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Surprising Tax on Distributions From a Partnership

Oct 24, 2023 | Business Planning, IRS / Tax Guidance, Podcasts

“Surprising Tax on Distributions from a Partnership,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Jim Milton, ACTEC Fellow from Tulsa, Oklahoma. Internal Revenue Code Section 731(a) details the extent of recognition of gain or loss on distributions by a partnership to a partner. In October of 2022, the tax court issued a memo in Clark, Raymond & Company v. Commissioner holding that the distribution of a book of business from a CPA firm to departing members was not a Code Section 731(a) non-recognition event but rather ordinary income. ACTEC Fellow Steve Gorin of St. Louis, Missouri, joins us today to explain the impact of this decision. Welcome, Steve.

Overview of Clark Raymond & Co. v. Comm’r

Steve Gorin: Thank you very much, Jim. So, welcome everybody to the podcast. As Jim mentioned, normally, when you have a distribution from a partnership, that distribution is not going to trigger income tax. Instead, what happens is that the basis of the partnership’s assets carry over to the partner in the hands of the partner. So, for example, if you had an asset that was worth $100,000 and had the basis of $5,000 and the partnership distributed it, there would be no recognition by the partnership ordinarily, and there would be no gain by the partner ordinarily, and just that $100,000 asset would get distributed out and have that $5,000 basis in the hands of the partner.

Now, when a partner’s interest is liquidated, then the partner’s basis gets allocated among the basis of the different assets that come out. And, again, generally, there’s no recognition of income, we’re just carrying over the basis. There are a lot of different exceptions to this rule under Code Section 731(c). So, you need to know these rules, as well as there’s some, what we call, anti-mixing rules that says that if you put property in and then it comes back out within seven years and it goes to someone other than the person who contributed it to the partnership, then there can be some gain as well going on with that. And that’s under 704(c)(1)(B) and Code Section 737.

Now, let’s suppose though we’re meeting all of the exceptions and we think that we have a non-taxable distribution. So, where can you get tripped up here? In this Clark Raymond case, the assets that were distributed were basically the clients. And this was a CPA firm, so– law firms, we can’t have a non-compete agreement, and we don’t generally pay for clients, although there are exceptions to that. But CPA firms tend to lock things down, and they want to say what the goodwill is. And basically, the book of clients is referred to as goodwill. This particular court called it something else, they called it something like client-based intangibles. They didn’t call it goodwill. But for all practical purposes, to me, it’s all the same.

Breaking Down the Partnership Agreement

So, the CPAs who took their clients with them were supposed to pay for those clients if they took more than their share of clients. The problem is they didn’t pay for them, they just stole the clients. And the partnership agreement had a provision that says that there’s a certain percentage sharing of the profits and losses. And, when you take a distribution, then for book purposes, there is a deemed sale. So, for tax purposes, we know that 731 says, generally, there is not a deemed sale.

But for book purposes, there is a deemed sale. And the way the partnership agreement read, the deemed sale allocated the book income to the remaining partners instead of to the departing partners. So, basically, this book income from the deemed sale of the client asset, basically the client-based intangible, mainly got allocated to the remaining partners. So, when the partners came out took those clients with them, they had a distribution of the value of those clients. And the partnership agreement was very clear that when you took the value of the clients out, that counted as a distribution, and it counted as a distribution that reduced your capital account.

And, as you generally should know when you have a partnership, a partner’s rights to the partnership are measured by their capital account, which is how much money they put in or other property they put in, plus any income they earn, minus any distributions they take. So, when you have a partner who’s taking some property out and the amount that they’re charged with is more than their capital account, well, then you have a distribution in excess of their capital account and then excess distribution has to be accounted for somehow. Now, often a partnership agreement would have allocated the book gain to the departing partners.

And so, they wouldn’t have wound up with an amount that was distributed in excess of their capital account. But in this case, the distribution was in excess of the capital accounts. And so, then the tax court is like, “Well, what do you do with that?” There’s a provision in– pretty much a standard provision called the qualified income offset. And partnership tax experts, they just throw those into the agreements. Nobody knows what it means. The partnership tax experts themselves don’t know what it means, nor does the rest of us. And there’s this qualified income offset in there that’s basically required by the regulations.

And the Tax Court said, “Okay. So, you have this negative capital account, and we have no way to get this zeroed out. We are going to use this qualified income offset account to allocate ordinary income to the departing partners.”

So, normally, when a departing partner is going to get– basically, they’re selling their partnership interest, and they get something for it- that would be a capital gain. But here, they got ordinary income allocated to them. So, not only did they get taxed, they got hit with ordinary income. Now, fair is fair. They were stealing the clients, so they got what was coming to them.

Takeaways from the Tax Court’s Decision in Clark Raymond & Co. v. Comm’r

But you should know that when you have a distribution on the termination of a partnership, you really need to be careful to look at those existing capital accounts and check how the allocation– how the book income gets allocated. So, worry about the book income and the tax income and make sure everything works out okay. So, take another look at this case. Don’t just assume that what looks like a non-taxable distribution actually is.

Jim Milton: Thank you, Steve, for this insight into this very important decision. We look forward to hearing from you next time.

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