Special partnership allocation lacks substantial economic effect

The Tax Court recently ruled in Clark Raymond & Co. PLLC et al. v. Commissioner (No. 2265-19; T.C. Memo. 2022-105) on two issues that highlight the importance of partnership capital account maintenance.

Specifically, the Court ruled that an accounting firm’s clients were client-based intangibles that resulted in a property distribution to two exiting partners, and that a special allocation of income to the exiting partners lacked substantial economic effect since the partnership failed to properly maintain capital accounts in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv).

The case addressed Clark Raymond & Co., PLLC (CRC), an accounting firm, that received a notice of final partnership administrative adjustment (FPAA) for the taxable year ending Dec. 31, 2013. The adjustments made by the IRS in the FPAA that were brought before the Tax Court related to the existence and distribution of client-based intangibles and the allocation of income to the partners based on the partner’s interest in the partnership (PIP) pursuant to Treas. Reg. Sec. 1.704-1(b)(3).

Specifically, certain CRC clients ceased engaging CRC and retained a withdrawing partner’s services through a new partnership. The Tax Court, disagreeing with the IRS, determined that the clients of CRC were client-based intangibles capable of valuation and distribution.

To arrive at this conclusion, the Tax Court looked to the terms of the operating agreement — including one provision where the determination of the value of a client was defined as gross revenue invoiced to the client over the prior 12 months. The Tax Court also considered the terms of a dispute settlement that stated the withdrawing partners would be able to keep the clients that had retained their services in the new partnership and found this to support CRC’s ownership of client-based intangibles.

The court also disagreed with the manner in which the IRS redetermined the allocation of income among the partners based on the PIP rules. The Tax Court determined a revised income allocation considering additional items the IRS did not consider when determining the partner’s interest in the partnership.

CRC stated that the capital accounts of the withdrawing partners were driven negative after subtracting the value of the client-based intangibles distributed to them causing the application of the qualified income offset (QIO) provision included in the partnership agreement. Therefore, CRC made special allocations of ordinary income to the withdrawing partners.

The Tax Court determined that the partnership agreement did contain the appropriate provisions that would have otherwise met the alternate test for economic effect. However, the special allocation of income made by CRC cannot have economic effect since it failed to properly maintain the capital accounts of its partners in accordance with the partnership agreement and Treas. Reg. Sec. 1.704-1(b)(2)(iv). Having determined that CRC’s special allocation of income lacked substantial economic effect, the Tax Court stated that the allocations need to be redetermined in accordance with PIP.

Treas. Reg. Sec. 1.704-1(b)(3)(i) provides, in determining the partners’ interests in the partnership, factors to be considered, including: 

• The partners’ relative contributions to the partnership
• The interests of the partners in economic profits and losses
• The interests of the partners in cash flow and other non-liquidating distributions
• The rights of the partners to distributions of capital upon liquidation

The Tax Court also considered the allocation provisions, including a QIO, in the partnership agreement.

The court determined certain adjustments were needed to partner capital accounts prior to applying the QIO provision in the partnership agreement. Specifically, the court noted CRC did not increase the partners’ capital accounts by the value of the unrealized gain in the client-based intangibles prior to distribution in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv)(e).

CRC argued the client-based intangibles did not have unrealized gain since any unrealized gain associated with the client-based intangibles was included in the partners’ average annual value account balances that were not subject to Section 704(b). However, the Tax Court found CRC did not provide support for this assertion, or relevant authority that would relieve CRC from its capital account maintenance responsibilities under Treas. Reg. Sec. 1.704(b)(2)(iv).

The Tax Court, after increasing the partner capital accounts for the unrealized gain in the client-based intangibles under Treas. Reg. Sec. 1.704-1(b)(2)(iv)(e) and decreasing the partner capital accounts by the fair market value of the assets distributed to each partner, determined the QIO provision in the partnership agreement was triggered and income allocations were needed to bring certain partner capital accounts up to zero.

The Tax Court looked to the maintenance of capital accounts in determining how to treat the distribution of client-based intangibles and the amount of income that should have been allocated to partners.

This recent case highlights the increased scrutiny by the IRS on partnerships, and in particular, the importance of partnerships maintaining partner capital accounts over the full term of the partnership’s life in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv).

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