Accounting Firm Distributed Client-Based Intangibles to Former Partners

(Parker Tax Publishing November 2022)

The Tax Court held that an accounting and tax firm distributed client-based intangible assets to two former partners when they withdrew from the firm, and the value of the assets so distributed were properly valued under the terms of firm's partnership agreement. The court further held that (1) because the firm failed to maintain capital accounts in accordance with Reg. Sec. 1.704-1(b)(2)(iv), its special allocations of income to the former partners lacked substantial economic effect and had to be reallocated in accordance with the partners' interests in the partnership, and (2) because the former partners had negative capital accounts at the end of the tax year and the firm's partnership agreement included a qualified income offset, ordinary income had to be allocated first to the former partners in an amount necessary to bring each partner's capital account up to zero. Clark Raymond & Company PLLC v. Comm'r, T.C. Memo. 2022-105.

Background

Clark Raymond & Co., PLLC (CRC) is an accounting firm that provides tax and accounting services to its clients. It was formed by D. Edson Clark. Since its formation, various entities have joined and withdrawn from CRC as partners. In 2013, there were three partners: (1) Clark PLLC, a professional limited liability company of which the sole shareholders are Clark and his wife, Barbara; (2) John E. Town, CPA, Inc., P.S. (Town PS), a professional services corporation incorporated by John E. Town, who became a CRC employee in 2007; and (3) Chris Newman CPA, PLLC (Newman PLLC), a professional limited liability company organized by Chris Newman, who became an employee in 2009.

Effective January 1, 2009, through December 30, 2011, a limited liability company agreement (the 2009 LLC Agreement) governed CRC's operation. Regarding a partner's withdrawal, the 2009 LLC Agreement provided a withdrawing member first had an option to receive as a distribution in full consideration of all of the partnership units owned by the member the following: (i) Member Clients and (ii) Net Book Value (i.e., the withdrawing member's percentage interest of the net book value of CRC). The 2009 LLC Agreement also stated that if any clients were distributed under the agreement, the value of such client would be the "client value," which was defined as the gross revenue generated from each respective client over the prior 12-month period. In lieu of taking a distribution of clients, a partner could agree to "leave" clients at CRC and apply a portion of the value of those clients to the partner's outstanding loan balance incurred upon its admission (if applicable).

Buyout Negotiations and Subsequent LLC Agreements

Around 2011, Clark started planning for a transfer of ownership and management of CRC to the remaining partners in preparation for his retirement. However, negotiations of Clark PLLC's prospective buyout reached a stalemate at the end of 2011. At that time Clark, Newman, and Town agreed to continue negotiations in 2012, and CRC operated under the terms of the 2009 LLC Agreement for the entire 2011 tax year.

In 2012, Clark PLLC, Town PS, and Newman PLLC agreed on buyout terms regarding the buyout of Clark PLLC's interest in CRC. They executed a "restated" version of the 2009 LLC Agreement on December 24, 2012 (the 2012 LLC Agreement) that was effective as of December 31, 2011. The 2012 LLC Agreement did not include a security provision relating to payments to be made to retiring partners, which the parties continued negotiating and agreed to finalize in January 2013 (the 2013 LLC Agreement). The 2012 terms remained unchanged in the 2013 LLC Agreement, except for minor items. The 2013 LLC Agreement provided that a separate capital account would be maintained for each member in accordance with Reg. Sec. 1.704-1(b)(2)(iv) and stated that each partner's capital account would be increased by the fair market value of contributions (in cash or property), by allocations of net profit, and by any items of income and gain specially allocated to the partner, and would be decreased by the fair market value of distributions (in cash or property), by allocations of expenditures, and by items of deduction and loss specifically allocated to the partner.

The 2013 LLC Agreement also stated that "If any Clients are Distributed under this Agreement, the value of such Client shall be the Client Value" (defined as the "gross revenue as invoiced to the Client over the prior twelve-month period"). This definition varied slightly from the 2009 LLC Agreement's definition of Client Value as the "gross revenue generated from the Client over the prior twelve-month period". The 2013 LLC Agreement further stated that maintenance of capital accounts under the agreement was intended to comply with the requirements concerning substantial economic performance under Code Sec. 704(b) and that the "[a]greement shall not be construed as creating a deficit restoration obligation or otherwise personally obligating any Member to make a capital contribution."

As part of the buyout negotiations, Clark PLLC, Town PS, and Newman PLLC agreed that, effective December 31, 2011, capital account balances would be as follows: Town PS's capital account balance would be $150,000; Clark PLLC's capital account would be $792,497; and Newman PLLC's capital account balance would be $200,000. Town PS also agreed to increase its capital account over the next five years, and accordingly made a $10,000 cash contribution to CRC before the end of 2012, increasing its capital account balance to $160,000.

The 2013 LLC Agreement also provided a multi-step formula for allocating profits and losses and provided for special allocations and established a qualified income offset (QIO) whereby, in the event that any member unexpectedly received any adjustments, allocations, or distributions, items of company income and gain would be specially allocated to such member in an amount and in a manner sufficient to eliminate as quickly as possible the deficit capital account of the member.

Effective May 1, 2013, Newman PLLC and Town PS withdrew as partners of CRC. Newman and Town thereafter started their own CPA firm, Newman Town, PLLC (NT PLLC). Certain clients of CRC thereafter ceased engaging CRC and retained the services of NT PLLC.

CRC's 2013 Tax Return

Clark PLLC, as the tax matters partner (TMP) for CRC, reported on CRC's 2013 Form 1065 that Newman and Town received property distributions of $318,144 and $424,425, respectively. Such amounts were equal to the value of the clients (as determined under the restated partnership agreement) that followed them to NT PLLC. Clark PLLC also decreased Newman's and Town's capital accounts by the value of the reported distributions, and thereby reduced their capital accounts below zero. To restore their capital accounts to zero, Clark PLLC allocated (for tax purposes) all of CRC's ordinary income for 2013 to Newman and Town, pursuant to the QIO provision in the partnership agreement, and so reported on CRC's tax return. As a result, Clark PLLC allocated to itself no taxable income from CRC. While there was no dispute that CRC realized $563,118 of ordinary business income for 2013, the parties did dispute how that income should be allocated among CRC's partners for tax purposes.

In September 2014, Newman PLLC and Town PS each filed Forms 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), with respect to the 2013 K-1s. In response, the IRS conducted a partnership-level audit of CRC's 2013 Form 1065. In 2017, the IRS issued a Letter 1827-F proposing adjustments to partnership items on CRC's 2013 Form 1065. In December of 2018, IRS Appeals issued to Clark PLLC a Final Partnership Administrative Adjustment (FPAA) determining adjustments to CRC's 2013 Form 1065.

The FPAA largely adjusted CRC's reported property distributions and income allocations consistently with the corrections proposed by Newman PLLC and Town PS in their Forms 8082. With regard to property distributions, the IRS determined: (1) reported "client distributions" of $705,249 were not distributions and should be disregarded, or, in the alternative, CRC failed to substantiate the identities and the values of the clients distributed (and it failed to show that CRC was capable of valuing the clients distributed), and therefore the distributions should be disregarded; and (2) a remaining distribution of $183,737 should be disregarded because it was the result of a bank loan owed personally by a partner who subsequently defaulted.

The FPAA also determined that CRC's reported allocation of ordinary income to Newman PLLC and Town PS had no substantial economic effect, was not consistent year to year, and did not use the allocation method described in the 2013 LLC Agreement. Further, the FPAA said that the allocation of ordinary income should be based on known amounts received by the partners. The FPAA determined that ordinary income should be allocated as follows: $538,118 (rather than $789,987) to Clark PLLC, $20,000 (rather than $307,759) to Newman PLLC, and $5,000 (rather than $255,799) to Town PS.

In December 2017, Newman PLLC and Town PS executed Forms 870-PT, Agreement for Partnership Items and Partnership Level Determinations as to Penalties, Additions to Tax and Additional Amounts, regarding CRC's 2013 tax year, and the IRS countersigned in January 2018. CRC filed a petition with the Tax Court contesting the income allocations that ultimately affected Clark PLLC only. The issues before the Tax Court were: (1) whether CRC made distributions of client-based intangible assets to its partners during 2013; and (2) whether CRC's ordinary income allocations reported on its Forms 1065 had substantial economic effect under Code Sec. 704(b).

Analysis

The Tax Court held that CRC distributed client-based intangible assets to Newman and Town when they withdrew from CRC, and the value of those assets were properly valued under the terms of CRC's partnership agreement. CRC's method for valuing client-based intangibles upon the withdrawal of Newman PLLC and Town PS, the court observed, comported with the fair market value definition of Reg. Sec. 1.704-1(b)(2)(iv)(h)(1). In the absence of any competing valuation presented by the IRS, or any critique of this valuation, the court found that CRC met its burden of proving that there was a distribution of clients, and that, on the evidence before it, CRC did in fact distribute client-based intangible assets of $318,144 to Newman PLLC and $424,425 to Town PS when certain clients left CRC and engaged NT PLLC following Newman PLLC's and Town PS's withdrawals.

The Tax Court further held that CRC failed to maintain capital accounts in accordance with Reg. Sec. 1.704-1(b)(2)(iv) and, therefore, CRC's special allocations of income to Newman and Town lacked substantial economic effect and had to be reallocated in accordance with the partners' interests in the partnership under Code Sec. 704(b) and Reg. Sec. 1.704-1(b)(3).

The court also concluded that, because Newman and Town had negative capital accounts at the end of the tax year and CRC's partnership agreement included a QIO, ordinary income had to be allocated first to Newman and Town in an amount necessary to bring their capital accounts up to zero.

For a discussion of the taxation of client-based intangibles, see Parker Tax ¶117,140, For a discussion of proper maintenance of capital accounts, qualified income offsets, and the substantial economic effect test, see Parker Tax ¶20,610 and ¶20,620.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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