CLARK RAYMOND & COMPANY PLLC, D. EDSON CLARK, CPA, PLLC, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2265-19
United States Tax Court
October 13, 2022
T.C. Memo. 2022-105
CRC, an accounting firm, is a partnership subject to the TEFRA provisions of
Shortly after executing the restated partnership agreement, N and T withdrew from CRC, and certain clients of CRC stopped engaging CRC and instead retained N’s and T’s new partnership (NT PLLC). C, as tax matters partner for CRC, reported on CRC’s 2013 Form 1065, “U.S. Return of Partnership Income”, that N and T received distributions from CRC in amounts equal to the value of the clients (as determined under the restated partnership agreement) that followed N and T to NT PLLC. C also decreased N’s and T’s capital accounts by the value of the
N and T filed Forms 8082, “Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR)”, contesting CRC’s 2013 income allocations, and R subsequently audited CRC’s 2013 return. R issued a Letter 1830–F, “Notice of Final Partnership Administrative Adjustment” (FPAA), disregarding CRC’s reported “client distributions” and redetermining allocations of ordinary income to N and T. Specifically, R determined that CRC’s “client distributions” had not been substantiated and that CRC’s corresponding allocations of income lacked substantial economic effect.
C, as TMP of CRC, timely filed a Petition in this Court contesting R’s determinations in the FPAA. The parties filed a joint motion to submit this case pursuant to Rule 122, which we granted.
Held: CRC distributed client-based intangible assets to N and T when they withdrew from CRC, and the value of the assets so distributed are properly valued under the terms of CRC’s partnership agreement.
Held, further, CRC failed to maintain capital accounts in accordance with
Held, further, because N and T had negative capital accounts at the end of the taxable year and CRC’s partnership agreement included a QIO, ordinary income must be allocated first to N and T in an amount necessary to bring each partner’s capital account up to zero.
Sandra Veliz, for petitioner.
Amy Chang and Gregory M. Hahn, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: On December 17, 2018, the Internal Revenue Service (“IRS”) issued a notice of final partnership administrative adjustment (“FPAA”) for the taxable year ending December 31, 2013, to D. Edson Clark, CPA, PLLC (“Clark PLLC”), the tax matters partner (“TMP”) for Clark Raymond & Co., PLLC (“CRC”). This case is a partnership-level action under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”),1 see
FINDINGS OF FACT
The facts below are based on the pleadings and the parties’ stipulations of fact (including the exhibits attached thereto).
I. CRC’s business activity
CRC is a professional limited liability company formed under the laws of the State of Washington. When it filed its Petition, CRC’s principal place of business was Redmond, Washington.4
CRC provides accounting, tax planning and preparation, and related professional services to its clients. Because it is a service-based organization, its tangible assets consist solely of office equipment and supplies, office furniture, cash, accounts receivable, and works-in-process.
CRC is generally a successful business and services many clients. Before performing services for a client, CRC and the client enter into an engagement agreement specifying the scope of CRC’s services and fees. The engagement between CRC and a client is terminable at will by either CRC or its client.
Generally, a certified public accountancy firm (“CPA firm”) such as CRC may not require a client to continue to retain its services if the client decides to terminate the business relationship, and a client may not require a CPA firm to continue providing services if the CPA firm decides to terminate the business relationship. Neither the CPA firm nor its clients (or former clients) may require the other to sign a new
If an accountant leaves his current CPA firm for a new firm, clients of the current firm may choose to terminate their relationship with the current firm and begin a relationship with the new firm. In such an instance, the client “follows” the accountant to his new firm; and the accountant, the prior firm, and the client will generally agree upon procedures to facilitate the transfer of the client’s files from the prior firm to the new firm. The clients who follow an accountant to a new firm, and who may generate future cash flow from payments made to the new firm, are generally referred to as that accountant’s “book of business”.
II. Partner-entities in CRC
D. Edson Clark formed CRC in 2006. Since its formation, various entities have joined and withdrawn from CRC as partners.5 The following entities were partners of CRC during the relevant years:6
A. Clark PLLC
Clark PLLC is a professional limited liability company organized under the laws of the State of Washington. Clark PLLC was a partner of CRC for the taxable years ending December 31, 2011, 2012, and 2013.
Mr. Clark and his wife, Barbara Clark, have been the sole shareholders of Clark PLLC, and therefore Mr. Clark held a partnership interest in CRC indirectly through Clark PLLC for the relevant years. CRC employed Mr. Clark as an accountant and Mrs. Clark as firm administrator during the relevant years.
Rachelle A. Benbow, PS (“Benbow PS”), is a professional services corporation incorporated under the laws of the State of Washington by Rachelle A. Benbow, who became a CRC employee in 1999.
Benbow PS purchased a 25% partnership interest in CRC from Clark PLLC for approximately $580,000 in 2006 and was admitted to CRC as a partner. The purchase was seller-financed by Clark PLLC, with Benbow PS obtaining a loan from Clark PLLC for the purchase price. The purchase price was calculated by totaling CRC’s prior 12 months of gross receipts (intended to reflect the total value of CRC’s “book of business”) and the net value of CRC’s tangible assets. The agreement between Benbow PS and Clark PLLC reflected that Benbow PS purchased an indirect interest in 25% of CRC’s tangible assets and 25% of CRC’s “book of business” when it purchased a 25% partnership interest in CRC. CRC credited Benbow PS’s capital account with an initial balance of $580,000.
CRC emplоyed Ms. Benbow as an accountant from 1999 until October 2011, at which time Benbow PS ceased being a partner of CRC.
C. Town PS
John E. Town, CPA, Inc., P.S. (“Town PS”), is a professional services corporation incorporated under the laws of the State of Washington by John E. Town, who became a CRC employee in 2007. Town PS did not make a direct capital contribution to CRC but instead purchased a 25% partnership interest from Clark PLLC in 2009 and was admitted to CRC as a partner on January 1, 2009.
The purchase was seller-financed by Clark PLLC, and Town PS obtained a loan from Clark PLLC for the entire purchase price.7 Clark PLLC and Town PS calculated the purchase price for Town PS’s 25% partnership interest by first summing the values of CRC’s tangible
CRC employed Mr. Town as an accountant from 2007 until May 1, 2013, at which time Town PS ceased being a partner in CRC.
D. Chris Newman CPA, PLLC
Chris Newman CPA, PLLC (“Newman PLLC”), is a professional limited liability company organized under the laws of the State of Washington by Chris Newman, who became an employee of CRC in 2009. Newman PLLC became a partner of CRC in December 2012 and remained a partner until May 1, 2013.
On December 22, 2012, Newman PLLC made a $200,000 cash contribution to CRC using funds it obtained from a loan from Washington Trust Bank (the “WTB Loan”). To obtain the loan, Newman PLLC executed a promissory note in favor of Washington Trust Bank. Mr. Newman, Mr. Clark, and Mrs. Clark each executed personal guaranties with respect to the WTB Loan promissory note. CRC set Newman PLLC’s initial capital account balance at $200,000.
III. CRC’s LLC agreement and restatement
CRC’s operating agreement (which it refers to as a “limited liability company agreement”) that was applicable during the year at issue was preceded by a prior version and by transactions that form the context for construing the operating agreement.
A. 2009 LLC agreement
Effective January 1, 2009, through December 30, 2011, a limited liability company agreement (the “2009 LLC Agreement”, Ex. 9–J (Doc. 33, at 247)) governed CRC’s operation. The 2009 LLC Agreement stipulated the partners’ agreement on the allocation of profits and losses among partners, distributions of cash and property to partners, capital account maintenance, partner withdrawal, and liquidation of the company.
Regarding partner withdrawal, Section 11.1 of the 2009 LLC Agreement provided:
In the event of a Withdrawal Event, the Withdrawing Member [i.e., Partner] shall first have an option to receive as a Distribution in full consideration of all of the Units of the Member the following:
(i) Member Clients. All, or any of, the Clients of the Withdrawing Member . . . and
(ii) Net Book Value. [The] Withdrawing Member’s Percentage Interest of the Net Book Value [of CRC].10
Section 8.3(b) of the 2009 LLC Agreement stated that “[i]f any Clients [were] [d]istributed under [the] agreement, the value of such Client [would] be the Client Value”, defined (in Section 1.19) as “the gross revenue generated from [each respective] Client over the prior twelve-month period.”
In lieu of taking a distribution of clients, a partner could agree to “leave” clients at CRC and apply a portion of the value of those clients to the partner’s outstanding loan balance incurred upon its admission (if applicable).
Schedule 1 attached to the 2009 LLC Agreement stated that Mr. Clark owned a 50% partnership interest in CRC, and Ms. Benbow and Mr. Town each owned a 25% partnership interest in CRC.
B. 2011 negotiations and events preceding the 2012 restatement of the LLC agreement
In 2011 the partners of CRC were Clark PLLC, Benbow PS, and Town PS.
1. Retirement negotiations
Mr. Clark planned to transfer ownership and management of CRC to the remaining partners in preparation for his retirement.11 Mr. Clark, Ms. Benbow, Mr. Town, and Mr. Newman discussed a potential buyout of Clark PLLC’s partnership interest in CRC, and the implementation of a new partner compensation model using a “Finders,
Negotiations of Clark PLLC’s prospective buyout reached a stalemate in the last quarter of 2011. At that time Messrs. Clark, Newman, and Town agreed to continue negotiations in 2012, and CRC operated under the terms of the 2009 LLC Agreement for the entire 2011 tax year.
2. Benbow PS’s withdrawal as partner
In October 2011 Ms. Benbow’s employment at CRC ended, and Benbow PS ceased to be a partner of CRC. Ms. Benbow began working for another CPA firm, and certain clients formerly engaging CRC decided to retain the services of Ms. Benbow’s new CPA firm. Pursuant to this transfer, Ms. Benbow, Benbow PS, and the moving clients executed documents relating to transfer of the client files from CRC to Ms. Benbow.
3. Capital accounts
Following Benbow PS’s withdrawal as partner and the migration of clients to Ms. Benbow’s new CPA firm, CRC reported—pursuant to the 2009 LLC Agreement—a property distribution to Benbow PS (and a corresponding capital account decrease) in an amount that reduced its
C. 2012 restatement of the 2009 LLC agreement and related events
In 2012 Clark PLLC, Town PS, and Newman PLLC continued negotiations regarding the buyout of Clark PLLC’s interest in CRC. The parties ultimately agreed on buyout terms and memorialized their agreement by executing a “restated” version of the 2009 LLC Agreement on December 24, 2012 (the “2012 LLC Agreement”). The 2012 LLC Agreement as executed did not include a form security agreement to a form promissory note (relating to payments to be made to retiring partners), which the parties continued negotiating and agreed to finalize in January 2013. The 2012 LLC Agreement was effective as of December 31, 2011.
D. 2013 LLC Agreement
As planned, the three entity partners of CRC finalized the security agreement and included it when they reaffirmed the terms of the 2012 LLC Agreement on January 18, 2013. (Hereinafter we refer to the reaffirmed 2012 LLC Agreement as the “2013 LLC Agreement”, Ex. 11–J (Doc. 33, at 352).) The 2012 terms remained unchanged in the 2013 LLC Agreement, except for minor items that are inconsequential to the outcome of this case. The parties to this case agree that the terms of the 2013 LLC Agreement are operative for this case.
The 2013 LLC Agreement governs many aspects of CRC’s operation, including the rights and responsibilities of partners and managers, admission of new partners, and transfer of partnership interests. We discuss below only the provisions relevant to this case.
The 2013 LLC Agreement contains sophisticated partnership tax provisions, including rules governing capital contributions and capital account15 maintenance for each partner.
The 2013 LLC Agreement states that “[a] separate Capital Account will be maintained for each Member throughout the term of the Company in accordance with the rules of Regulation Section 1.704-1(b)(2)(iv).” It states explicitly that each partner’s capital account will be increased by the fair market value of contributions (in cash or property), by allocations of “net profit”,16 and by any items of income and gain specially allocated to the partner, and will be decreased by the fair market value of distributions (in cash or property), by allocations of expenditures, and by items of deduction and loss specifically allocated to the partner.
The 2013 LLC Agreement further states that maintenance of capital accounts under the agreement is intended to comply with “the requirements concerning substantial economic performance [sic] under Code Section 704(b)” and that the “[a]greement shall not be construed as creating a deficit restoration obligation or otherwise personally obligating any Member to make a capital contribution”.
As part of the buyout negotiations, Clark PLLC, Town PS, and Newman PLLC agreed that, effective December 31, 2011, capital account balances would be as follows: Town PS’s capital account balance would be $150,000; Clark PLLC’s capital account would be $792,497; and Newman PLLC’s capital account balance would be $200,000.17
2. Allocation of net profits and losses
Section 8.1 of the 2013 LLC Agreement allocates “Net Profit [and] Loss” of CRC among its partners using a multi-step formula. Profit and loss are allocated under Section 8.1 in the following order and priority: First, income equal to “10% of the average Tangible Net Worth18 reflected in each Member’s Net Book Value Capital Account for the year” is allocated to each partner. Second, Clark PLLC “receive[s] a special allocation of taxable income with respect to the amounts collected on the Accounts Receivable that have been reserved for non-collectability”.19 Finally, all remaining income is allocated according to the FMG system.20 The 2013 LLC Agreement also allocates income, gain, loss, and deductions according to its proportional “Net Profits [and] Loss” allocation formula.21
However, section 8.1 begins by noting that its allocations are “subject to [the special allocation provisions of] Section[] 8.3”. Section 8.3 (entitled “Special Allocations”) establishes a “Qualified Income Offset” (“QIO”), whereby “[i]n the event that any Member unexpectedly receives any adjustments, allocations, or distributions[,] . . . items of Company income and gain [are] specially allocated to such Member in an amount and in a manner sufficient to eliminate as quickly
3. AAV system
Articles 10 and 11 of the 2013 LLC Agreement (along with definitions in Article 1) provide a method for computing retirement payments for a retiring partner in a manner that takes account of, among other things, CRC’s “goodwill”.
“Average Annual Value” is defined in Section 1.6 to mean “the goodwill value of the Company, calculated as one times the annual accrual basis net client fee revenue of the Company” (emphasis added); and under Section 1.7, the “Average Annual Value Method” is “the method pursuant to which an individual Member is allocated his portion of the Average Annual Value”.
Article 10 of the 2013 LLC Agreement, entitled “Accumulated Annual Value Method”, provides the method by which each partner’s “AAV account” (a term not defined in the 2013 LLC Agreement) is adjusted annually. Each partner’s “AAV” is adjusted up or down in accordance with the ratio of income allocations under the FMG system (Article 8 of the 2013 LLC Agreement). Upon a partner’s withdrawal, the partner’s AAV is “adjusted for any changes in client relationships that would result in a material decrease in fees billed” before any AAV distribution to the partner. Upon voluntary withdrawal from the company, the withdrawing partner forfeits “50% of any vested right to AAV retirement payments”.
Article 11 of the 2013 LLC Agreement, entitled “Member Retirement Payments”, provides the method for calculating payments to retiring partners.23 The retiring partner first receives a payment equal to his capital account balance, then a payment equal to “85% of the retiring member’s AAV accоunt on the date of retirement”.
4. Contributions
Section 7.1 of the 2013 LLC Agreement states that “[e]ach Member shall contribute such amount as is set forth in . . . Schedule 1 (or as shown on the books of the Company) as such Member’s share of the Members’ initial Capital Contribution.”24 Schedule 1, entitled “Member and Class B Unit Holder25 Information (as of December 31, 2011)” consists of a table with each partner’s name and address, AAV balance, capital account balance, and number of respective voting or non-voting units, with a total for each column on the last row of the table. The AAV balance for each partner mirrors the balances negotiated by the partners, and Clark PLLC, Newman PLLC, and Town PS each hold an amount of Class A units equal to their respective AAV balances (2,650,000 units for Clark PLLC, 700,000 units for Newman PLLC, and 314,200 units for Town PS—for a grand total of 3,664,200 units across all partners). The table shows a zero balance in each partner’s capital account column (contrary to the partners’ agreement regarding initial capital account balances), and the total for this column (theoretically showing the sum of all capital accounts) likewise reflects a zero balance.
Asterisks appear next to each partner’s name and link to footnotes appearing below the table. The footnote corresponding with Clark PLLC states that Clark PLLC’s initial capital contribution consisted of “[f]ormation costs, contribution of property from predecessor
5. Distributions
Article 9 of the 2013 LLC Agreement is entitled “Distributions from the Company”. Cash distributions are made pursuant to Section 9.1 (“Net Profit Distributions”) “in the Manager’s reasonable discretion, provided that such Distributions will be consistent with the allocations of income made pursuant to Section 8.1” (regarding allocation of net profit and loss).
Section 9.3 provides for “Distributions In-Kind”. Section 9.3(a), addressing “Non-cash assets”, is especially significant in our analysis below. Section 9.3(a) states that any such assets “shall be distributed in a manner that reflects how cash proceeds from the sale of such assets for fair market value would [be] distributed (after any unrealized gain or loss attributable to such noncash assets has been allocated among the Members in accordance with Article 8)”. That is, Section 9.3(a) requires that unrealized gain be allocated among the partners (“in accordance with Article 8”)26 and that non-cash assets be distributed like cash proceeds (which, under Section 9.1, would be “in the Manager’s reasonable discretion” but “consistent with the allocations of income made pursuant to Section 8.1”).
Section 9.3(b) of the 2013 LLC Agreement states for the distribution in kind of a particular non-cash asset—i.e., “Clients”—“If any Clients are Distributed under this Agreement, the value of such Client shall be the Client Value” (defined in Section 1.19 as the “gross revenue as invoiced to the Client over the prior twelve-month period”).27
Upon voluntary withdrawal, a partner is entitled to a distribution in an amount equal to his positive capital account balance, with the exception that Town PS is not entitled to a distribution unless its “Tangible Net Worth exceeds $150,000 [or] until Clark [PLLC] is paid in full”.28
In the event of a liquidation, after repayment of CRC’s creditors, the 2013 LLC Agreement states that liquidating distributions are made “[t]o the Members in repayment of the positive balances of their respective Capital Accounts, as determined after taking into account all Capital Account adjustments for the taxable year during which the liquidation occurs”.
6. Non-solicitation agreement
The 2013 LLC Agreement contains a non-solicitation agreement whereby the partners agree (for a period of two years) that a withdrawing partner will not provide services to or solicit any current or prospective29 client of CRC, remove client files from CRC’s offices, or hire or solicit CRC employees. Partners who violate the non-solicitation agreement agree to pay certain financial penalties relative to the category of violation. For example, for violations relating to clients the violating partner must pay to CRC a penalty equal to a portion of the
IV. Newman PLLC’s and Town PS’s withdrawal as partners
Effective May 1, 2013 (i.e., not quite four months after the execution of the 2013 LLC Agreement), Newman PLLC and Town PS withdrew as partners of CRC. Mr. Newman and Mr. Town thereafter started their own CPA firm, practicing under the name of “Newman Town, PLLC” (hereinafter, “NT PLLC”)
A. Book of business
Certain clients of CRC thereafter ceased engaging CRC and retained the services of NT PLLC. That is, the withdrawing partners took with them a “book of business”. We find (as the parties have stipulated) that, under the terms of the 2013 LLC Agreement, the “Client Value” of the clients that retained NT PLLC was $742,569, that the portion of this total “Client Value” allocable to Newman PLLC was $318,144, and that the portion allocable to Town PS was $424,425.
B. Civil litigation
The WTB Loan remained outstanding at the time Newman PLLC withdrew from CRC. Pursuant to the guaranty that Mr. Clark signed, Washington Trust Bank looked to Mr. Clark for repayment of the loan.
Mr. Clark thereafter filed a civil lawsuit in the King County Superior Court of the State of Washington, suing Newman PLLC, Mr. Newman, and Mr. Newman’s spouse, praying for relief in an amount equal to the outstanding balance of the WTB Loan, with interest. The parties engaged in arbitration and mediation, with Mr. Town joining the proceedings some time thereafter.
In preparation for mediation, each party filed a “Statement of Claims”. Among other items, Mr. Clark claimed that Messrs. Newman and Town breached the 2013 LLC Agreement and their fiduciary duty to CRC when they “took CRC clients . . . [and] competed against CRC”. Mr. Clark’s statement sought relief for, among other things, the “value of the practice grown by [Mr. Newman] at CRC”.30 Messrs.
and Town requested relief for compensation they argued was outstanding from CRC.
C. Settlement
In October 2013, CRC, Mr. Clark, Clark PLLC, Mr. Newman, Newman PLLC, Mr. Town, and Town PS agreed to settle the civil lawsuit and arbitration and entered into a “Civil Rule 2A Agreement” outlining the terms of the agreed settlement. In February 2014 they executed a “General Release and Settlement Agreement” (“Settlement Agreement”,31 Ex. 33–J (Doc. 33, at 620)) to finalize the settlement terms.32 The Settlement Agreement acknowledged the 2013 LLC Agreement that the parties had executed in January 2013 and settled all claims relating to Mr. Newman’s and Mr. Town’s departure from CRC and resolved all claims (known or unknown) that the parties brought or could have brought in the civil lawsuit or arbitration proceedings.
The Settlement Agreement stated that “Newman PLLC” and “Town PS” would make the $200,000 capital contribution to CRC (although it did not specify the denomination of capital contribution that each entity would make—e.g., $100,000 each or otherwise).
The Settlement Agreement resolved the controversy about the clients that Newman PLLC and Town PS had taken with them when they withdrew from CRC. Clark PLLC had previously proposed an “Agreement Regarding Client File Transfer Procedure”, which had “anticipate[d] that certain clients of CRC [would] wish to have NT PLLC provide accounting and tax service” and had set out the routine by which
D. Adjustments to capital accounts
CRC made certain adjustments to the capital accounts of the partners after the withdrawal of Newman PLLC and Town PS. CRC first decreased Newman PLLC’s capital account by $419,043 and decreased Town PS’s capital account by $447,437, to account for property distributions that it reported to each of those partners.33 It then decreased Town PS’s capital account further by $150,000 and increased Clark PLLC’s capital account by the same $150,000 (and later reported this $150,000 capital account increase as a capital contribution by Clark PLLC).34 CRC did not adjust Newman PLLC’s or Town PS’s capital account to reflect the allocations of any inherent gain in the property distributions before decreasing the partners’ capital accounts in the amounts of the distributions.
V. Realization of ordinary income
CRC realized $563,118 of ordinary business income for 2013. This fact is not in dispute. Rather, the dispute is about how that income should be allocated among CRC’s partners for tax purposes.
VI. CRC’s federal returns of partnership income
CRC is a calendar year taxpayer and filed as a partnership for federal income tax purposes for 2011, 2012, and 2013. CRC was subject to the TEFRA partnership procedures set forth in Code sections 6221–6234 for the years 2011, 2012, and 2013. For each of these years,
A. 2011
CRC filed its 2011 Form 1065 in September 2012, and reported that its partners were Clark PLLC, Town PS, and Benbow PS. On its attached Schedule L, “Balance Sheets per Books“, CRC reported $1,512,905 as its amount of intangible assets at the beginning of the year, and zero as its amount of intangible assets at the end of the year.
| Clark PLLC | Town PS | Benbow PS | |
|---|---|---|---|
| Beginning capital account balance | $1,834,050 | $466,146 | $479,297 |
| Capital contributions35 | 238,766 | 7,727 | — |
| Income allocations (net of deductions) and other items (e.g., nondeductible expenses) | 665,014 | 129,920 | 148,909 |
| Distributions | |||
| Cash | 549,329 | 102,653 | 113,922 |
| Property | 1,396,004 | 351,140 | 514,284 |
| Ending capital account balance36 | 792,497 | 150,000 | -0- |
CRC filed its 2012 Form 1065 in September 2013, and reported that its partners were Clark PLLC, Newman PLLC, and Town PS. CRC did not report any intangible assets on its Schedule L for 2012.
The Schedules K–1 issued to the partners reported the following information:
| Clark PLLC | Town PS | Newman PLLC | |
|---|---|---|---|
| Beginning capital account balance | $792,497 | $150,000 | — |
| Capital contributions | — | 10,000 | 200,000 |
| Income allocations (net of deductions) and other items (e.g., nondeductible expenses) | 1,259,382 | (1,817) | (983)37 |
| Distributions | |||
| Cash | 903,585 | 61,545 | 164,045 |
| Property | 16,745 | — | — |
| Ending capital account balance38 | 1,131,549 | 96,638 | 34,972 |
CRC filed its 2013 Form 1065 in September 2014, and issued Schedules K–1 to Clark PLLC, Newman PLLC, and Town PS. CRC did not report any intangible assets on its Schedule L for 2013.
The Schedules K–1 issued to the partners reported the following information:
| Clark PLLC | Town PS | Newman PLLC | |
|---|---|---|---|
| Beginning capital account balance | $1,131,549 | $96,638 | $34,972 |
| Capital contributions39 | 150,000 | 100,000 | 100,000 |
| Income allocations (net of deductions) and other items (e.g., nondeductible expenses) | 789,987 | 255,799 | 307,759 |
| Distributions | |||
| Cash | 632,201 | 5,000 | 23,688 |
| Property | — | 447,437 | 419,043 |
| Ending capital account balance40 | 1,439,335 | -0- | -0- |
In September 2014 Newman PLLC and Town PS each filed Forms 8082, “Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR)“, with respect to CRC’s 2013 issued Schedules K–1 that reported the following information:41
Newman PLLC—Form 8082
| Ordinary income (loss) | Property distributions | |
|---|---|---|
| Schedule K–1 issued to Newman PLLC | $307,759 | $419,043 |
| Form 8082 filed by Newman PLLC | -0- | 183,737 |
Town PS—Form 8082
| Ordinary income (loss) | Property distributions | |
|---|---|---|
| Schedule K–1 issued to Town PS | $255,799 | $447,437 |
| Form 8082 filed by Town PS | 5,000 | -0- |
A. CRC’s partnership-level proceeding
In response to Newman PLLC’s and Town PS’s filed Forms 8082, the IRS conducted a partnership-level audit of CRC’s 2013 Form 1065. On August 24, 2016, the IRS issued the Letter 1787–F, “TMP Notice of Beginning of Administrative Proceedings“, to notify Clark PLLC that the IRS was beginning an administrative partnership-level audit of CRC’s 2013 Form 1065. On November 6, 2017, the IRS issued a Letter 1827–F proposing adjustments to partnership items on CRC’s 2013 Form 1065 and notifying the TMP of its right to file a protest to the IRS Appeals Office (“IRS Appeals“).42
B. Notice of Final Partnership Administrative Adjustment
On December 17, 2018, IRS Appeals issued the TMP an FPAA determining adjustments to CRC’s 2013 Form 1065.
The FPAA largely adjusted CRC’s reported property distributions and income allocations consistently with the corrections proposed by Newman PLLC and Town PS.43 With regard to property distributions, the IRS determined: (1) reported “client distributions” of $705,249 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; and (2) a remaining distribution of $183,737 should be disregarded because it was the result of a bank loan owed personally by
[CRC’s] reported allocation of [o]rdinary income [to Newman PLLC and Town PS] had no substantial economic effect, was not consistent year to year, and did not use the allocation method described in Article 8 of the [2013 LLC Agreement] . . . [and that] [t]he allocation of [o]rdinary [i]ncome should be based on known amounts received by the partners.
The FPAA determined that ordinary income should be allocated as follows: $538,118 to Clark PLLC, $20,000 to Newman PLLC, and $5,000 to Town PS.
C. Newman PLLC’s and Town PS’s Forms 870–PT
In December 2017 Newman PLLC and Town PS executed Forms 870–PT, “Agreement for Partnership Items and Partnership Level Determinations as to Penalties, Additions to Tax and Additional Amounts“, regarding CRC’s 2013 taxable year, and the IRS countersigned in January 2018. Each Form 870–PT determined, similarly to the FPAA, that the partner’s distributive share of ordinary income should be allocated: $538,558 to Clark PLLC, $20,000 to Town PS, and $5,000 to Newman PLLC.45 (These agreements resolve the tax consequences of the withdrawal for Town PS and Newman PLLC, so we do not adjudicate here any claim by those entitles. Rather, at issue here
IX. Tax Court proceedings
CRC’s petition contesting the FPAA was timely filed in this Court on January 30, 2019. The parties filed three stipulations of settled issues, resolving their disagreements regarding multiple determinations in the FPAA, and leaving the remaining issues for our decision. The parties also filed a stipulation of facts and a supplement to that stipulation. On January 5, 2021, the parties filed a joint motion to submit the case pursuant to Rule 122, and we granted the motion on January 27, 2021.
OPINION
I. Applicable legal principles
A. Jurisdiction to determine partnership items
Under the default rules of
B. Burden of proof
As a general rule, the Commissioner’s determinations in an FPAA are presumed correct, and the taxpayer has the burden of proving them incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996). The Commissioner, however, bears the burden of proof with respect to any new matter, increase in deficiency, and affirmative defenses pleaded in the answer. Rule 142(a). Petitioner does not allege that its burden should shift to the Commissioner for any issue in this case, and thus, petitioner bears the burden of proof.
C. Partnership intangible assets
Business entities may own intangible assets. See, e.g., Tomlinson v. Commissioner, 58 T.C. 570, 580 (1972) (“We have long recognized that these intangibles [including customer lists] are capital assets“), aff‘d, 507 F.2d 723 (9th Cir. 1974); Topeka State J., Inc. v. Commissioner, 34 T.C. 205, 215, 221 (1960) (“It is well established that [subscription lists] are an intangible asset of a newspaper [company]“).47 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) (holding that purchase price for partnership included payment for tangible assets and goodwill); Tolmach v. Commissioner, T.C. Memo 1991-538.
A “client-based intangible” asset (such as a customer list or “book of business”48) 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) (holding that a corporation proved that a customer list of “‘paid
The Commissioner disputes the existence of the client-based intangible that petitioner asserts and CRC’s ability to distribute such an asset, and we address that dispute below in Part II.A.
D. Substantial economic effect
1. General principles
The regulations provide that 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
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
2. 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:
a. Basic test of economic effect
The basic test for economic effect is set forth in
b. 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. Consequently, 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. Specifically, 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.50 See
The alternate test also requires that the partnership agreement provide for a QIO, i.e., a “qualified income offset“. 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
c. Economic equivalence test
There is a third economic effect test, referred to as the “economic equivalence” test.
E. Partner’s interest in the partnership
sharing arrangement may or may not corrеspond to the overall economic arrangement of the partners. . . . [I]n the case of an unexpected downward adjustment to the capital account of a partner who does not have a deficit make-up obligation that causes such partner to have a negative capital account, it may be necessary to allocate a disproportionate amount of gross income of the partnership to such partner for such year so as to bring that partner’s capital account back up to zero.
Id. Accordingly, an examination of a partner’s interest in the partnership “shall be made by taking into account all facts and circumstances relating to the economic arrangement of the partners.” Id. Among the relevant factors to be taken into account in determining the partners’ interests in the partnership are: (1) the partners’ relative contributions to the partnership, (2) the interests of the respective partners in profits and losses (if different from that in taxable income or loss), (3) the partners’ relative interests in cash flow and other non- liquidating
We address the Commissioner’s contentions as to a “partner’s interest in the partnership” below in Part II.C.
F. Partnership distributions
The basic capital accounting rules in
We address in Part II.A–C the parties’ contentions as to the existence of “client-based intangibles“, the presence of “unrealized gain” inherent in those intangibles, and the corresponding “book-up” of the partners’ capital accounts.
II. Analysis
A. Distribution of client-based intangibles to Newman PLLC and Town PS in 2013
The FPAA determined that CRC’s reported “client distributions” were not distributions and should be disregarded. In the alternative, the IRS determined that the “client distributions” had not been substantiated as to the clients distributed, their overall value, or CRC’s ability to value each client distributed. In response, petitioner argues that “goodwill” is an asset of CRC and that when Newman PLLC and Town PS “took clients from CRC“, they effected a distribution of goodwill from CRC to each of them. CRC aptly cites Rudd v. Commissioner, 79 T.C. 225, 238 (1982), in which we stated:
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.
The client-based component of such generalized “goodwill” is the asset at issue here.
Taking into consideration the terminology used in the FPAA (i.e., “client distribution“), it is clear to us that, although both parties intermittently refer to a contribution to and distribution of general “goodwill” from CRC, at issue in this case is a distribution of CRC’s clients or a client list in particular, both of which we refer to as the “client-based intangibles“. Client lists and other client-based intangibles have value. See, e.g., Newark Morning Ledger Co., 507 U.S. at 570; Holden Fuel Oil Co., 31 T.C.M. (CCH) at 187–89. 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) (holding that insurance contract “expirations“, which did not guarantee renewal of an insurance contract, but contained client and policy information and were analogous to customer lists, goodwill, or just intangibles in the nature of goodwill, constituted valuable capital assets capable of transfer); see also Holden, 31 T.C.M. at 184–85, 187 (“[Although] customers [on a customer list] were not obligated to purchase fuel oil from [the taxpayer] . . . [i]n acquiring the list [the taxpayer] was afforded the opportunity of contacting persons who were known to be using fuel oil to heat their homes and who were in the need of a new supplier; clearly providing [the taxpayer] with a valuable asset.“). Business entities, such as limited liability companies, may own and distribute such intangible assets. See, e.g., JHK Enters., Inc., 8 T.C.M. (CCH) at 1032. CRC could therefore hold and distribute such assets, and although the evidence does not support that Newman PLLC and Town PS either contributed client-based intangibles to CRC or
CRC’s dealings demonstrate that it and its partners understood that a partner’s “book of business” consisting of current clients would be valued upon entry of a partner and charged for upon withdrawal. For example, when Benbow PS withdrew from CRC, its capital account was reduced to zero to reflect the distribution of CRC clients to Benbow PS. Similarly, when Town PS joined CRC as a partner, Clark PLLC and Town PS calculated the price that Town PS would pay to Clark PLLC for 25% of its interest in CRC by adding up the values of CRC’s assets, multiplying the total by 25% (the amount of Town PS’s anticipated partnership interest) and then subtracting from that total an amount (i.e., $234,046) that was equal to the prior year’s revenue generated from Mr. Town’s “book of business“. The record also contains an exhibit entitled “John’s Buy-in Calculation” relating to the price for Town PS’s purchase of a 25% partnership interest from Clark PLLC. This document was contemporaneously used to determine the purchase price of Town PS’s partnership interest in CRC, and it reflects thе same purchase price discount with the label “[a]greed upon value of John’s book brought in“.
The 2013 LLC Agreement’s distribution provisions likewise treat clients as a valuable partnership asset. Section 9.3(b) of the 2013 LLC Agreement (like Section 9.3(b) of the 2012 LLC Agreement and Section 8.3(b) of the 2009 LLC Agreement) states that “[i]f any Clients are Distributed . . . the value of such Client shall be the Client Value“, defined as gross revenue invoiced to the client over the prior 12 months. Although the 2013 LLC Agreement as executed in 2012 and reaffirmed in 2013 lacks the express client distribution provision of Section 11.1(a)(i) of the 2009 LLC Agreement, the partners agreed to Section 9.3(b) when they executed the 2013 LLC Agreement, and neither party argues we should disregard their agreement to this effect. In some cases, we might ignore an agreed-upon valuation method where there was evidence of collusion between the partners; but here the partners’ interests were adverse at the time they agreed to the 2013 LLC Agreement. Plainly, the partners were negotiating at arm’s length the terms of Clark PLLC’s buyout.
Consequently, we hold that CRC’s method for valuing client-based intangibles upon the withdrawal of Newman PLLC and Town PS comports with the fair market value definition of
As is stated above, under the terms of the 2013 LLC Agreement, the “Client Value” of the clients that retained NT PLLC was $742,569, of which $318,144 was allocable to Newman PLLC and $424,425 was allocable to Town PS. We therefore hold that petitioner has met its burden to prove that there was a distribution of clients, and that, on the evidence before us,54 CRC did in fact distribute client-based intangible assets of $318,144 to Newman PLLC and $424,425 to Town PS when certain clients left CRC and engaged NT PLLC following Newman PLLC’s and Town PS’s withdrawals.
Obviously, this was not a textbook instance of a partnership distribution, labeled as such by agreement of the parties when the partner withdrew. Rather, CRC initially contended that the taking of property (i.e., the clients) was wrongful and was a breach of the 2013 LLC Agreement. We can imagine a circumstance in which a partner’s taking of property from a partnership was outright robbery; and in such a circumstance it might be treated for tax purposes not as a distribution but as a theft, perhaps deductible on the partnership return as a theft loss under
The Commissioner argues, in effect, that the transfer of the client-based intangibles should be ignored as non-factual, because (he says) the intangibles did not exist and were not transferred. For the reasons
Having structured the economic deal that goodwill was not a partnership asset, petitioner is bound by the treatment the parties negotiated. A taxpayer, although free to structure his transaction as he chooses, “once having done so, he must accept the consequences of his choice, whether contemplated or not . . . and may not enjoy the benefit of some other route he might have chosen to follow but did not.” Comm’r v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (citations omitted). To disavow the LLC Agreement’s treatment of goodwill, petitioner must present strong proof that the LLC Agreement was wrong.
But the partners of CRC did not negotiate a deal that clients were not a value that could be brought into the firm and taken out of it. Rather, the partners took into account an entering partner’s book of business in determining on what terms the partner would enter the partnership; and Section 5.1 of the 2013 LLC Agreement acknowledges that CRC “expended substantial time and funds in developing . . . the Company’s clientele and their patronage“; Section 1.6 postulates a “goodwill value of the Company” (used for calculating AAV rights); and it expressly makes provision (in Section 9.3(b)) for “Clients [to be] Distributed under this Agreement” and (in Section 1.19) for the “Client Value” to be determined. When Newman PLLC and Town PS did withdraw, they took clients with them, and the parties executed an “Agreement Regarding Client File Transfer Procedure“.
It is true that the 2013 LLC Agreement does not make express provision for goodwill to be contributed by a partner and included in his capital account, but that silence does not amount to an agreement that client-based intangibles do not exist and cannot be transferred. It is also true that CRC failed to reflect intangible values in partners’ capital accounts (and that is part of the reason that we hold below that CRC’s special allocation fails the tests for economic effect, see infra Part II.B); but a partnership’s failure to reflect an asset on its books does not make the asset cease to exist. If a partnership fails to book its cash (to choose an extreme instance), a distribution of that unbooked cash is still a distribution. Treating the distribution of the client-based intangibles as a distribution does not (in the words of the Commissioner’s brief quoted above) require “disavow[ing] the LLC Agreement’s treatment of
B. Lack of substantial economic effect in 2013 income allocations
Having held that CRC distributed client-based intangible assets to Newman PLLC and Town PS upon their withdrawal as partners, we now turn to CRC’s allocation of income to Newman PLLC and Town PS, which the IRS determined did not have substantial economic effect.
Petitioner argues that Newman PLLC’s and Town PS’s capital accounts, which had initial balances of $34,972 and $96,638 respectively, were driven negative by subtracting the value of the clients distributed to them. These negative capital account balances “triggered” the QIO provision of the 2013 LLC Agreement and required that CRC allocate income to Newman PLLC and Town PS in 2013 in amounts sufficient to restore their capital account balances to zero. CRC argues that its income allocations have substantial economic effect because they are consistent with the economic arrangement of the partners in the 2013 LLC Agreement.
We first examine whether the income allocation at issue satisfies any of the tests under
1. The allocation fails the basic test.
The basic test for economic effect requires (in part) that the partnership agreement contain a deficit restoration obligation. The 2013 LLC Agreement contains no such provision and in fact explicitly states that “this Agreement shall not be construed as creating a deficit restoration obligation or otherwise personally obligating any Member to make a capital contribution in excess of those required by [a section detailing initial and additional capital contributions].” (Emphasis added.) Without a deficit restoration obligation in the 2013 LLC Agreement, the special allocation cannot satisfy the basic test for economic effect. See
2. The allocation meets the criteria of the alternate test but does not have economic effect.
The alternate test requires that the partnership agreement provide: (1) for the determination and maintenance of partners’ capital
The 2013 LLC Agreement does contain provisions that (1) require maintenance of capital accounts in accordance with
The Commissioner asserts persuasively that CRC failed to maintain capital accounts in accordance with
As we have discussed, petitioner has not shown that the partners ever actually contributed “goodwill” or client-based intangibles to CRC56 (or exchanged client-based intangibles for an AAV account), or, if such a contribution (or exchange) did occur, the value of the assets at that time. Neither does it cite any authority (controlling or otherwise) to support its position regarding the AAV accounts and the inapplicability of
The FPAA determined that the income allocation lacked substantial economic effect, and so the burden is on Clark PLLC, as petitioner, to prove that such allocation did have substantial economic effect. It necessarily follows that, under an analysis of the economic effect of the income allocation, one element of petitioner‘s burden is to prove that CRC maintained capital accounts in accordance with
To determine whether the client-based intangible asset contained unrealized gain, we must determine the partnership‘s adjusted basis in the asset. See
The parties have stipulated that the partners’ opening capital account balances in 2013 did not include the value of any intangibles and that CRC did not increase the partners’ capital accounts by the value of any inherent gain in the client-based intangibles. Therefore, CRC failed to maintain the partners’ capital accounts in accordance with
In some cases, despite not adhering to the formal requirements of the economic effect tests, an allocation may produce the same income tax results as if the allocation had satisfied the requirements of the basic test.
The substantial economic effect analysis under
C. Partner‘s interest in the partnership
Having determined that CRC‘s allocations of income to Newman PLLC and Town PS lack substantial ecоnomic effect, we must redetermine the allocations in accordance with “the partners’ interests in the partnership“.
The terms of the 2013 LLC Agreement ostensibly complied with the criteria of the alternate test for economic effect, but the special allocation lacked substantial economic effect because the partnership failed to correctly maintain capital accounts in accordance with those terms and with the regulations.62 We proceed with examining the relevant factors, keeping in mind that our goal is to derive 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“,
1. The partners’ relative contributions to the partnership
The record is insufficient to chronicle the entire history of the partners’ contributions to CRC, and so we are unable to conduct a complete evaluation of their relative contributions.63 Town PS purchased its interest in CRC from Clark PLLC for $639,000 in 2009 and contributed $10,000 in 2012, and Newman PLLC contributed $200,000 in 2012, but we are lacking information regarding Clark PLLC‘s contributions. Although we lack sufficient information to calculate overall contributions, the economic reality evidenced by the partners’ relative ownership of membership “units” in CRC is that Clark PLLC owned the largest percentage and therefore likely made the largest “contribution” of his business.64 Consistent with this economic reality, the Commissioner reckons Clark PLLC‘s “Percentage of total capital accounts” as 69%, but he “provide[s] more weight tо the other factors“. As a proxy for partners’ contributions, he uses partners’ account balances, but this may understate Clark PLLC‘s dominance.
The 2013 LLC Agreement clearly enumerates the criteria for allocating income to each of the partners, and we follow the 2013 LLC Agreement to make our analysis.65
The 2013 LLC Agreement allocates income according to a three-step formula. The first step (in Section 8.1(a)) allocates income equal to 10% of the “Tangible Net Worth” reflected in each partner‘s capital account balance to the respective partner. On the basis of the 2013 LLC Agreement‘s definition of “Tangible Net Worth” and the partnership‘s notable exclusion of intangible assets from the partners’ capital accounts, we understand this first step to allocate an amount of income to each partner equal to 10% of such partner‘s positive capital account balance. The second step (in Section 8.1(b)) then allocates income to Clark PLLC for amounts collected on accounts receivable (which the parties have stipulated was $15,387 in 2013). Third, Section 8.1(c) allocates the remaining income according to the FMG system, which the parties have stipulated should be allocated fully to Clark PLLC for 2013.
The first step in the formula under Section 8.1 allocates a portion of income to the partners’ capital accounts in accordance with their positive capital account balances. Therefore, an income allocation analysis necessarily begins with the capital accounts balances of the partners, as adjusted for allocations, distributions, and other adjustments as stipulated by the parties and as we have held in this Opinion (in some respects different from the Commissioner‘s contentions, as we will discuss). We outline the necessary adjustments to the capital accounts below.
| Partner | Capital account balance |
|---|---|
| Clark PLLC | $1,131,549 |
| Newman PLLC | 34,972 |
| Town PS | 96,638 |
CRC did not allocate the unrealized gain inherent in the client-based intangible to the partners’ capital accounts before the decrease corresponding with the distribution. We have held that the client-based intangible held unrеalized gain, and therefore, such gain must be allocated to the partners’ capital accounts before the distribution of the client-based intangibles. The 2013 LLC Agreement states that “all items of Company . . . gain . . . shall be divided among the Members in the same proportions as they share Net Profits or Net Losses“. Therefore, the allocation of unrealized gain realized on the hypothetical sale of the client-based intangibles follows the same tiered formula governing income allocations, discussed above.
Following the allocation of unrealized gain, Newman PLLC‘s and Town PS‘s capital accounts must be decreased by the value of the client-based intangibles distributed to them. See
Section 8.1 of the 2013 LLC Agreement, “Allocation of Net Profit or Loss“, allocates income according to the formula above, but “subject to Section[] 8.3“. Section 8.3 of the 2013 LLC Agreement includes (among other provisions that are inapplicable here) the QIO provision. Therefore, all income allocations under Section 8.1 are subject, first, to the QIO, which requires that, if any partner unexpectedly receives an adjustment (i.e., following an unexpected distribution) that results in a deficit capital account balance for that partner, items of income and gain must be allocated to that partner to rectify the deficit capital account balance as quickly as possible.
Therefore, we hold that, for the purposes of this factor of the partner‘s interest in the partnership analysis, the partners agreed to allocate income from the 2013 taxable year to Newman PLLC and Town PS in amounts (yet to be precisely determined) sufficient to increase their capital account balances to zero.
We note that the Commissioner calculates the partnership‘s allocation of income using a similar method, but he fails to adjust the partners’ capital accounts by the various adjustments throughout the year, in particular: (1) the allocation of unrealized gain; (2) the distributions of client-based intangible assets to Newman PLLC and Town PS; and (3) the property distribution to Newman PLLC on account of the outstanding balance of the WTB Loan.67 He then calculates the
3. The interests of the partners in cash flow and other non-liquidating distributions
The 2013 LLC Agreement states that distributions of “[c]ash may be made to the Members at such time and amounts as determined in the Managers’ reasonable discretion, provided that such [d]istributions will be consistent with the allocations of income made pursuant to Section 8.1“.
The Commissioner argues that we should look to the cash distributions actually received by the partners in 2013 (instead of looking to the 2013 LLC Agreement) to determine the parties’ agreement as to cash and non-liquidating distributions. He cites Estate of Tobias, 81 T.C.M. (CCH) at 1163, and Interhotel Co., 81 T.C.M. (CCH) at 1804, to argue that the economic burden (i.e., the tax burden) should follow the economic benefit received by the partners. He argues that Clark PLLC‘s receipt of the largest portion ($632,201) of total cash distributions ($660,889) is evidence of the partners’ agreement as to how they would share the economic benefit of CRC‘s income in 2013.
However, the facts of this case distinguish it substantially from those of Interhotel and Estate of Tobias. Notably, the partnership
4. The rights of the partners to distributions of capital upon liquidation
The 2013 LLC Agreement states that, upon liquidation of the partnership, assets will be distributed “[t]o the Members in repayment of the positive balances of their respective Capital Accounts, as determined after taking into account all Capital Account adjustments for the taxable year during which the liquidation occurs“. Upon a partner‘s voluntary withdrawal (i.e., a liquidation of that partner‘s interest), a partner is entitled to a distribution amount equal to its capital account balance.70
On the basis of our calculations above, Clark PLLC is the only partner that ends 2013 with a positive capital account balance after adjustments. Therefore, under the provisions of the 2013 LLC Agreement, if CRC liquidated at the end of 2013, Clark PLLC would
This outcome generally comports with the observation that we made in our contribution analysis: that Clark PLLC owned the largest portion of CRC. Therefore, it makes intuitive sense that, in a liquidation of CRC, Clark PLLC would receive the largest portion of distributions. However, given that the allocation at issue is an allocation of annual income (not in liquidation of the partnership), we believe that the partners’ agreement as to how to allocate that income, in particular the provisions regarding the QIO, are the most indicative of how the partners agreed to share the economic benefits and burdens of the partnership. We therefore afford this liquidation factor the least weight in our consideration of the partner‘s interest in the partnership.
D. “Align[ing]” distribution and income allocation in the “book-up”
The Commissioner has another argument to resist the allocation of income away from Clark PLLC and toward the other two partners. He contends:
Section 9.3 [of the 2013 LLC Agreement], when read in conjunction with . . . section 9.1 requires a matching of the book-up and the distribution. Because section 9.3(a) requires that non-cash distributions reflect how the cash proceeds from the sale of such property would have been distributed, it follows that the book-up must be allocated to the distributee[s] – had the property been sold first, with the proceeds distributed to Newman PLLC and Town PS, the matching rule of section 9.1 would have required the gain from the hypothetical sale to be allocated in a manner that is consistent with that cash distribution from a
[*53] hypothetical sale. . . . If CRC would have distributed the cash proceeds from a hypothetical sale of $419,043 and $447,437, to Newman PLLC and Town PS, respectively, then it follows that the book-up would have been allocated in these same amounts to the distributee partners, resulting in a wash to their capital accounts.
Assuming his premises, the Commissioner is partly right: He is right that, if the unrealized gain is allocated only to the distributee partners (Newman PLLC and Town PS) and not to Clark PLLC, then that gain allocation would increase their capital accounts, and the immediately subsequent distribution would reduce their capital accounts, and the net effect would be “a wash“. Their accounts would not be driven into negative status; the QIO would not be triggered; and CRC‘s 2013 income would not be allocated to those partners.
But we disagree with the Commissioner‘s insistence that a “matching” is required and that the unrealized gain is allocated solely to the distributee partners. The 2013 LLC Agreement explicitly says otherwise. Section 9.3(a) requires that, before the distribution, unrealized gain must be allocated among the partners not in accordance with their being distributees of the gain but rather “in accordance with Article 8” (i.e., in accordance with their allocations of “Net Profit or Net Loss for [the] fiscal year of the Company“). The LLC agreement could hardly be clearer. The allocation of gain, made before any distribution has occurred, is in accordance with Article 8.
Less clear is how to reconcile the 2013 LLC Agreement with the distribution of client-based intangible assets to only two of the partners. Section 9.3(a) states that “[n]oncash assets . . . shall be distributed in a manner that reflects how cash proceeds from the sale of such assets for fair market value would have been distributed“; and Section 9.1 states that “Distributions of Distributable Cash may be made to the Members as such time and amounts as determined in the Managers’ reasonable discretion, provided that such Distributions will be consistent with the allocations of income made pursuant to Section 8.1“. Section 9.1 thus does state that the distributions “will be consistent with” the provisions of Section 8.1 (providing for allocations of net profit or loss); but Section 9.1 commits the matter to managerial discretion, so opinions might differ about the propriety of the client distribution under the 2013 LLC Agreement.
We conclude that the unrealized gain is properly allocated among all three partners (as set out in Section 8.1) so that the capital accounts of all three are increased, but we conclude that because the agreed-upon distribution was made only to the withdrawing partners, only their capital accounts are reduced. Consequently, the withdrawing partners’ capital accounts did go negative, the QIO was triggered, and considering our analysis of the partners’ interests in the partnership (and weighing most heavily the partners’ agreement regarding their interests in economic profits and losses), CRC‘s 2013 income should be allocated to the withdrawing partners’ accounts to bring them up to zero.71
We will order the parties to submit computations under Rule 155 to determine the exact amount of Newmаn PLLC‘s and Town PS‘s 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. Those computations should account for the following capital account adjustments, beginning with
III. Conclusion
CRC‘s special allocation of income of $307,759 to Newman PLLC and $255,799 to Town PS in 2013 did lack substantial economic effect (as the FPAA determined) because the partnership failed to maintain capital accounts in accordance with the requirement of
Therefore, the IRS‘s determinations in the FPAA disregarding CRC‘s “client distributions” and reallocating CRC‘s allocations of ordinary income in the 2013 taxable year are hereby rejected and shall
Decision will be entered under Rule 155.