Clark Raymond & Company PLLC, D. Edson Clark, CPA, PLLC, Tax Matters Partner
2022 TC Memo 105
Tax Ct.2022Background
- CRC (Clark Raymond & Co., PLLC) was a multi-member LLC taxed as a partnership; partners included Clark PLLC (D. Edson Clark), Newman PLLC, and Town PS. The parties executed a 2013 LLC Agreement containing a client-valuation formula and a Qualified Income Offset (QIO) provision.
- Newman PLLC and Town PS withdrew effective May 1, 2013 and some CRC clients began engaging the new firm (NT PLLC). The 2013 LLC Agreement defined “Client Value” as gross revenue invoiced in the prior 12 months and provided how noncash distributions (including clients) should be treated.
- CRC reported on its 2013 Form 1065 that Newman and Town received property distributions equal to the Client Value ($318,144 to Newman; $424,425 to Town), reduced their capital accounts below zero, and then allocated all ordinary income to them under the QIO so their capital accounts returned to zero. Clark (as TMP) petitioned after the IRS issued an FPAA.
- The IRS disregarded the reported client distributions (or found them unsubstantiated) and determined the income allocations lacked substantial economic effect, reallocating most income to Clark. Newman and Town executed Forms 870–PT resolving their partner-level tax consequences with the IRS.
- The Tax Court held (1) the client-based intangible distributions occurred and their valuation under the LLC agreement was accepted; (2) CRC failed to maintain capital accounts per Treas. Reg. §1.704‑1(b)(2)(iv) because it did not "book up" unrealized gain (the partnership produced no basis proof, so basis was assigned zero); (3) therefore the special allocations lacked economic effect; but (4) because the QIO was triggered by negative capital accounts, ordinary income must be allocated first to Newman and Town in amounts necessary to bring their capital accounts to zero, with remaining income allocated in proportion to their combined deficits — computations referred under Rule 155. The FPAA’s disregard of the distributions and its reallocation of income were not sustained.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| 1. Were client-based intangibles distributed, and are their values valid? | CRC: clients (client-based intangibles/goodwill) are partnership assets; 2013 LLC Agreement prescribes Client Value; distributions occurred and are valued under that method. | IRS: distributions not substantiated; clients left voluntarily so no partnership distribution or value; CRC cannot reliably value clients. | Court: Distribution occurred; Client Value under the LLC agreement accepted as fair market value ($318,144 to Newman; $424,425 to Town). |
| 2. Do the reported special allocations of ordinary income have substantial economic effect under §704(b) and Treas. Reg. §1.704‑1? | CRC: QIO in the LLC was triggered when partners’ capital accounts went negative and thus allocations restoring accounts have economic effect. | IRS: allocations lacked economic effect and consistency; should be reallocated to reflect economic benefit received (mostly Clark). | Court: Allocations lack economic effect because CRC failed to maintain capital accounts per Treas. Reg. §1.704‑1(b)(2)(iv) (failed to allocate unrealized gain/book‑up); basic and alternate tests fail; economic equivalence not shown. |
| 3. If allocations lack economic effect, how should income be reallocated? | CRC: QIO requires allocating income to restore the withdrawing partners’ capital accounts to zero. | IRS: reallocates most income to Clark, arguing economic benefit inured to Clark and distributions should be disregarded or matched to allocations. | Court: QIO controls — allocate ordinary income first to Newman and Town in amounts necessary to bring their capital accounts to zero; because total income is insufficient to do so for both, allocate available income between them pro rata to their combined deficits; FPAA’s alternative reallocation is rejected; computations remanded under Rule 155. |
Key Cases Cited
- Rudd v. Commissioner, 79 T.C. 225 (T.C. 1982) (goodwill of an accounting firm includes client files, relationships, reputation).
- Newark Morning Ledger Co. v. United States, 507 U.S. 546 (U.S. 1993) (customer lists are intangible assets with ascertainable value).
- Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (U.S. 1974) (taxpayer bound by the form it chose for a transaction).
- Helvering v. Horst, 311 U.S. 112 (U.S. 1940) (realization concept for income recognition).
- Welch v. Helvering, 290 U.S. 111 (U.S. 1933) (Commissioner’s determinations are presumed correct; taxpayer bears burden).
- Watson v. Commissioner, 35 T.C. 203 (T.C. 1960) (purchase price for partnership interest can include goodwill).