Tax Court: Banished Partner Must Report His Share of Partnership Income

Tax Court: Banished Partner Must Report His Share of Partnership Income

We’d hope that if you garner nothing else from this blog — aside from a healthy appreciation for the genius of The Simpsons — you’d take away an understanding that theIRS is notin the business of being sympathetic to a taxpayer’s view as to what is “fair.”The law is the law, and it is designed solely to levy and collect taxes fromthe masses. As a result, if therelevant authority indicates that the tax treatment of an item is clearly established, theIRS and the courts will adhere to it with strict compliance; ourpersonal plights bedamned.

To illustrate: in 2003, Jose Martignon (Martignon) and Alejandro Vargas (Vargas) formed a partnership to operate a restaurant, Café Savannah. Vargas controlled the restaurant’s finances, whileMartignon focused on the operations.

The relationship between Vargas and Martignon soured shortly after Café Savannah opened, and by March 2008, Vargas had effectively shut Martignon out of the business. Vargas changed the locks, refused to communicate with Martignon, and ignored Martignon’s request for the restaurant’s records.

In early 2008, Café Savannah’s CPA prepared the partnership’s 2007 tax return using information supplied by Vargas. The partnership reported $56,361 of taxable income on its Form 1065, and allocated $22,544 to Martignon on his Schedule K-1.

Martignon was surprised to learn Café Savannah had earned a profit for 2007, primarily because he hadn’t received any distributions of cash during the year. Figuring he shouldn’t have to pay tax on income from a partnership that he was no longer involved with and received no cash from, Martignon did not report his share of Café Savannah’s income on his 2007 individual tax return.

Seems reasonable, right? If Vargas cut Martignon out of the business and kept all the cash inside the business, then Vargas should be forced to recognize all of the income, no?

No.

As mentioned in our opening,the tax law simply doesn’t work that way; it is concerned with statute, regulations and judicial precedents, not personal squabbles and perceived inequities.

As a result, upon auditing Martignon’s 2007 return, the IRS adjusted his income to reflect the $22,544 allocation from Café Savannah and assessed additional tax, penalties and interest.

The Tax Court agreed, citing the regulations and a body of case law.

I.R.C. § 1.702-1(a) provides that “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)

In interpreting this regulation, the courts have long held that the failure to receive a distribution cash does not justify a partner’s failure to report his share of the partnership income, even when it appears the partner is on the losing end of a personal battle. For example, in Stoumen v. Commissioner, [i] the Third Circuit held that the taxpayer’sdistributive share of partnership income was taxable to him in the year of realization by the partnership, despite the fact that (1) his partner had embezzled funds which did not appear in the partnership books, and (2) the taxpayer was unaware of the existence of the funds and never received any of them.

In holding that Martignon was required to include in his taxable income the amount allocated to him on his Café Savannah K-1, the Tax Court applied its customary level of empathy:

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