I am reading
a tax case with an unfortunate result.
It does not
seem that difficult to me to have planned for a better outcome.
I have to
wonder: why didn’t they?
Let’s set it
up.
We have a
law firm in New York. There is a “heavy” partner and the other partners, which
we will call “everybody else.” The firm faced hard times, and “everyone else”
kept-up their bleed rate (the rate at which they withdraw cash), with the
result that their capital accounts went negative.
COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative.
Let’s return
to our heavy partner.
He was
concerned about the viability of the firm. He was further concerned that New
York law imposed on him a fiduciary responsibility to assure that the firm be
able to pay its bills. I applaud his sense of responsibility, but I have to
point out that any increased uncertainty over the firm’s capacity to pay its
bills might have something to do with “everybody else” taking out too much
cash.
Just sayin’.
Our
partner’s share of firm income was almost $500 grand.
Problem is
that the cash did not follow the income. His “share” of the income may have
been $500 grand, but he left around $400 grand in the firm to make-up for the
slack of his partners.
And you have
one of those things about partnership taxation:
· The allocation of income does not
have to follow the allocation of cash.
There are
limits to how far one can push this, of course.
Sometimes
the effect is beneficial to the partner:
· A partner tales out more cash than
his/her share of the income because the partnership owns something with
big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect
his/her distribution of cash.
Sometimes
the effect is deleterious to the partner:
· Our guy took out considerably less
cash than the $500K income.
Our guy did
not draw enough cash to even pay the taxes on his share of the income.
OBSERVATION: That’s cra-cra.
What did he
do?
He reported
$75K of income on his tax return. Seeing how did not receive the cash, he
thought the reduction was “fair.”
Remember: his
partnership K-1 reported almost half a million.
The number
on his personal return did not match what the partnership reported.
COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.
Sure enough,
the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.
Off to Tax
Court they went.
And he had …
absolutely … no … chance.
Partnerships
have incredibly flexible tax law. There is a reason why the notorious tax
shelters of days past were structured around partnerships. One could send
income here, losses there, money somewhere else and muddy the waters so much
that you could not see the bottom.
In response,
Congress and the IRS tightened up, then tightened some more. This area is now
one of the most horrifying, unintelligible stretches in the tax Code. It can – with little exaggeration – be said
that all the practitioners who truly understand partnership tax law can fit
into your family room.
Back to our
guy.
The Court
did not have to decide about New York law and fiduciary responsibility to one’s
law firm or any of that. It just looked at tax law and said:
Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.
Those are my
words, by the way, and not a quote.
Our law
partner owed the tax and penalties.
Ouch and
ouch.
I must point
out, however, that the law firm’s tax advisors warned our guy that his
“fiduciary” theory carried no water and would be disregarded by the IRS, but he
decided to proceed nonetheless. He brought much of this upon himself.
What would I have recommended?
For
goodness’ sake, people, change the partnership agreement so that the “everybody
else” partners reported more income and our guy reported less. It is fairly
common in more complex partnerships to “tier” (think steps in a ladder or the
cascade of a fountain) the distribution of income, with cash being the second –
if not the first – step in the ladder. The IRS is familiar with this structure
and less likely to challenge it, as the movement of income would make sense.
Another
option of course would be to close down the law firm and allow “everybody else”
to fend for themselves.
I would
argue that my recommendation is less harsh.
