The Dark Side of Flow-through Entities - Taxable Income Without Cash

Originally Published on forbes.com on March 8th,2012

______________________________________

Jose Martignon v. Commissioner, TC Summary Opinion 2012-18

Image via Wikipedia

You really should be careful about who you partner up with. Jose Martignon took a 40% interest in a partnership with Alejandro Vargas to open a restaurant – The Cafe Savannah – in Anchorage, Alaska.  Mr. Martignon focused on operations including cooking and waiting on tables.  Mr. Vargas handled financial matters.  Partnership harmony did not persist very long.

In March 2008 Mr. Vargas shut petitioner out of the business. Mr. Vargas changed the locks, refused to communicate with petitioner, and ignored petitioner’s request for the restaurant’s records. After Mr. Vargas shut him out of the business, petitioner contacted an attorney toresolve the dispute and gain access to the partnership’s records but was unsuccessful.

Don’t you just hate it when that happens ?

Mr. Vargas still considered Mr. Martignon a partner for income tax purposes though.  Mr. Martignon received a K-1 with slightly more than $2o,000 in taxable income – no cash distributions though.  At Joseph B. Cohan and Associates we had a saying for that situation.  Like many of our sayings, it would not pass the contributor guidelines.  Mr. Martignon questioned the income allocation.

 Petitioner was surprised to learn Cafe Savannah had earned a profit for 2007 because the restaurant had reported a loss every prior year and he had not received any distributions from the partnership. Petitioner had his 2007 tax return prepared by an accountant. Petitioner’s accountant listed Cafe Savannah as a partnership in which petitioner held an interest on the Schedule E, Supplemental Income and Loss, attached to petitioner’s Form 1040, U.S. Individual Income Tax Return, but did not report on the Schedule E any of the $22,544 reported on petitioner’s Schedule K-1.

The Tax Court was not willing to cut Mr. Martignon a break on the tax, even though the result seemed unfair:

Section 1.702-1(a), Income Tax Regs., provides: “Each partner is required to take into account separately in his return his distributive share,whether or not distributed, of each class or item of partnership income”. (Emphasis added.) “Few principles of partnership taxation are more firmly established than that no matter the reason for nondistribution each partner mustpay taxes on his distributive share.”

The fact that petitioner did not receive any distribution from the partnership because of Mr. Vargas’ alleged wrongdoing does not change the general rule that a partner is taxed on his distributive share, whether or not received.

They did give him a break on penalties, though:

After receiving the Schedule K-1 that he believed was incorrect, petitioner made several attempts to contact Mr. Vargas and to access the partnership’s records. Petitioner even sought counsel in an attempt to resolve the dispute with Mr. Vargas and gain access to the partnership’s records. Additionally, petitioner had his tax return prepared by an accountant in a good-faith attempt to properly assess his proper tax liability. We find that petitioner made a significant effort to assess his proper tax liability. See id. On the facts and circumstances, we find that petitioner had reasonable cause and acted in good faith.

There wasn’t that much money involved (in absolute terms that is) so it is understandable that Mr. Martignon was pro se.  If the restaurant had been an S corporation, I would agree that the situation was hopeless.  S Corporation income is allocated on a strict percentage basis.  Allocations of partnership income are supposed to have substantial economic effect, though.  If somebody is getting all the money, they should be taxed on all the income.  There is not really enough information in the decision to tell if this issue was addressed.

Another item that is not discussed is what you are supposed to do if you get a K-1 you disagree with and don’t want to just roll over.  You can file Form 8082 – Notice of Inconsistent Treatment.  I am not certain that 8082 would have taken the penalty issue off the table, but there is a chance it would have made Mr. Vargas miserable, which probably would have been worth something to Mr. Martignon.

Sophisticated deal structures will usually have mandatory “tax distributions” so investors do not get stuck picking up income while management holds onto all the cash.  There is still no substitute for picking partners that you can trust.You can follow me on twitter @peterreillycpa.