Owing Partnership Tax As A Partner

 

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.

Losing An Alimony Tax Deduction

There are certain tax topics that repeat – weekly, monthly, ceaselessly and without end. One such is the tax issues surrounding divorce. I have often wondered why this happens, as divorce is surely one of the most lawyered life events an average person can experience. I will often skip divorce tax cases, as I am just tired of the topic.

But a recent one caught my eye.

The spouses were trying to work something out between them. It was clear to me that they solicited no tax advice, as they plunged off the bridge without checking the depth of the water below.

John and Beatrix were married. They legally separated in 2008 and divorced in 2013. In the interim John agreed to make 48 monthly maintenance payments of $2,289. There was a clause stipulating that payments were to be taxable to her and deductible by him, and the payments were to cease upon her remarriage or death.

John found himself unemployed. His payments were to begin in 2010. Presumably concerned about his financial situation, he and Beatrix agreed in 2009 to transfer his IRA worth $38,913.

John did not deduct the IRA as an alimony payment on his 2009 tax return.

Why not? Because Beatrix was to start withdrawing $2,289 monthly from the IRA the following year, presumably until the $38,913 was exhausted. It made more sense to John that those monthly payments would trigger the alimony.

There is some rhyme or reason to his thinking.

It appears his finances improved, as in 2010 he was able to directly pay Beatrix $6,920.  

In 2010 he deducted $27,468 ($2,289 times 12) as alimony.

The IRS disallowed all but $6,920.

Off to Tax Court they went.

There are four key statutory requirements before any payment can be deductible as alimony:

(1)  The payment must be required under a divorce or separation decree.

(2) The decree cannot say that the payments are not deductible/taxable.

(3)  The two individuals cannot be members of the same household.

(4) There cannot be any requirement to continue the payments after the death of the payee spouse.

It is amazing how often someone will fail one of these. A common story is one spouse beginning payments before the court issues the order, or a spouse paying more than the court order. Do that and the payment is not “required.” Another story is presuming that the payment is deductible because the decree says that it is. The IRS does not consider itself bound because one included such language in the decree.

Then there are the softer, non-key requirements.

For example, only cash payments will qualify as alimony.

If you think about this one for a moment, it makes sense. The Code already allows spouses to transfer property in a divorce without triggering tax (Code section 1041). This allows spouses to transfer the house, for example, as well as retirement benefits under a QDRO order. The Code views these transactions as property settlements – meaning the ex-spouses are simply dividing into separate ownership what they previously owned together.

COMMENT: It is highly debatable whether John’s IRA is “cash.”  Granted, there may be cash in the IRA, but that not is not the same as saying the IRA is cash or a cash equivalent. It would make more sense to say that it is the equivalent of stocks or mutual funds. This would make it property, not cash.

Let’s next go back to rule (4) above. A way to rephrase that rule is that the payee spouse cannot be enriched after death. Obviously, if maintenance payments were to continue after death, then the payee-spouse’s estate would be enriched. That is not allowed.

In our situation, Beatrix now owned an IRA. Granted, the expectation may have been that she would outlive any balance in the IRA, but that expectation is not controlling. If she passed away, the balance in the IRA would be hers to transfer pursuant to her beneficiary designation.

She was enriched. She had something that continued past her (albeit hypothetical) death.

Another issue was whether John should get credit for IRA withdrawals by Beatrix in 2010. Why?  John transferred the IRA to her in 2009. The account was no longer his. It was hers, and he could no longer piggyback on anything the IRA did. If he was going to deduct anything, he would have had to deduct it in 2009.

Which, by the way, he could not because of rule (1): it was not required under the decree. The decree called for payments beginning in 2010, not in 2009.

The Tax Court decided that John had a 2010 alimony deduction for $6,920, the amount he paid Beatrix directly.

Why did John do it this way? 

If John was less than 59 1/2, so he could not get into his IRA without penalty.  He could QDRO, but that is just a property settlement. John wanted an alimony deduction. If he kept the IRA, he would have income on the withdrawal and a deduction for the alimony. That is a push - except for the 10% penalty on the early withdrawal. John was in a tough spot.

Then again, maybe he didn't think of tax matters at all.