Friday, November 25, 2011

Shoemaker's Children

WALLIS v. COMM., Cite as 106 AFTR 2d 2010-5755, 08/11/2010

This was originally published on September 27th, 2010.

Many tax professionals practice as partners in partnerships.  So you would think the tax aspects of professional partnerships would be pretty well worked out.  Think again.  When I think about thoroughly applying 704(c), for example, to an ongoing professional firm that has partners coming and going, I get a headache.  Thus, I can't really say I am shocked, shocked that a tax attorney couldn't prevail on the proper treatment of the guaranteed payments from his own partnership, but I'd still like to give you some comments on Wallis v Com. (106 AFTR 2d 2010-5755).  I'm not sure if my motivation is compassion or schadenfreude.  Since it's a tax attorney rather than a CPA it's probably schadenfreude.

Donald Wallis was a partner in the firm Holland & Knight. Under the partnership agreement he was awarded something called Schedule C units for each year of service.  When he withdrew from the partnership in 2003 he had a capital account of  $98,161.75 and $240,000 in "Schedule C" units.  In 2003 he began receiving quarterly payments of $28,180.15.  $20,000 of each payment was with respect to "Schedule C" payments and the the balance toward his capital account.  In 2005 the partnership sent him From 1099-MISC in the amount of $80,000 and deducted the payment to him in computing its taxable income. 

In preparing his 2005 return Mr. Wallis did not report the $80,0000 at all.  He subsequently abandoned the theory that the payment was non-taxable and took the position that it was in exchange for his partnership interest and should be accorded capital gains treatment.  The 11th circuit sustained the tax court in treating the payment as ordinary income and allowing an accuracy related penalty to be charged.

The argument about the penalty was the most interesting.  The court cited Section 6662 which requires you to be consistent with a partnership's treatment of transactions unless you notify the IRS that you are being inconsistent.  The notification is done by attaching Form 8082 which has the apt title of Notice of Inconsistent Treatment.  Mr. Wallis argued that since he didn't have a disagreement with his K-1, which apparently did not include the payment but rather with the 1099-MISC, the consistency requirement didn't apply.  The court was unsympathetic:

Section 6222 provides a means for a partner to inform the IRS when his own treatment of a partnership item “is (or may be) inconsistent with the treatment of the item on the partnership return.” 26 U.S.C. § 6222(b)(1). Given that Donald Wallis has 35 years of experience as a tax lawyer, the Tax Court reasonably could conclude that Wallis should have been aware there were inconsistencies between (1) his not reporting the Schedule C payments at all to the IRS and (2) the income Form 1099 he received from H&K. See Treas. Reg. 1.6664-4(b)(1).

The Wallises argue that they had no obligation to report under § 6222 because their inconsistency was with H&K's Form 1099-MISC, not with H&K's 2005 return. Nonetheless, § 6222 requires partners to report even possible inconsistencies to the IRS if they wish to treat partnership items differently on their own return from the partnership's return. And, Wallis's receipt of the Form 1099-MISC should have alerted him that the Schedule C payments would be reflected as deductions on H&K's partnership return. Rather than alerting the IRS to Wallis's (now-abandoned) theory that the payments did not represent taxable income, the Wallises made no mention of the Schedule C payments when they filed their return. Under the circumstances, the Tax Court did not clearly err in finding that the Wallises did not have reasonable cause for the underpayment or act in good faith with respect to it.

It is interesting to note that the instructions Form 8082 state "... you generally must report items consistent with the way they were reported to you on Schedule K-1."  It goes on to state, however, that you should report "any inconsistency" between your tax treatment and the way the partnership reported on "its return".  Presumably Mr. Wallis didn't see the H&K return, but apparently the 1099-MISC was supposed to be enough of a clue.

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