Partnerships Have to Maintain Accurate Capital Accounts

Published Categorized as Business Tax, Partnership Tax, Tax
capital accounts

One of the tax benefits of partnerships is that they are flexible. The parties can agree to differing terms and the values and dollars associated with those terms can be trued-up in subsequent years.

The allocation of profit and loss provisions provides an example. Depending on their agreement, the parties can allocate profits and losses in several different ways. The Code includes several tests that have to be met for the IRS to accept these allocations.

Compare this to S corporations which are inflexible. S corporations require allocations to be equal to stock ownership. There is no adjusting the allocations with S corporations.

This flexibility is the problem with partnerships, however. The flexibility can be very difficult to implement and track over time as businesses usually don’t just collect revenue and pay expenses year after year. Businesses buy and sell property, admit and expel partners, etc. This can make it very difficult to determine the tax consequences and how to even report the items of income, loss, deduction, credit, etc. from the partnership. This is one example of why the choice of entity and tax planning is so important.

This brings us to the Clark Raymond & Company PLLC v. Commissioner, T.C. Memo. 2022-105, case. The case addresses allocations made to the partners and whether the IRS has to accept the allocations determined by the primary partner. More specifically, the case addresses the requirement that partnerships maintain accurate capital accounts.

Facts & Procedural History

The taxpayer is an accounting firm. It had four partners, with one partner who departed and the primary partner who was seeking to retire.

After the agreements related to the retirement of the primary partner, the two remaining partners withdrew as partners and started their own firms. The partners took some clients with them to their new firms and some clients stayed with the taxpayer firm.

The retiring partner sued the other two partners as the taxpayer firm still had a bank loan outstanding and he sought repayment from the other partners.

Two of the departing partners filed Forms 8082, “Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR),” to report their items of income, etc. from the partnership differently than the way they were reported by the taxpayer firm.

That is when the IRS auditor showed up. The business received just over $500,000 in income in 2013. The dispute with the IRS focused on how to allocate this income among the partners.

The IRS allocated $538,118 to the primary partner and $20,000 and $5,000 to the other two partners. The other two partners agreed to these amounts and settled up with the IRS. This tax court case was brought and maintained by the primary partner for the partnership as the IRS allocated just about all of the firm’s profit in 2013 to the primary partner. This left the primary partner on the hook for the income tax due for the partnership for 2013.

Partnership Allocations

Many taxpayers just use boilerplate language for the allocation provisions of partnership agreements. This language typically says that partners will maintain capital accounts and allocate profits and losses according to the ending balances of positive capital accounts. These terms then go on to say that allocations are to be made to correct negative capital accounts.

There are other ways to structure allocations. Most of these variations are written to comply with the Section 704 rules. Section 704 sets out several rules that basically dictate whether the IRS has to accept the allocation scheme that the partners agreed to. The rules refer to this as “economic effect.”

These rules set out three options, as noted by the court in this case:

  1. Basic test for economic effect
  2. Alternate test for economic effect
  3. Economic equivalence test

The standard language noted above often follows the basic test for economic effect.

The second option, the alternate test for economic effect, is used when limited partners do not have to contribute more funds to the partnership. This would fail the basic test. The second test allows the partnership to make adjustments to capital accounts and income to make up for negative capital accounts by limited partners.

The economic equivalence test is the fallback provision that applies if the other two do not. This provision assumes a hypothetical liquidation and asks whether the result is the same as one of the options above.

The Court’s Analysis

The partnership in this case had an agreement that purported to comply with the second option, i.e., the alternate test for economic effect. This provision requires certain language, including a qualified income offset provision.

This language in turn requires the partnership to maintain capital accounts. To maintain capital accounts, one has to make certain adjustments. This includes increasing capital accounts for gain on distribution.

The IRS argued that the partnership did not maintain capital accounts, as required, as it had an unrealized gain on the distribution of assets to the departing partners. The partnership countered that it did not have unrealized gain.

The court considered whether the partnership had gain on the assets it distributed. The court applied the gain formula, which is the amount realized less adjusted basis. Since there was no evidence of basis, the court assumed no basis, which results in a gain. This, in turn, meant that the partnership did not maintain capital accounts.

The court did not simply make the adjustment. It concluded that this failure, whether a footfault or inadvertent error or valid legal position, was fatal. As such, the court concluded that the second test was not met. This is a strict interpretation of the capital account requirement.

[This left only the economic equivalence test. The court noted that the partnership did not make an argument in support of this test, so the test did not apply.]

Maintaining Accurate Capital Accounts

The court’s interpretation of the requirement to maintain capital accounts is problematic. According to the court’s analysis, any failure or footfault in tracking capital accounts is fatal.

This means that any addition or subtraction to capital accounts that is missed–whether intentionally or not–results in otherwise valid allocations not being respected. Why is this such a big deal? The short answer is that few partnerships track capital accounts accurately. There is no data to cite for this, but it might be less than one percent of partnerships actually track capital accounts accurately–even though they are now required to be reported on Schedule K-1s by the partnership. The more common scenario is that capital accounts are tracked at a high level and then trued up when there is a loss, or distribution that results in a negative capital account, a partner exits, or there is a liquidation.

The result, as in this case, is that the allocations that are reported to the partners and that go on the partners’ income tax returns are subject to being adjusted by the IRS on audit–which is often years after the events that gave rise to the adjustments.

The Takeaway

This case shows how important it is to maintain accurate capital accounts. Even missing one or a few adjustments can be extremely problematic.

The only solution for this is to ensure that the allocations comply with the third test, i.e., that the economic equivalence test is met. This can require extensive analysis, even for partnerships with relatively nominal transactions.

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