Tax, Finance, CE, CPE, EA, CPA, CFP Blog: Partnership Dispute ...

Martignon v. Commissioner, T.C. Summ. Op. 2012-18 (March 1, 2012)
It can get cold in Alaska, but not nearly as cold as the relationship between Jose Martignon and his business partner Alejandro Vargas. Back in 2003 the pair opened Café Savannah in Anchorage as a limited liability company taxed, with Jose owning 40% and Alejandro owning the other 60%. The LLC elected federal tax status under the rules for partnerships, as studied in courses for CPA licensing.
Unfortunately, there was trouble from the beginning. Jose worked full-time as the manager of another restaurant, but helped out at Café Savannah when he could, sometimes waiting tables and sometimes cooking. Alejandro handled the finances, drank, and yelled at the employees (or at least that’s Jose’s side of the story). The fact that the restaurant was losing money did not help matters. After five years of increasing tensions, Jose and Alejandro had finally had enough of each other. Alejandro changed the locks and told Jose to stay away from the restaurant, and refused to speak with him further. Jose sought information about the finances of the restaurant, but his requests fell on deaf ears.
Shortly thereafter, Jose received a K-1 showing that the restaurant made $56,000 and that his share was approximately $22,000. Shocked that the restaurant was suddenly making money, and even more shocked that he had not received any distributions, Jose hired a lawyer in an effort to force Alejandro to provide him with detailed financial information. It was not until more than three years later, however, that access to these records was gained.
In the meantime, Jose filed his tax return, but did not include the amount of his distributive share from Café Savannah as shown on the K-1. The IRS asserted a deficiency and the Tax Court held in favor of the IRS, observing that the fact that petitioner did not receive any distribution from the partnership due to Alejandro’s alleged wrongdoing does not change the general rule that a partner is taxed on his distributive share, whether or not received. Frequently, enrolled agent tax advice describes this general condition to the surprise of minority partners.
Background
Subchapter K of the Internal Revenue Code does not impose tax on partnerships. Rather, Subchapter K requires that the income or loss of the partnership “flows through” to the owners. The resulting tax consequence also flows through to the owners (i.e., partners), whether or not any actual distributions are made. As a general rule, a partner's distributive share of income, gain, loss, deduction, or credit is determined by the partnership agreement.
The partnership, in essence, is just a reporting entity for tax purposes, and each partner’s distributive share of tax items is reported on a Form K-1. This is the core tax description of partnerships from CPA exam study. No taxable event is generally associated with a cash pay-out of the partner’s distributive share because the tax is imposed when the income is earned, not when it is paid.
On the partners’ individual tax returns, each partner is separately required to take into account his or her distributive share, whether or not distributed, of each class or item of partnership income. Since these items are reported on a partner’s K-1, tax professionals learn in a tax preparer course to include them on the partner’s individual return. Quoting the Supreme Court in United States v. Basye, 410 U.S. 441, 454 (1973), the Tax Court reiterated that “few principles of partnership taxation are more firmly established than that no matter the reason for nondistribution each partner must pay
taxes on his distributive share." The fact that a partner’s distributive share is not be currently distributable, whether by agreement of the parties or operation of law, is not material. For example, in Stoumen v. Commissioner, 208 F.2d 903, 907-908 (3d Cir. 1953) the Court of Appeals held that the taxpayer’s distributive share was taxable to him despite the fact that his partner had embezzled funds which did not appear in the partnership books, the taxpayer was unaware of the existence of the funds, and never received any of them.
Question: Under which of the following circumstances would a taxpayer not have to report any income from his or her distributive share of a partnership’s income in which the taxpayer was a partner?
a. The taxpayer did not receive any distributions of cash
b. The taxpayer’s partners embezzled all of the cash before the taxpayer could get a distribution
c. The partnership agreement provides that no cash distributions will be made
d. The partnership did not generate any taxable income.
Answer: d IRS Circular 230 Disclosure Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

Source: http://fastforwardacademy.blogspot.com/2012/10/partnership-dispute-does-not-change-tax.html

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