Partner Must Pay Tax on Full Amount of Flow Through Income Even If the Result is Unfair

The tax law may be “unfair and unjust” but that doesn’t allow a taxpayer to ignore the law to arrive at what he may believe is a more just result.  That’s the key lesson the case of Walter S. Mack Jr. et ux. v. Commissioner, T.C. Memo. 2016-229 provides.

Mr. Mack was a partner in a law firm.  He received K-1s from two law firm related partnerships for 2011 that showed total income of $479,473.  However, he only reported income of $75,000 from the partnerships on his Form 1040 for that year. 

Mr. Mack did not claim that the amounts on the K-1 did not reflect his share of the reported income on the partnership returns.  Rather, he claimed that he should only have to report a lesser amount of income for the following reasons as reported by the Tax Court:

However, Mr. Mack alleges that, in the wake of the 2008 recession, other partners at DRKM could not cover their shares of the firm's expenses and that, as a result, the firm had gone into “significant negative capital”. Mr. Mack felt that it was his fiduciary obligation under New York partnership law to cover other partners’ partnership expenses. Mr. Mack claims that his DRKM “capital account bore no relationship to the financial condition of the partnership, and what little money was available to * * * [Mr. Mack] was used to absorb expense [sic] that normally would have been expenses of the firm.” Mr. Mack does not allege that any partnership expenses were omitted from the partnership's returns and Schedules K-1.

That is, Mr. Mack’s income was not paid out to him by the partnership, but rather was apparently held in the partnership and used to pay other expenses.  Mr. Mack, feeling it would be unfair for him to have to pay taxes on the income he did not receive in cash, sought the advice of the firm’s accountants and tax return preparers.

The Court opinion notes that Mr. Mack related their response to his position as follows:

When I sought the advice of the firms’ accountants and tax preparers, I was in essence told that the tax law was unfair and unjust under these circumstances, and my options were to dissolve the firm, take all the capital in the firm to pay my taxes and move on, and let my partners fend for themselves, and the employees go on unemployment. When I discussed [m]y obligations under New York State Partnership Law to act as a fiduciary to my partners, I was told to be prepared to face the consequence of that decision as I am now, that the Respondent would likely be deaf to the financial realities of the firm and not respect the state law fiduciary partnership duties.

Mr. Mack did not follow this advice.  Rather, he decided to report what was “fair” and, in his words, “face the consequence.”

The consequence was that Mr. Mack found himself facing the IRS demanding additional tax, interest and penalties and a Tax Court that found in favor of the IRS.

The Court notes, first, that a partner is obligated under the law to report his/her share of partnership income regardless of whether that income is distributed to him/her.  As the Court noted:

If Mr. Mack did in effect plow his share of the 2011 income back into the firm (because he thought that State law required him to do so), then that amount presumably constituted a contribution to the firm's capital and would increase his own capital account at the firm, see 26 C.F.R. sec. 1.704-1(b)(2)(iv)(b) and (c), Income Tax Regs., but such a capital contribution is not deductible, see sec. 721 (providing nonrecognition treatment for contributions to partnerships by partners); Lopo v. Commissioner, T.C. Memo. 1961-126, 20 T.C.M. (CCH) 620, 624 (1961) (holding that capital contributions to joint ventures are not deductible business expenses).

As a partner in DRKM, Mr. Mack was obliged to report his share of the firm’s income, whether or not it was distributed to him, and whether or not that money was thereafter used to pay firm expenses.

But, argued Mr. Mack, given how little of the income he felt he could take out of the partnership without violating his duty under state law, how was he to pay the income tax?  The Tax Court noted that this was not a relevant consideration at this point—rather, the question of ability to pay could only be raised as part of a later collection action.

The opinion continues:

A taxpayer’s assertion that he has no money to pay an income tax liability might be relevant in a “collection due process” (“CDP”) case brought pursuant to section 6330(d); and in a deficiency case the assertion might be relevant to an argument that he should not be held liable for an addition to tax for failure to timely pay, pursuant to section 6651(a)(2) (which the IRS did not determine in this case). But where, as here, the issue is the unreported amount of the liability, the Macks' argument misses the mark.

A taxpayer’s ability to pay the tax he owes has no bearing on the amount of his or her tax liability. The Macks may in the future raise issues of collectibility at a CDP hearing before IRS Appeals under section 6320 or 6330, and the judicial appeal of an IRS determination in such a hearing would lie in this Court. However, in the instant case, a deficiency case arising under section 6213(a), the Macks’ argument about their inability to pay is not relevant to our ultimate issue -- the amount of their tax liability.

With regard to the accuracy related penalty under IRC §6662(a), the Tax Court found that Mr. Mack had no defense to that penalty in this case.  In this case, since the tax in question would exceed the greater of 10% of the tax due on the return or $5,000, the burden shifted to the taxpayer to show the penalty would not apply.

The penalty could be lifted if Mr. Mack could show his position either had substantial authority or was adequately disclosed and had a reasonable basis—but the Court found Mr. Mack did not make a showing that would bring in either of these provisions.

That left the exception found at IRC §6664(c)(1) which provides the penalty will not apply if the taxpayer has reasonable cause for the understatement and acted in good faith.  But the Court found that Mr. Mack could not show that he reasonable cause or had acted in good faith.

As the opinion concludes:

If the Macks contend that their failure to include the proper amounts was for reasonable cause or in good faith, then the contention fails. Mr. Mack admits that tax professionals explained to him that the tax law required him (albeit “unfair[ly]”, they said) to report his share of the partnership income (and advised him to dissolve the firm in order to stay in compliance with his own tax obligations), and that he disregarded their advice and affirmatively decided not to do so but instead to “face the consequence”. The accuracy-related penalty is now part of that consequence.