October 20, 2022
Tax Court holds that accounting firm 'clients' are an intangible asset, partnership's allocations of income lacked substantial economic effect
In Clark Raymond & Co. PLLC, et al. v. Commissioner, T.C. Memo. 2022-105 (Oct. 13, 2022), the Tax Court held that "clients" distributed by a partnership to two departing partners were intangible assets that should have reduced the respective partner's capital accounts by the value of those assets. Because the partnership failed to recognize IRC Section 704(b) book gain on the distributed assets, however, its capital accounts were not properly maintained, causing current-year income allocations to lack substantial economic effect. Therefore, the Tax Court reallocated the income in question in accordance with the two departing partners' interests in the partnership (the "PIP" standard) to bring their negative capital accounts (as properly calculated) up to zero.
CRC is an accounting firm that is a partnership. Its partnership agreement (1) allocated profit and loss to the partners and generally liquidated in accordance with capital account balances; (2) included a qualified income offset (QIO) provision; and (3) provided a method for valuing a distribution of "clients" from the partnership.
In 2013, two partners withdrew from CRC to start their own firm — NT PLLC. Some clients left CRC for NT PLLC.1 CRC reported on its 2013 Form 1065, U.S. Return of Partnership Income, that the departing partners received as distributions the value of the "clients" that went to NT PLLC from CRC. The partnership did not perform a revaluation within the meaning of Treas. Reg. Section 1.704-1(b)(2)(iv)(e)(1) or (f) in connection with the departures and "clients" distribution. The partnership nevertheless decreased the departing partners' capital accounts by the value of those distributions, which reduced their capital accounts below zero. The partnership allocated all of CRC's ordinary income for 2013 to the departing partners, purportedly under the partnership agreement's QIO provision, and thus did not allocate any income to the remaining CRC partner.
The departing partners filed Forms 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), contesting CRC's 2013 income allocations. After auditing CRC's 2013 return, the IRS issued a Letter 1830-F, Notice of Final Partnership Administrative Adjustment (FPAA), disregarding CRC's client distributions and redetermining allocations of ordinary income to the departing partners. The IRS determined that CRC's client distributions had not been substantiated and that CRC's corresponding allocations of income lacked substantial economic effect. The remaining partner filed a petition in court contesting the IRS's determinations in the FPAA.
After the parties' stipulations, two issues remained the Tax Court: (1) whether CRC made distributions of client-based intangible assets to its partners during 2013 and (2) whether CRC's ordinary income allocations reported on its Form 1065 had substantial economic effect under IRC Section 704(b).
The Tax Court held in a memorandum opinion that CRC distributed client-based intangible assets to the departing partners in 2013 and properly valued those distributions. The Tax Court also held that the income allocations lacked substantial economic effect and must be reallocated in accordance with the partners' interests in the partnership by (1) tracking the remaining partner's capital account to that partner's retention of value and (2) causing the departing partner's capital accounts to be zero (taking into account the "client" distributions).
Clients were intangible assets
The Tax Court first held that client lists and other client-based intangibles can have value and that business entities may own and distribute them. The Tax Court found that CRC owned client-based intangible assets (i.e., the "clients") that could be valued and distributed. Moreover, the Tax Court held that CRC's method for valuing the distributed intangibles complied with the definition of fair market value in Treas. Reg. Section 1.704-1(b)(2)(iv)(h)(1).
Income allocation did not have economic effect
The Tax Court agreed with the IRS that the income allocation did not satisfy the tests under Treas. Reg. Section 1.704-1(b)(2)(ii) and therefore did not have economic effect. The Tax Court first noted that the partnership agreement did not contain a deficit restoration obligation, so it could not meet the basic test for economic effect.
Under the alternate test, the partnership agreement must require:
Applying the alternate test, the Tax Court found that CRC failed to maintain the partners' capital accounts in accordance with the agreement or Treas. Reg. Section 1.704-1(b)(2)(iv) because, before distributing the client-based intangible assets, CRC did not increase the partners' capital accounts by the value of the unrealized gain inherent in those assets.
Finally, the Tax Court held that the allocation did not have economic equivalence (an issue not briefed by the parties) because the allocations lacked economic effect, presumably on the grounds that an over restoration of a negative capital account balance did not entitle the departing partners to additional liquidation proceeds associated with the earnings in question.
Tax Court redetermines allocations
Because CRC's allocations of income to the departing partners lacked substantial economic effect, the Tax Court determined that allocations must be made in accordance with the partners' interests in the partnership. The Tax Court rejected the IRS's contention that the "PIP" standard required the partnership to match its allocations with the client distributions such that the unrealized gain should have been allocated solely to the departing partners. The Tax Court determined that the 2013 LLC Agreement clearly stated the criteria for allocating income to each of the partners so the Tax Court could follow that agreement, along with a superseding settlement agreement, to make its analysis.
The Tax Court concluded that the unrealized gain was properly allocated among all three partners so that the capital accounts of all three increased; because the agreed-upon distribution was made only to the departing partners, however, only their capital accounts were reduced. Consequently, their capital accounts went negative, the QIO (imported by the Tax Court into the PIP test) was triggered, and CRC's 2013 income should be partially (as opposed to wholly) allocated to the departing partners' accounts to bring them up to zero.
This case affirms the principle that an agreement among adverse partners to value partnership property can satisfy the "fair market value" definition in Treas. Reg. Section 1.704-1(b)(2)(iv)(h)(1) and thus the partnership and its partners need not separately establish a "willing buyer/willing seller" based valuation. The case also demonstrates that a partnership's failure to maintain IRC Section 704(b) capital accounts can cause the partnership's allocations to fail the substantial economic effect requirements, leaving the validity of the allocations subject to the amorphous "PIP" standard.
Finally, the IRS affirmatively advocated for a partnership allocation that appears to be based on "stuffing" principles, generally attempting to align allocations of income from the sale or exchange of property (here, through a revaluation) with the receipt of proceeds from such property (here, the property itself).
1 The Tax Court did not address any IRC Section 708 partnership continuation or division potential regarding these departures and the carrying-on of the same business in partnership form.