Limited partners generally are not responsible for partnership debts; nonetheless, creditors often demand they guarantee them. When a limited partner who has guaranteed a debt wants to leave the partnership, he must satisfy the guarantee or have it cancelled. How this is accomplished can greatly affect the partnership’s taxation.

MAS One, a limited partnership, had two equal partners—MAS One Generals, the sole general partner, and Midland Mutual Life Insurance Co. (Midland), the sole limited partner. In 1989 MAS One entered into an agreement to construct an office building using a $14.5 million loan from Huntington National Bank. The loan required monthly interest payments, a $2.5 million payment upon completion of construction and repayment of the balance in 1994. Midland guaranteed the monthly interest and the $2.5 million payment. When MAS One failed to make the payments, Midland paid the interest to Huntington and the $2.5 million in 1991 when it was due. In 1994 Midland decided to abandon its partnership interest and notified Huntington, agreeing to pay some money to be released from the mortgage. Also, as a condition of abandoning its interest, Midland paid MAS One $185,000.

MAS One sold the building the next day for $4.1 million, assigning the proceeds to Huntington, and Midland paid the bank $8.3 million, the remaining balance of the loan. On its tax return MAS One treated the $8.3 million payment as a nontaxable contribution to capital by Midland. The IRS reclassified the payment as forgiveness-of-debt income. When the Tax Court ruled for the IRS, MAS One appealed.

Result. For the IRS. When a third party pays another’s debt, the debtor is considered to have taxable income, so MAS One would have reported income when Midland repaid the bank. MAS One argued that this rule applies only when the payor is unrelated to the debtor. The Sixth Circuit Court of Appeals rejected the argument because no authority existed for it, but substantial authority existed for ignoring any relationship when applying the general rule.

MAS One then argued it did not have income because Midland was obligated to pay the debt. If in fact this had been the case, then MAS One would have been correct. However, since Midland was obligated to pay only the interest and the $2.5 million payment, this argument also failed.

MAS One’s final argument was that IRC section 721 shielded it from recognizing income. The Sixth Circuit said section 721 did not apply for two reasons. First, Midland had abandoned its interest before the debt payment, which, therefore, could not be considered a contribution by a taxpayer for an interest in a partnership. MAS One’s attempt to argue substance over form to ignore this fact was rejected. And second, section 721’s primary requirement is that a contribution to capital must be in exchange for an interest in the partnership, but in this case Midland made the payment to sever its relationship with MAS One. In Twenty Mile Joint Venture, 200 F3d 1268, the Tenth Circuit Court of Appeals had ruled that payments to sever an interest were excluded from section 721. The Sixth Circuit concluded that the precedent set in Twenty Mile was directly applicable to MAS One and mandated a rejection of the taxpayer’s arguments.

Taxpayers involved in these transactions will have to consider a recent code change—the 2004 American Jobs Creation Act amended section 108(e)(8) on cancellation of debt in exchange for a partnership interest—in addition to the rules established in MAS One. A partnership now is required to recognize forgiveness-of-debt income to the extent the amount of debt forgiven exceeds the value of the interest transferred to the creditor. Therefore, future partnerships whose debt is cancelled as part of a severance may have to recognize income even if the transaction meets the requirements of section 721. However, neither the 2004 act nor MAS One addresses the possibility the transaction could be a contribution to capital and treated as tax-free under a general rule similar to section 118, which applies to corporations.

MAS One Limited Partnership v. United States, 390 F3d 427 (CA-6).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Mount Sinai Medical Center of Florida Inc., Miami Beach, is a teaching hospital. Between 1996 and 1999 the hospital staff included about 100 medical residents receiving training in various specialties, on whose wages the hospital paid approximately $2.4 million in FICA taxes. The hospital applied for and received refunds of those taxes on the basis that they were payments for services under the student exception of section 3121(b)(10). The IRS filed a court action with the U.S. District Court of Southern Florida seeking repayment of the refunded taxes, arguing the refund had been paid erroneously.

Result. For the IRS. Mount Sinai argued that wages paid to residents were exempt from FICA taxes under the student exception since the hospital was a school and the residents were students. The district court disagreed, saying that, for any question concerning whether employees were covered by the Social Security system, courts should “err on the side of including employees in the system.” The court agreed with the government’s position that wages paid to medical residents had never been exempt from the FICA tax, although medical interns at one time had been exempt.

The court noted that the differing treatment of interns and residents at the time had created some confusion and said Congress had responded by specifically eliminating the medical intern exception, intending that all medical residents and interns be covered by the Social Security system. Congress at that time referred to both groups as “young doctors,” not students, in its committee reports.

Mount Sinai argued that the decision in United States v. Mayo Foundation for Medical Education and Research, 282 FSupp2d 997, made it possible to apply the student exception to medical students. In Mayo, a Minnesota district court held that the student exception could be applied to medical residents in individual cases based on the relationship of the residents to their school. It said under regulations section 3121(b)(10)-1(c) medical residents could be considered students if they provided services to the school incidental to and for the purpose of pursuing a course of study at that school. Since the services to patients rendered by the Mayo medical residents “were incidental to and for the purpose of pursing a course of study in postgraduate medical education,” the district court concluded the residents were students and their wages were exempt from FICA taxes.

The Florida district court, however, rejected this argument, stating that the case-by-case approach advocated by the Minnesota decision was wrong and not practical. Following it would mean individually litigating each of the 7,000 claims for refunds of FICA taxes paid by residents and hospitals—totaling over $1 billion—filed with the IRS since 1998. The court concluded Congress never had intended such an application of the law and payments to medical residents always would be subject to FICA taxes.

The two district courts reflect very different views on whether medical residents are covered by Social Security. It appears this issue is destined for frequent litigation unless Congress intervenes with legislation.

United States v. Mount Sinai Medical Center of Florida, Inc., 2005 US Dist., Lexis 909.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

In United States v. Galletti, Marina Cabrillo Partners (the partnership) failed to pay federal employment taxes for the years 1992 through 1995, which it was required to withhold under IRC section 3402. The IRS properly assessed the tax against the partnership within the requisite three-year period; however, the partnership never paid the deficiency. Subsequently, Abel Galletti and three other general partners filed petitions for bankruptcy. The IRS filed proof of claims with the bankruptcy court related to the unpaid taxes, which the court disallowed on the basis they were not enforceable against the individual partners. The IRS appealed the disallowance of the claim to the federal district court, which affirmed the bankruptcy court decision. The IRS then appealed to the Ninth Circuit Court of Appeals.

The issue before the Ninth Circuit, and subsequently before the U.S. Supreme Court, was whether a proper assessment of tax against a partnership is extended to individual partners. The IRS argued that the code did not require the individual partners to be assessed and that the valid assessment of the partnership should extend to the individual partners. Galletti and the other partners, however, argued that since section 6203 requires assessment of the taxpayer , a term defined in IRC section 7701(a)(14) as including individuals, they were entitled to a separate assessment naming each individually. Further, since the three-year statute of limitations on assessment had expired, they argued that no proper assessment ever could be made and the IRS was permanently prohibited from collecting the deficiency from them.

The Ninth Circuit agreed with the partners. Basing its opinion on the definition of the term taxpayer in IRC section 7701(a)(14), it found the partners were taxpayers separate and distinct from the partnership and, therefore, an assessment that did not name them individually was not valid. The IRS petitioned the U.S. Supreme Court and was granted certiorari.

Result. For the IRS. Reversing the decision of the Ninth Circuit, the Supreme Court unanimously held that the proper assessment of the partnership extended to the general partners. While the Court agreed with the Ninth Circuit that the partners could be considered taxpayers within IRC section 7701(a)(14), it focused on the language of section 6203, which states the “liability of the taxpayer” must be properly assessed. The assessment requirements do not focus on all possible taxpayers, but rather only on one—the taxpayer on which the liability was imposed. Therefore, it is necessary to determine which person or entity is liable for the tax.

The tax deficiency in Galletti arose under section 3403, which holds an employer liable for taxes it is required to withhold from wages paid to its employees. Accordingly, for purposes of assessment, the employer is the taxpayer, and in Galletti the employer was the partnership, not the general partners. The fact that the partners were ultimately called upon to satisfy the partnership’s deficiency was irrelevant. Once a tax has been properly assessed, the code doesn’t require the IRS to then separately assess the same tax against the parties that are secondarily liable for it.

Thus, as long as the IRS makes a proper assessment of tax that names the person or entity that primarily is responsible for the deficiency, the assessment is considered valid for purposes of collection, even if such collection procedures are initiated against persons other than those named in the assessment. As the Court explained, “it is the tax that is assessed, not the taxpayer.“

United States v. Galletti, 541 US 114 (2004).

Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John’s University, Jamaica, New York.

The Supreme Court decision covered two consolidated cases. In the first, John Banks II was fired from his position as educational consultant to the California Department of Education. He sued for employment discrimination, hiring an attorney on a contingent fee basis. He did not include any of the $464,000 settlement in income on his tax return. The IRS issued a deficiency notice based on the full amount, and the Tax Court upheld the deficiency. The appellate court held that the correct amount of included income was the settlement minus the $150,000 attorney fee.

In the second case Sigitas J. Banaitis left his job as vice-president and loan officer at the Bank of California. He hired an attorney on a contingent fee basis to sue the bank and its successor, Mitsubishi Bank, for willful interference with the employment contract, attempting to induce him to breach his fiduciary responsibility and firing him for refusing.

Banaitis was awarded compensatory and punitive damages. He settled for a payment of $4.9 million, which he included in income, plus $3.9 million to be paid directly to his attorney, which he did not. The IRS determined that the amount paid to the attorney should have been included in income. The Tax Court agreed, but the appellate court reversed based mainly on state law.

Result. For the IRS. The Supreme Court opinion began with two clarifying points. First, the issue really involved the alternative minimum tax. The legal fees for both taxpayers were deductible for regular tax purposes as miscellaneous itemized deductions, but the alternative minimum tax denies such deductions. Taxpayers who receive large recoveries, therefore, are subject to the alternative minimum tax on the gross amount rather than on the net after-expense amount. Second, the Jobs Creation Act of 2004 added IRC section 62(a)(19)(20), which allows taxpayers to deduct from adjusted gross income attorney’s fees and costs associated with cases involving unlawful discrimination. Therefore, in the Court’s opinion the issue was relevant mainly for tax years prior to the effective date of the 2004 act.

The IRS said attorney’s fees must be included in income under the assignment-of-income doctrine. The taxpayers argued the doctrine should not apply since the assignment occurred while the claim was speculative or contingent. The Court rejected this position because prior cases had upheld the doctrine even when the exact amount of income was undetermined. The conclusion did not address several distinguishing factors raised by the taxpayers. Therefore the doctrine will apply to any assignment of amounts that will be included in income.

The taxpayers’ second argument, as phrased by the Court, was that the fee should not be included in their income because they and their attorneys had entered into a business to jointly earn the income. The Court concluded there was no joint business. The attorneys were the taxpayers’ agents, not partners. This fact cannot be changed by contract or state laws, even ones that provide protection and special rights in the recovery. This part of the opinion overrules cases decided based on state property rights.

The Supreme Court also refused to consider any arguments presented in amicus briefs because they were new and had not been evaluated at the lower court level. Nor would it consider Banks’ argument that the statutory fee-shifting provisions overrode the assignment-of-income doctrine because, in his settlement, the attorney’s fee had been calculated under a contingent fee contract rather than by statutory provision.

Tax practitioners should be aware that new IRC section 62(a)(19)(20) does not apply to all lawsuits. For lawsuits brought under contingent fee contracts, which are not covered by the new law, taxpayers will have to include the full amount in income unless they are willing to risk a court fight in hopes the court will accept one of the arguments presented in the amicus briefs, which the Supreme Court labeled as “novel propositions of law.“

Commissioner v. John W. Banks II, 2005 US Lexis 1370.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.