Partnership tax vs. Individual tax return Problem Resolution

Supreme Court won’t review case holding that partner must pay tax on escrowed disputed funds

Mike Habib, EA

The Supreme Court has declined to review a decision of the U.S. Court of Appeals for the First Circuit that an individual who was a partner in a partnership had to pay tax on his distributive share of the partnership’s income, notwithstanding that the partnership’s receipts had been placed in escrow pending the outcome of a suit by the individual against the other partner.

Facts. In ’93, Timothy J. Burke formed a partnership with Jeffrey Cohen named “Cohen & Burke,” agreeing to split the proceeds of the enterprise evenly after allocating a 10% origination fee to the partner who generated new business. In ’98, a dispute arose between the two partners when Cohen allegedly refused to comply with a superseding partnership agreement that linked the distribution of the partnership’s proceeds more tightly to each partner’s individual efforts and stole money received by the partnership. As a result of the dispute, Burke filed suit against Cohen in state court on Oct. 4, ’99, alleging breach of fiduciary duty, breach of contract, deceit, and conversion, and requesting an accounting. Cohen and Burke agreed to keep the partnership receipts in an escrow account pending the outcome of the litigation.

Meanwhile, Cohen filed the partnership tax return for ’98 reporting $242,000 in ordinary income, with $121,000 as each partner’s distributive share. Burke reported zero as his distributive share of partnership income and filed a notice of inconsistent determination stating that Cohen’s partnership tax filing was factually and legally inaccurate.

IRS issued Burke a notice of deficiency alleging that he had improperly failed to report his distributive share of partnership income on his individual return. Burke timely petitioned the Tax Court for redetermination of the deficiency, claiming that his distribution of partnership income from ’98 should not have been taxed that year because the money was being held in escrow and he therefore did not have access to it.

IRS filed a motion for summary judgment arguing that, as a matter of law, a partner’s distribution of partnership income was taxable in the year the partnership received the income, regardless of whether the partner actually received the distribution. Burke countered that there were material facts in dispute precluding summary judgment in favor of IRS and moved for partial summary judgment on the issue of whether he had to report his distributive share of the ’98 partnership income. The Tax Court granted summary judgment to IRS, holding that Burke had to include his distributive share of partnership income for the ’98 tax year even though he had not yet received that distribution.

Taxpayer argument before the Appeals Court. Burke cited numerous cases (not dealing with partnerships) holding that individuals must only include income to which they have a claim of right. Citing the language of Code Sec. 703 that “[t]he taxable income of a partnership shall be computed in the same manner as in the case of an individual,” Burke argued that the partnership did not earn taxable income in ’98 because “the restriction of funds…defers the recognition of income at the partnership level, as it does for individuals, until the restriction is removed.”

The First Circuit rejected this argument. It said that Code Sec. 703 didn’t help Burke because a self-imposed restriction on the availability of income cannot legally defer recognition of that income. The Court stressed that the partnership received the money free and clear in ’98. It was Burke and Cohen, who chose to place the funds in escrow–not the partnership’s clients or other persons owing the partnership money.

The Appeals Court also pointed to the well settled rule that partners’ distributions are taxed in the year the partnership receives its earnings, regardless of whether the partners actually receive their share of partnership earnings.

The Court also rejected an argument that there were facts in dispute which should have operated to prevent IRS from getting summary judgment. Specifically, Burke claimed that the Tax Court incorrectly assumed Burke’s taxable income for ’98 was about $151,000, but that this number was incorrect because it included money that Cohen had stolen from the partnership. The Appeals Court rejected this claim because the record showed that the Tax Court properly found that IRS used Burke’s own calculation of the partnership’s gross receipts for ’98, subtracting from that number his calculations of the allegedly stolen funds, in arriving at his taxable income for ’98. Accordingly, it affirmed the Tax Court.

It’s not clear why Burke disputed IRS in the first instance when the law and authorities clearly seemed to be against him. Perhaps it was because he lacked the funds to pay the tax. In any event, a footnote to the decision indicates that he did ultimately prevail in the underlying dispute with Cohen.

Mike Habib, EA