Recent Tax Court Case Emphasizes Importance of Maintaining Partner Capital Accounts

October 24, 2022
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In Clark Raymond and Company PLLC v. Comm’r, the Tax Court held that a partnership failed to maintain capital accounts in accordance with the substantial economic effect rules, resulting in certain special allocations being disregarded for lack of substantial economic effect.

Clark Raymond and Company PLLC v. Comm’r: Background

In brief, the taxpayer was an accounting firm, and for the year at issue the accounting firm distributed out certain client relationships to two departing partners in liquidation of those partners’ capital accounts.

In the same year, the partnership allocated all of its ordinary income as a special allocation to the two departing partners to cure their negative capital accounts. The departing partners disagreed with this treatment and filed Form 8082 to report their income inconsistent with the Schedule K-1.

Clark Raymond and Company PLLC v. Comm’r: Findings

In its opinion, the Tax Court acknowledged the substance of the distribution (recognizing that an intangible asset can be part of a distribution), but the Tax Court found the partnership failed to restate all partner capital accounts immediately prior to the distribution, as required by the partnership agreement and the section 704(b) regulations.

Thus, the Tax Court held that the partnership failed to properly maintain capital accounts under section 704(b) and the substantial economic effect rules.

Based upon this, the Tax Court re-allocated income in the year at issue to all the partners in accordance with the partners’ interest in the partnership (failure to maintain section 704(b) capital accounts can allow the IRS to argue for making allocations in accordance with the “partners’ interest in the partnership”, a facts and circumstances analysis).

Essentially, the Tax Court determined that each partner had economic rights in the unrealized appreciation associated with the distributed client relationships, and the Tax Court effected allocations based upon these economics.

Finally, the Tax Court also confirmed that because the partnership agreement contained a qualified income offset (QIO) provision to cure negative capital accounts, ordinary income must first be allocated to the departing partners to ‘cure’ their negative capital accounts.

The Importance of the Case

This case is noteworthy for many reasons, including:

  • Case law discussing capital accounts and the substantial economic effect rules is rare.
  • Intangible assets (even if those assets have zero tax basis) can constitute property and have economic effect as either a distribution or contribution.
  • Partnership agreements often contain similar boilerplate language to the language at issue in this case, and practitioners may not always appreciate the significance of this language. Yet failure to abide by this boilerplate language and the capital account maintenance rules can allow the IRS, upon audit, to challenge allocations, and can also result in certain partners contesting allocations (through, for instance, Form 8082).
  • Many modern partnership agreements contain QIO provisions. These provisions generally require an ordinary income allocation to a distributee partner if a distribution causes that partner’s section 704(b) capital account to go negative.

The findings of Clark Raymond and Company PLLC v. Comm’r have noteworthy implications for how partnerships track and maintain partner capital accounts. The experienced tax attorneys and accountants that make up our passthrough consulting team know the ins and outs of partnerships and can help ensure that your capital accounts are tracked correctly.

Our passthrough consulting team has specialized expertise in partnerships.

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