While philosophers may still debate the question of whether a noise is made if a tree falls in the forest and no one hears it, the Tax Court has no doubt that if a person does not receive a K-1 from a partnership that had income, nor receive a cash distribution that indicates there was income allocable to him, the taxpayer nevertheless must recognize the income. The reality of this was discovered by a blogger in the case of Lamas-Richie v. Commissioner, TC Memo 2016-63.
Nik Lamas-Richie had founded a gossip blog about Scottsdale, Arizona. As the Court described, “[t]his Web site initially posted gossip about local topics, including ‘the cool kids in Scottsdale who thought they were celebrities.’” Discovering success, he decided good gossip wasn’t limited to the west’s most western town, expanding the site to cover regional and then national gossip.
His success lead to the partnership that would play the key role in this case:
As the Web site gained more viewers, it attracted the attention of investors. An investor named James Grdina approached petitioner and suggested the formation of a partnership that would take over the Web site and supply capital to help it expand. The partnership was called “Dirty World LLC” (Dirty World), and it began operations in September 2007. Mr. Grdina provided capital by causing Intrigue Investment Co. (Intrigue) to lend the partnership $650,000. Mr. Grdina and Intrigue together owned a 59% interest in the partnership; petitioner received a 41% limited partnership interest.
Nik was then hired as a W-2 employee by another entity controlled by Mr. Grdina, paid for his work editing the gossip provided to the site and managing the blog. For the year in question Nik was paid $74,500 in this capacity and represented the only cash he received related to the site.
Nik filed his 2011 income tax return on April 14, 2012, reporting his wages but not containing any information about partnership income. Nik testified that the partnership had never shown income in the prior years (from 2007-2010) and had never made any distributions to him, testimony the Court found credible and which the IRS did not dispute (although the amount of such losses was not established).
It turns out that the 2011 partnership return was not actually filed until September 17, 2012 and that it had turned a profit. The partnership return had attached a K-1 for Nik showing his share of income of $25,417, along with no distributions made to Nik during the year.
Nik never actually received a copy of this K-1 and first became aware of the income on the K-1 when the IRS examined his return for 2011.
Nik relinquished his interest in the partnership in 2013 due to concerns regarding litigation (turns out some people who have information posted about them on gossip sites get upset enough to sue), though he remained a W-2 employee and continued to edit the site. The site continues to thrive, with Nik noting that it has operations in 365 markets worldwide (Scottsdale now has lots of company) and has 24 million unique visitors to the site monthly.
The basic issue here is one decided long ago—a partner always ends up having to report his/her share of the income, even if not aware of its existence. As the opinion notes:
It was established long ago that “a partner must report his distributive share whether received or not.” Bourne v. Commissioner, 62 F.2d 648, 649 (4th Cir. 1933), aff’g 23 B.T.A. 1288 (1931); see Jones v. Commissioner, T.C. Memo. 2010-112, 99 T.C.M. (CCH) 1457, 1458; Burke v. Commissioner, T.C. Memo. 2005-297, 90 T.C.M. (CCH) 635, 637, aff’d, 485 F.3d 171 (1st Cir. 2007); sec. 1.702-1(a), Income Tax Regs. A partner must report his distributive share of partnership income even if he was not aware that such income existed at the time it was earned. Stoumen v. Commissioner, 208 F.2d 903, 905-906 (3d Cir. 1953) aff’g 12 T.C.M. (CCH) 267; see Pridgen v. Commissioner, T.C. Memo. 1999-188, 77 T.C.M. (CCH) 2117, 2127-2131, aff’d, 2 F. App’x 264 (4th Cir. 2001); Brooks v. Commissioner, T.C. Memo. 1995-400, 70 T.C.M. (CCH) 458 460.
What about Nik’s decision to not go for an extension of time to await the K-1, but rather file his return timely? Isn’t that a reasonable decision?
Well, the Court had the following commentary on that:
Dirty World did not file its Form 1065 for 2011 until September 2012, six months after petitioners filed their individual return. The partnership’s failure to supply petitioners with a timely Schedule K-1, however, does not relieve them of their obligation to include in income petitioner’s distributive share of the partnership’s profits. As noted earlier, “[a] partner is taxable on her distributive share of partnership income regardless of whether she receives it or is even aware of its existence.” Brooks, 70 T.C.M. (CCH) at 460; cf. Healey v. Commissioner, T.C. Memo. 1996-260, 71 T.C.M. (CCH) 3148, 3149-4 (nonreceipt of Schedule K-1 does not relieve taxpayer of obligation to make reasonable estimate of income on Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return). Although petitioner testified that Dirty World had losses for prior years, he introduced no evidence at trial concerning the magnitude of those losses or the existence of any loss carryforward to 2011. We accordingly have no alternative but to sustain respondent’s determination that petitioner’s distributive share of Dirty World’s business income constituted taxable income to petitioners for 2011.
Effectively, what should have happened is that Nik, being a partner in a partnership, should have inquired of Mr. Grdina’s organizations whether the partnership appeared profitable and what amount of income might be allocated to Nik.
The good news for Nik was that the Court did not apply the accuracy related penalties in this case due to reasonable reliance on a tax professional:
Petitioner credibly testified that he viewed himself as an employee of Dirty World, and he properly reported the wages of $74,500 that he received through iNetwork for his editorial and related services. He had not received a Schedule K-1 from Dirty World at the time petitioners filed their 2011 return, and he credibly testified that Dirty World had not previously earned income that he would have been required to report. Petitioners supplied their return preparer with all tax-related documents relevant to this issue, and we find that they reasonably relied on his assurance that the return in that respect was correct as filed. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); sec. 1.6664-4(b)(1), (c), Income Tax Regs.
Implied by this statement is that Nik had disclosed his involvement with the partnership to the preparer who had assured them the return was correct without the K-1. Presumably the preparer cooperated in this case and agreed that all such information had been provided (the preparer did not claim Nik had hidden the partnership interest from him/her).
While we don’t know all of the facts, there is a risk that a situation like this may open the preparer him/herself up to a claim of having failed to meet his/her obligation to perform due diligence. While Nik reasonably may not have understood the implications of being a partner, the preparer presumably should have recognized the potential issue. After all, the Court’s commentary about making a “reasonable estimate” even if no K-1 is received did not suggest that such a “reasonable estimate” had actually been made in this situation. Rather Nik relied on the assurance that his return was correct as filed given to him by the preparer.
Of more concern is the lack of information about prior losses that may or may not have been available to offset Nik’s income. Hopefully Nik had actually claimed the losses in prior years and used them to offset other income, which would mean there was nothing available to offset and Nik already had received the benefit of the losses.
However, sometimes clients who “want to file on time” in a situation like this might have ignored the prior loss K-1s. In such a case Nik may have ended up losing the benefit of the losses but nevertheless have been required to pay tax on the income in a later year.
That sort of “worst case” scenario is something advisers must counsel clients who unreasonably refuse to accept an extension when they have invested in a partnership that hasn’t completed its return about—if the “missing” K-1 shows a loss then the return would need to be amended to get the benefit, while if it shows income the taxpayer is liable for the tax. Unfortunately, quite often such clients simply treat the prior year as “finished” once that return is filed by April 15 and simply ignore any K-1 that is later received, either unintentionally or due to a reluctance to incur the fees involved with revising the return.
And all too often we as advisers, having “accepted” going without the K-1 once end up with a long series of returns where we “went without” the K-1 and never received information later regarding what the K-1 actually contained, nor advised the client about amending the prior return to deal with that information to the extent the return may now be materially deficient.