Is Disputed Partnership Income Taxable?

TAX CASE

he claim of right doctrine requires taxpayers who receive disputed income to treat it as taxable income if there are no restrictions on how they can use this money. When there are restrictions—as when the disputed money is in an escrow account—they pay taxes on the disputed amount only when and if they receive the money.

In 1993 Timothy Burke, an attorney and CPA, joined a partnership. In 1996 the partners orally agreed to a new method for dividing partnership income for the years 1996–1998. In 1998 Burke’s partner denied he had consented to the new arrangement. Later that year, the two partners agreed to place all partnership profits (after expenses) into an escrow account until they resolved their differences.

The partnership return for 1998 showed $242,000 of partnership profits; $121,000 appeared on Burke’s schedule K-1. Since he was unable to use the money, Burke did not report it on his individual tax return. The IRS made a deficiency assessment of $41,338. Burke petitioned the Tax Court for relief.

Result . For the IRS. Burke referred to IRC section 703(a), which requires a partnership’s taxable income to be computed in the same manner as an individual’s taxable income, and cited a series of cases in which individuals did not have to report taxable income that had restrictions on the money’s use. He argued that he did not have to report the income until resolution of the dispute because the partnership had deposited the money in an escrow account, which restricted his use of it.

The court disagreed, stating that IRC section 703(a) merely described how a partnership calculates its taxable income before dividing that amount among the partners. Regulations section 1.702-1(a) specifically states that partners must report their individual distributive shares of partnership income even when the amount is not distributed. The court cited a series of cases in which a partner had to report his or her distributive share in the year the partnership reported the income even though the parties contested the amount of each partner’s share. The court further stated that the cases cited by the taxpayer did not apply since none of them involved a partnership or its distributive shares.

It is important to note how the court applied the claim of right doctrine. The partnership had unrestricted use of the receipts—the partners only disputed the division of the money. If the partnership had placed the receipts in an escrow account as the result of a dispute with a third party, under the claim of right doctrine the receipts would not be included in its income until the matter was settled and the partners would need to report income only if the dispute was settled in its favor. In this case, however, “there was nothing conditional or contingent about” the partnership’s income, and therefore each partner had to report his or her distributive share of that income, even though the partnership contested the exact amount of that distributive share.

Timothy Burke v. Commissioner, TC Memo 2005-297.

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