Clark Raymond involved three single-member entities— Clark Raymond & Co., PLLC (“Clark”), Chris Newman CPA, PLLC (“Newman”), and John E. Town, CPA, Inc., P.S. (“Town”)—that were partners in Clark Raymond & Co., PLLC (CRC), a professional accounting firm that was treated as a partnership for US federal income tax purposes.
In May 2013, Newman and Town withdrew from CRC and started their own accounting firm. A number of CRC’s clients chose to retain the services of the new accounting firm founded by Newman and Town. In connection with Newman’s and Town’s withdrawal, CRC adjusted their capital accounts. Notably, CRC decreased both of their capital accounts to reflect property distributions—i.e., distributions of the departing books of business—to each partner as provided for in the CRC partnership agreement. CRC, however, did not adjust Newman’s or Town’s capital account to reflect allocations of any inherent gain in the distributed books of business before decreasing their respective capital accounts. CRC also allocated ordinary income that it earned in 2013 to Newman and Town.
On audit of CRC, the IRS determined that CRC did not make actual distributions when it distributed books of business to Newman and Town, or alternatively, that such distributions had not been substantiated as to the clients distributed, their overall value or CRC’s ability to value such clients. The IRS further determined that CRC’s allocations of income to Newman and Town in 2013 did not have substantial economic effect.
The Tax Court’s Analysis
The Tax Court first tackled the IRS’s assertion that CRC, in distributing books of business to Newman and Town, did not actually distribute anything. The Tax Court noted that business entities “may own intangible assets,” which are “generally included in the valuation of a partnership.” The Tax Court identified “client-based intangible assets” (e.g., customer lists or books of business) as a category of intangible asset that a partnership could own and distribute. The Tax Court further noted that CRC’s partners understood that a partner’s book of business (i.e., that partner’s clients) would be valued upon entry of a partner into CRC and charged for upon that partner’s exit from CRC. With these considerations in mind, the Tax Court held that CRC“ did in fact distribute client-based intangible assets” to Newman and Town after they left CRC and their clients followed them. Although CRC failed to reflect the values of those intangibles in its partners’ capital accounts, the Tax Court concluded that “a partnership’s failure to reflect an asset on its books does not make the asset cease to exist”.
The Tax Court then turned to the issue of whether CRC’s allocation of income to Newman and Town in 2013 had substantial economic effect under Treas. Reg. § 1.704-1(b)(2). At a high level, the rules under such regulation provide three tests for an allocation to have economic effect. First, under the basic test, the partnership agreement must require (1) the determination and maintenance of capital accounts in accordance with the regulations, (2) liquidation distributions in accordance with the partners’ positive capital account balances, and (3) a partner to restore its deficit capital account balance upon liquidation of the partnership (a “deficit restoration obligation” or DRO). Second, the “alternate test” incorporates parts (1) and (2) of the basic test, but instead of a DRO, requires that the partnership agreement provides for (3) the reduction of capital accounts, as of the end of the year, for reasonably expected allocations or distributions, and (4) the allocation. of income to a partner with an unexpected negative capital account (“qualified income offset” or “QIO”). Third, the “economic equivalence” test provides that, if an allocation would produce the economic equivalent of meeting the basic test, it will be deemed to have economic effect even if it does not otherwise meet the formal requirements of such test.
CRC argued that as a result of the distributions of client-based intangibles, Newman’s and Town’s capital accounts were driven negative (by subtracting the value of the clients distributed to them) and that such negative capital account balances triggered the QIO provision of the partnership agreement, requiring that CRC allocate income to Newman and Town in 2013 in amounts sufficient to restore their capital account balances to zero.
However, the court concluded that the special allocation of income did not have economic effect because CRC did not actually maintain capital accounts in accordance with the regulations (requirement (1) above), in that before distributing the books of business to Newman and Town, CRC should have increased the partners’ capital accounts by the value of the unrealized gain inherent in such assets (see Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1)). CRC did not argue that the allocations satisfied the economic equivalence test, so the court concluded that it was not applicable, either.
Having concluded that the allocations did not satisfy any of the regulatory safe harbors, the court next determined how income should be allocated in accordance with the partners’ interests in the partnership. Here, the court took an odd turn in its decision. Even though the court had concluded that the allocations in the partnership agreement lacked substantial economic effect, the court concluded that the manner in which income should be allocated should take into account the QIO that was put into the agreement for the sole purpose of satisfying this requirement. Specifically, the Tax Court noted that (1) Clark had likely made the largest contribution to CRC because it owned the largest number of units in CRC; (2) the partners had agreed to allocate income in amounts necessary to bring their capital account balances up to zero, as evidenced by the QIO in CRC’s partnership agreement; (3) CRC’s partnership agreement provided that CRC could distribute cash as determined in its managers’ reasonable discretion, including in 2013; and (4) Clark had the most significant rights to distributions from CRC on its liquidation (although the Tax Court conceded this factor carried the least weight because an allocation of annual income was at issue, rather than an allocation in liquidation of CRC).
According to the court, the unrealized gains inherent in the client-based intangibles that were distributed to Newman and Town had to be allocated under the general allocation provision of the partnership agreement, without regard to the fact that the intangibles were distributed to some but not all partners. Thus, the court held that the unrealized gain was properly allocated among all three partners so that the capital accounts of all three were increased, but that because the agreed-upon distribution was made only to the withdrawing partners, only their capital accounts should have been reduced. Consequently, the withdrawing partners’ capital accounts did go negative and the court required CRC to allocate ordinary income to Newman and Town in the amounts necessary to bring their capital account balances up to zero, pursuant to the QIO.
The Tax Court’s opinion in Clark Raymond highlights the danger that can arise when a partnership agreement includes language from the regulations (particularly a QIO and liquidation in accordance with capital accounts) when transactions involving partners occur. Moreover, the opinion provides further evidence that it is important that partnership agreements should generally not provide for liquidation of partnerships in accordance with capital accounts. In addition, the opinion reaches some very questionable conclusions about how income is allocated when a partner’s interest in a partnership is liquidated. For a more in-depth analysis of this case, please see R. Lipton’s upcoming article in the Journal of Taxation, "Did the Tax Court Correctly Apply Subchapter K in Clark Raymond?"