We have wrapped-up (almost) another filing season here
at Galactic Command. I include “almost” as we have nonprofit 990s due
next month, but for the most part the heavy lifting is done.
Tax seasons 2020 and 2021 have been a real peach.
I am looking at a tax case that mirrors a conversation
I was having with one of our CPAs two or three days ago. He was preparing a return
for someone with significant partnership investments. The two I looked at are
commonly described as “trader” partnerships.
The tax reporting for trader partnerships can be
confusing, especially for younger practitioners. A normal investment
partnership buys and sells stocks and securities, collects interest and
dividends and has capital gains or losses along the way. The tax reporting
shows interest and dividends and capital gains and losses – in short, it makes
sense.
The trader partnership adds one more thing: it
actively buys and sells stocks and securities as a business activity, so to
speak. Think of it as a day trader as opposed to a long-term investor. The tax
issue is that one has interest, dividends and capital gains and losses from the
trader side as well as the nontrader side. The trader partnership separates the
two, with the result that trading dividends (as an example) might be reported
somewhere different on the Schedule K-1 from nontrading dividends. If you don’t
know the theory, it doesn’t make sense.
The two partnerships pumped out meaningful taxable
income.
What they did not do was pump out equivalent cash
distributions. In fact, I would say that the partnerships distributed
approximately enough cash to pay the taxes thereon, assuming that the partner was
near the highest tax bracket.
The client had issues with the draft tax return.
Why?
There was no way he could have that much income as he
did not receive that much cash.
And therein is a lesson in partnership taxation.
Let’s take a look at the Dodd case.
Dodd was the office manager at a D.C. law firm. The
firm specialized in real estate and construction law.
She in turn became a 33.5% member in a partnership (Cadillac)
transacting in – wait on it – the purchase, leasing and sale of real property.
The other 66.5% partner was an attorney-partner in the law firm.
Routine so far.
Cadillac did well in 2013. Her share of gains from
property sales was over a $1 million. Her cash distributions were approximately
$200 grand.
Got it: 20 cents on the dollar.
When she prepared her individual return, she included that
$1 million-plus gain as well as partnership losses. She owed around $170 grand
with the return.
She did not send a check for the amount due.
The case has been bogged-down in tax procedure for
several years. The IRS wanted its tax, and Dodd in turn requested Collections (CDP)
hearings. We have had three rounds of back-and-forth, with the result that we
are still talking about the case in 2021.
Her argument?
Simple. She had never received the $1 million. The money instead went to the
bank to pay down a line of credit.
This is going to turn out badly for Dodd.
At 30 thousand feet, partnership taxation is
relatively intuitive. A partnership does not pay taxes itself. Rather it files a
tax return, and the partners in the partnership are allocated their share of the
income and are themselves responsible for paying taxes on that share.
The complexity in partnership taxation comes primarily
from how one allocates the income, as tax attorneys and CPAs have had decades
to bend the rules.
Notice that I did not say anything about cash
distributions.
Mind you, it is bad business to pump-out taxable
income without distributing cash to cover the tax, but it is unlikely that a
partnership will distribute cash exactly equal to its income. Why? Here are a
couple of reasons that come immediately to mind:
· Depreciation
The partnership buys
something and depreciates it. It is likely that the depreciation (which follows
tax rules) will not equal the cash payments for whatever was bought.
· Debt
Any cash used to repay
the bank is cash not available to distribute to the partners.
There is, by the way, a technique to discourage creditors
of a partner from taking a partner’s partnership interest. Why would a creditor
do this? To get to those distributions, of course.
There is a legal issue here, however. Let’s say that
you, me and Lucy decided to form a partnership. Lucy has financial difficulties,
and one of her creditors takes over her partnership interest. You and I did not
form a partnership with Lucy’s creditor; we formed a partnership with Lucy.
That creditor cannot just come in and force you and me to be partners with
him/her. The best the creditor can do is get a “charging order,” which means the
creditor receives only the right to Lucy’s distributions. The creditor cannot otherwise
vote, demand the sale of assets or force the termination of the partnership.
What do you and I do in response to the new guy?
The creditor will have to report Lucy’s share of the partnership
income, of course.
We in turn make no distributions to Lucy - or to the new
guy. The partnership distributes to you and me, but that creditor is on his/her
own. Sorry. Not. Go away.
As you can guess, creditors are not big fans of going
after debtor partnership interests.
Back to Dodd.
What did the Court say?
No matter the reason for
nondistribution, each partner must pay taxes on his distributive share.”
To restate:
Each partner is taxed on the
its distributive share of partnership income without regard to whether the
income is actually distributed.”
Dodd had no hope with this argument.
Maybe she would have better luck with her Collections appeal,
but that is not the topic of our discussion this time.
We have been discussing Dodd v Commissioner,
T.C. Memo 2021-118.
