The Tax Court addressed the proper treatment of an accounting firm’s distributions of “client-based” intangible assets, the capital accounting rules of Regs. Sec. 1.704-1(b)(2)(iv), and the tests for substantial economic effect of partnership allocations. Finding that the taxpayer failed to properly maintain and adjust capital accounts for unrealized gain in the client-based intangible assets it distributed to two withdrawing partners, the court held that allocations of firm income in the year of the distributions did not have substantial economic effect and would not be respected.
Facts: Clark Raymond & Co. PLLC (CRC) was an accounting firm that in 2013 had three members (partners): Clark PLLC (Clark); John E. Town, CPA, Inc., P.S. (Town); and Chris Newman CPA, PLLC (Newman). After negotiations for a buyout of Clark stalled, Town and Newman withdrew from CRC in May 2013, and a number of CRC clients chose to become clients of their new firm. Civil litigation ensued as a result of their departure, which ended with a settlement agreement that acknowledged the latest limited liability company (LLC) agreement the partners had executed in January 2013 and settled all claims regarding Town’s and Newman’s departure from the LLC.
The CRC LLC agreement required the firm to maintain capital accounts in accordance with regulations under Sec 704(b) and to liquidate in accordance with the capital account balances. In lieu of a deficit restoration agreement, the agreement contained a qualified income offset provision. A qualified income offset is activated by a negative capital account balance and requires allocation of all income and gain to partners with negative capital balances to bring the balances to zero. The agreement also contained provisions that permitted a “distribution” of clients to withdrawing partners.
CRC’s 2013 partnership return treated the clients as a distribution of property to Town and Newman at a value prescribed by the operating agreement. Because the distributions drove their capital accounts negative, the qualified income offset was triggered, and all the partnership’s 2013 taxable income was allocated to them, with none allocated to Clark.
Issues: CRC was subject to the audit regime of the Tax Equity and Fiscal Responsibility Act (TEFRA), P.L. 97-248 (codified at Secs. 6221–6234), and Town and Newman each filed a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), contesting the income allocations. The IRS then audited CRC’s 2013 partnership return and issued a Notice of Final Partnership Administrative Adjustment (FPAA) disregarding the client distributions and reallocating the ordinary income. It determined there were no distributions of clients or, alternatively, that CRC failed to establish the value of the distributed clients. The FPAA also found that the allocations of income lacked substantial economic effect and reallocated the income: $538,118 to Clark, $20,000 to Newman, and $5,000 to Town. CRC timely filed a petition in Tax Court.
Holding: The Tax Court rejected the IRS’s determinations in the FPAA disregarding CRC’s client distributions and reallocating its ordinary income. It held the client distributions were distributions of client-based intangibles that should be valued under the terms of CRC’s LLC agreement.
The Tax Court also held, however, that CRC failed to properly maintain capital accounts under Regs. Sec. 1.704- 1(b)(2)(iv); therefore, its allocations of its 2013 income lacked substantial economic effect and the income must be reallocated in accordance with the partners’ interests in the partnership under Sec. 704(b) and Regs. Sec. 1.704-1(b)(3). Finally, it held that because Town and Newman had negative capital accounts at the end of the tax year, under CRC’s qualified income offset, ordinary income must be allocated first to them in an amount necessary to bring each partner’s capital account up to zero.
The Tax Court stated, citing the Supreme Court in Newark Morning Ledger Co., 507 U.S. 546 (1993), that a “client-based intangible” asset, such as a customer list, is an intangible asset that may be capable of valuation, distribution, and sale to third parties. The court held that the CRC’s clients or client list was a client-based intangible asset that was owned and could be distributed by CRC. Therefore, it rejected the IRS’s argument that CRC’s client distributions should be disregarded.
Regarding the value of the client distributions, the Tax Court observed that neither CRC nor the IRS argued that the provision in CRC’s LLC agreement regarding the valuation method for client distributions should be disregarded, and no evidence suggested that it was invalid due to collusion by the partners. Thus, the court held that CRC’s method for valuing the client distributions to Town and Newman comported with the fair market value definition of Regs. Sec. 1.704-1(b)(2)(iv)(h)(1).
Regarding whether CRC’s allocation of its 2013 income had substantial economic effect, the Tax Court considered whether the LLC met the three tests for economic effect (the basic test, the alternate test, and the economic-equivalence test) under Regs. Sec. 1.704-1(b)(2)(ii). CRC failed the basic test because its partnership agreement did not contain a deficit restoration agreement.
Under the alternate test, the first requirement is that the partnership agreement provide for the determination and maintenance of partners’ capital accounts in accordance with Regs. Sec. 1.704-1(b)(2)(iv). CRC’s partnership agreement met this and the other three requirements of the alternate test. Nonetheless, the Tax Court found that CRC’s allocation of income did not have economic effect under the alternate test because the LLC did not actually meet the capital determination and maintenance requirement. CRC did not meet this requirement because, before making the client distributions to the withdrawing partners, CRC did not increase its partners’ capital accounts by the value of the unrealized gain inherent in the client-based intangible assets that were distributed.
Under the economic-equivalence test, in some cases, an allocation that does not meet the basic test or the alternate test will be respected if it produces the same income tax results as if the allocation had satisfied the requirements of the basic test. CRC neither argued nor demonstrated that its allocation of income met the economic-equivalence test, so the Tax Court found it had not.
Because CRC did not satisfy any of the tests, the Tax Court held that its allocations of its 2013 income to the withdrawing partners did not have economic effect. Because the allocations did not have economic effect, the court did not analyze whether the effect was substantial.
Having determined that CRC’s allocations of income to the partners did not have substantial economic effect and should be disregarded, the Tax Court then considered what the proper allocations of income to the partners should be. For this, the court looked at CRC’s LLC agreement, taking into account the settlement agreement from the litigation over Town’s and Newman’s withdrawal from CRC. The Tax Court concluded that the unrealized gain in the client-based intangible assets should be allocated among all three partners, increasing their capital accounts. However, because the client distributions were made only to the two withdrawing partners, only their capital accounts should be reduced.
Following these standards, the capital accounts of the withdrawing partners would go negative. This triggered the qualified income offset, so the Tax Court held that in determining the income allocations, CRC’s 2013 income should be allocated first to Town’s and Newman’s capital accounts to bring them up to zero.
The Tax Court ordered the parties to determine the exact amount of the 2013 income allocations based on its decision. By the court’s preliminary calculations, the amount of CRC’s income for 2013 would be insufficient to bring Town’s and Newman’s capital accounts up to zero. Thus, as CRC originally reported on its partnership return, none of CRC’s 2013 income would be allocated to Clark. Regarding the allocation of the income between Town and Newman, the court held that CRC’s income should be allocated to each partner’s deficit capital account “in an amount equal to that partner’s pro rata ‘share’ of the total negative balances of those accounts, calculated by dividing the deficit balance of each partner’s capital account by the combined deficits of both partners’ capital accounts and then multiplying the resulting ratio for each partner by the total amount of ordinary income to be allocated.”
■ Clark Raymond & Co., PLLC, T.C. Memo. 2022-105
— Charles Keith Kebodeaux, J.D., LL.M., MSA, is a clinical assistant professor at Texas State University in San Marcos, Texas. To comment on this column, contact Paul Bonner, the JofA’s tax editor.
