But according to Taxpayer,
When I sought the advice of the firm’s accountants and tax preparers, I was in essence told that the tax law was unfair and unjust under these circumstances, and my options were to dissolve the firm, take all the capital in the firm to pay my taxes and move on, and let my partners fend for themselves, and the employees go on unemployment. When I discussed [m]y obligations under New York State Partnership Law to act as a fiduciary to my partners, I was told to be prepared to face the consequence of that decision as I am now, that the [IRS] would likely be deaf to the financial realities of the firm and not respect the state law fiduciary partnership duties.
That is, the tax professionals told Taxpayer that the law “unfairly” required him to report the income, but he decided not to follow their advice.
The Return and Its Aftermath
Taxpayer prepared and filed his own Form 1040, “U.S. Individual Income Tax Return”, for 2011. On the attached Schedule E, “Supplemental income and loss”, (“Nonpassive income from Schedule K-1”), Taxpayer reported that his income from Partnership (i.e., revenue over expenses) was much less than the actual amount of $461,386.
In 2013, the IRS issued a notice of deficiency to Taxpayer relating to his 2011 tax year. The IRS determined that Taxpayer had failed to properly report his share of Partnership income. The IRS also determined an accuracy-related penalty.
In 2014, Taxpayer timely petitioned the Tax Court, contending that: (1) New York partnership law imposed a fiduciary duty upon him that prevented him from withdrawing his capital account and thereby causing Partnership to fail; and (2) the expenditure of Partnership funds to pay partnership expenses left the firm with no money to pay Taxpayer his share of income and, thus, left him with no money to pay his Federal income tax liability.
The IRS filed a motion for summary judgment.
As to his underlying Federal tax liability, Taxpayer’s response to the IRS’s motion essentially advanced the same two arguments that were in his petition – i.e., he received no actual income in 2011, and he was, therefore, unable to pay his income tax.
As to the accuracy-related penalty, Taxpayer argued that it would be inappropriate to impose the penalty in light of his good-faith payment of Partnership expenses.
The Tax Court
The issue for decision was whether Taxpayer failed to report taxable income from Partnership for taxable year 2011; in other words, whether Taxpayer’s otherwise taxable income from Partnership was reduced by his alleged obligation to make expenditures on behalf of Partnership.
The Code provides: “A partnership * * * shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” In determining his individual income tax, each partner must separately include his distributive share of the entity’s taxable income or loss. [Sec. 701, 702]
Even assuming Taxpayer’s factual assertions, Partnership’s income was taxable to Taxpayer as a partner to the extent of his distributive share. This was so whether Taxpayer received distributions or not; “[f]or it is axiomatic,” the Court stated, “that each partner must pay taxes on his distributive share of the partnership’s income without regard to whether that amount is actually distributed to him.”
Taxpayer did not provide evidence to challenge the IRS’s determinations for 2011. He did not dispute that Partnership had income (revenue greater than expenses) in 2011 nor the amount of his share thereof. Rather, Taxpayer simply asserted that the firm did not distribute to him his share of the 2011 income (a fact that would not affect the attribution of that income to him) and that the firm used its available money to pay firm expenses (a fact that could generate partnership deductions, reducing the firm’s income, and Taxpayer’s share of it).
If Taxpayer did in effect plow his share of the 2011 income back into the firm (because he thought that State law required him to do so), then that amount presumably constituted a contribution to the firm’s capital, and would increase his own capital account at the firm, but such a capital contribution was not deductible.
As a partner in Partnership, Taxpayer was obliged to report his share of the firm’s income, whether or not it was distributed to him, and whether or not that money was thereafter used to pay firm expenses.
But I Can’t Pay
Taxpayer did not advance an argument based on partnership taxation principles. Rather, his argument was that he could not reasonably be expected to pay tax on money that was never paid to him.
The Court replied that a taxpayer’s assertion that he has no money to pay an income tax liability might be relevant in a “collection due process” case.” But where the issue was the unreported amount of the liability, the Court stated, Taxpayer’s argument “missed the mark.”
According to the Court, a taxpayer’s ability to pay the tax he owes has no bearing on the amount of his tax liability. Taxpayer may in the future raise issues of collectability at a collection due process hearing before the IRS. However, in a deficiency case, Taxpayer’s argument about his inability to pay was not relevant to the ultimate issue – the amount of Taxpayer’s tax liability.
The Court therefore upheld the IRS’s determinations regarding the taxability of Taxpayer’s distributive share of Partnership’s income.
Query why Partnership and its members did not amend their partnership agreement to specially allocate to Taxpayer the deductions attributable to his payment of Partnership’s expenses. Indeed, such an amendment could have ben adopted as late as the date prescribed for filing Partnership’s 2011 tax return (not including any extension) on Form 1065.
Whatever the reason, it is clear that Taxpayer and his fellow partners were ignorant of, or chose to ignore, some basic principles of partnership taxation:
- Each partner of a business organization that is treated as a partnership for tax purposes is required to take into account separately in his income tax return his distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit.
- The character in the hands of a partner of any item of income, gain, loss, deduction, or credit is determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership.
- In general, the taxable income of a partnership is computed in the same manner as the taxable income of an individual; there are certain statutorily- and regulatory-prescribed exceptions.
- A partner’s distributive share of any item or class of items of income, gain, loss, deduction, or credit of the partnership shall be determined by the partnership agreement, provided such allocation has “substantial economic effect”; otherwise, the partner’s distributive share shall be determined in accordance with such partner’s interest in the partnership (taking into account all facts and circumstances).
We will revisit these and other partnership concepts throughout 2017.
Happy New Year.
With apologies to St. Mark 8:36. “For what does it profit a man to gain the whole world and forfeit his soul?”