Clark Raymond & Company PLLC, D. Edson Clark, CPA, PLLC, Tax Matters Partner

United States Tax Court

T.C. Memo. 2022-105

CLARK RAYMOND & COMPANY PLLC, D. EDSON CLARK, CPA,

PLLC, TAX MATTERS PARTNER,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 2265-19. Filed October 13, 2022.

—————

CRC, an accounting firm, is a partnership subject to

the TEFRA provisions of I.R.C. §§ 6221–6234. Three

single-member entities—C, N, and T—were partners of

CRC in 2013 and negotiated a buyout of C in anticipation

of the retirement of C’s principal owner, which they

memorialized in a restated partnership agreement. The

partnership agreement also included provisions governing

allocations of income and distributions (both liquidating

and non-liquidating) to the partners, and it included a

qualified income offset (QIO) provision. The partnership

agreement anticipated that a partner could receive a

distribution of “clients” from the partnership and provided

a method for valuing such a distribution.

Shortly after executing the restated partnership

agreement, N and T withdrew from CRC, and certain

clients of CRC stopped engaging CRC and instead retained

N’s and T’s new partnership (NT PLLC). C, as tax matters

partner for CRC, reported on CRC’s 2013 Form 1065, “U.S.

Return of Partnership Income”, that N and T received

distributions from CRC in amounts equal to the value of

the clients (as determined under the restated partnership

agreement) that followed N and T to NT PLLC. C also

decreased N’s and T’s capital accounts by the value of the

Served 10/13/22

2

[*2] reported distributions, and thereby reduced N’s and T’s

capital accounts below zero. To restore N’s and T’s capital

accounts to zero, C allocated (for tax purposes) all of CRC’s

ordinary income for 2013 to N and T, pursuant to a QIO

provision in the partnership agreement, and so reported on

CRC’s tax return. As a result, C allocated to itself no

taxable income from CRC.

N and T filed Forms 8082, “Notice of Inconsistent

Treatment or Administrative Adjustment Request (AAR)”,

contesting CRC’s 2013 income allocations, and R

subsequently audited CRC’s 2013 return. R issued a Letter

1830–F, “Notice of Final Partnership Administrative

Adjustment” (FPAA), disregarding CRC’s reported “client

distributions” and redetermining allocations of ordinary

income to N and T. Specifically, R determined that CRC’s

“client distributions” had not been substantiated and that

CRC’s corresponding allocations of income lacked

substantial economic effect.

C, as TMP of CRC, timely filed a Petition in this

Court contesting R’s determinations in the FPAA. The

parties filed a joint motion to submit this case pursuant to

Rule 122, which we granted.

Held: CRC distributed client-based intangible assets

to N and T when they withdrew from CRC, and the value

of the assets so distributed are properly valued under the

terms of CRC’s partnership agreement.

Held, further, CRC failed to maintain capital

accounts in accordance with Treas. Reg. § 1.704-1(b)(2)(iv);

therefore, CRC’s special allocations of income to N and T

lacked substantial economic effect and must be reallocated

in accordance with the partners’ interests in the

partnership under I.R.C. § 704(b) and Treas. Reg. § 1.704-

1(b)(3).

Held, further, because N and T had negative capital

accounts at the end of the taxable year and CRC’s

partnership agreement included a QIO, ordinary income

must be allocated first to N and T in an amount necessary

to bring each partner’s capital account up to zero.

3

[*3] Held, further, R’s determinations disregarding

CRC’s “client distributions” and redetermining allocations

of ordinary income are not sustained.

—————

Sandra Veliz, for petitioner.

Amy Chang and Gregory M. Hahn, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GUSTAFSON, Judge: On December 17, 2018, the Internal

Revenue Service (“IRS”) issued a notice of final partnership

administrative adjustment (“FPAA”) for the taxable year ending

December 31, 2013, to D. Edson Clark, CPA, PLLC (“Clark PLLC”), the

tax matters partner (“TMP”) for Clark Raymond & Co., PLLC (“CRC”).

This case is a partnership-level action under the Tax Equity and Fiscal

Responsibility Act of 1982 (“TEFRA”), 1 see § 6221, 2 based on a Petition

filed by the TMP pursuant to section 6226. After concessions by the

parties, 3 the remaining issues for decision are: (1) whether CRC made

1 TEFRA, Pub. L. No. 97-248, §§ 401–407, 96 Stat. 324, 648–71, codified at

sections 6221 through 6234, was repealed for returns filed for partnership tax years

beginning after December 31, 2017.

2Unless otherwise indicated, statutory references in this opinion are to the

Internal Revenue Code (“the Code”, Title 26 of the United States Code) as in effect at

the relevant times; references to regulations are to Title 26 of the Code of Federal

Regulations (“Treas. Reg.”) as in effect at the relevant times; and references to Rules

are to the Tax Court Rules of Practice and Procedure. Some dollar amounts are

rounded. Each citation in this Opinion to a “Doc.” refers to a document so numbered

in the Tax Court docket record of this case, and a pinpoint citation therein refers to the

pagination as generated in the portable document format file.

3 In stipulations of settled issues (Docs. 18, 28, and 32), the parties have

stipulated that for the 2013 tax year: (1) CRC’s “other income” was −$322,639; (2) CRC

made guaranteed payments in the total amount of $62,000 (comprising $7,200 to Clark

PLLC, $2,400 to Chris Newman CPA, PLLC (“Newman PLLC”), $2,400 to John E.

Town, CPA, Inc., P.S. (“Town PS”), and $50,000 to Tony H. Chang, CPA, PLLC, an

entity that would become a partner of CRC after the events at issue); (3) CRC’s

reported “other deductions” should be increased to $596,818; (4) CRC’s reported

ordinary business income should be increased to $563,118; (5) CRC made distributions

of cash and marketable securities in the total amount of $657,201 (comprising

$632,201 to Clark PLLC, $20,000 to Newman PLLC, and $5,000 to Town PS); (6) CRC

4

[*4] distributions of client-based intangible assets to its partners during

2013; and (2) whether CRC’s ordinary income allocations reported on its

Form 1065, “U.S. Return of Partnership Income”, had substantial

economic effect under section 704(b). The parties jointly filed

stipulations of fact and moved to submit this case under Rule 122 for

consideration without trial. For the reasons detailed below, we will not

sustain the IRS’s determinations.

FINDINGS OF FACT

The facts below are based on the pleadings and the parties’

stipulations of fact (including the exhibits attached thereto).

I. CRC’s business activity

CRC is a professional limited liability company formed under the

laws of the State of Washington. When it filed its Petition, CRC’s

principal place of business was Redmond, Washington. 4

CRC provides accounting, tax planning and preparation, and

related professional services to its clients. Because it is a service-based

organization, its tangible assets consist solely of office equipment and

supplies, office furniture, cash, accounts receivable, and works-in-

process.

CRC is generally a successful business and services many clients.

Before performing services for a client, CRC and the client enter into an

engagement agreement specifying the scope of CRC’s services and fees.

The engagement between CRC and a client is terminable at will by

either CRC or its client.

Generally, a certified public accountancy firm (“CPA firm”) such

as CRC may not require a client to continue to retain its services if the

client decides to terminate the business relationship, and a client may

not require a CPA firm to continue providing services if the CPA firm

decides to terminate the business relationship. Neither the CPA firm

nor its clients (or former clients) may require the other to sign a new

is not liable for the accuracy-related penalty under section 6662(a); and (7) CRC made

a property distribution with a fair market value of $183,737 to Newman PLLC, with

respect to a loan from the Washington Trust Bank.

4 Absent stipulation otherwise, venue for an appeal in this case would be in the

U.S. Court of Appeals for the Ninth Circuit. See § 7482(b).

5

[*5] engagement agreement or renew a terminated engagement

agreement.

If an accountant leaves his current CPA firm for a new firm,

clients of the current firm may choose to terminate their relationship

with the current firm and begin a relationship with the new firm. In

such an instance, the client “follows” the accountant to his new firm; and

the accountant, the prior firm, and the client will generally agree upon

procedures to facilitate the transfer of the client’s files from the prior

firm to the new firm. The clients who follow an accountant to a new

firm, and who may generate future cash flow from payments made to

the new firm, are generally referred to as that accountant’s “book of

business”.

II. Partner-entities in CRC

D. Edson Clark formed CRC in 2006. Since its formation, various

entities have joined and withdrawn from CRC as partners. 5 The

following entities were partners of CRC during the relevant years: 6

A. Clark PLLC

Clark PLLC is a professional limited liability company organized

under the laws of the State of Washington. Clark PLLC was a partner

of CRC for the taxable years ending December 31, 2011, 2012, and 2013.

Mr. Clark and his wife, Barbara Clark, have been the sole

shareholders of Clark PLLC, and therefore Mr. Clark held a partnership

interest in CRC indirectly through Clark PLLC for the relevant years.

CRC employed Mr. Clark as an accountant and Mrs. Clark as firm

administrator during the relevant years.

5 CRC filed as a partnership for federal income tax purposes during the year

at issue. See Treas. Reg. § 301.7701-3(b)(1). Although CRC’s partnership agreements

refer to Clark PLLC, Newman PLLC, and Town PS as “members” (and each, a

“member”), we refer to each of them as “partners” of CRC; and we generally refer to

the members of LLCs as “partners”. See § 761(b) (“the term ‘partner’ means a member

of a partnership”).

6 Our reference to the “relevant years” means the tax years 2011, 2012, and

2013. Although only the income allocations from the 2013 tax year are at issue, we

discuss partnership operations in the prior years to provide context to the partners’

agreements and prior handling of client distributions upon withdrawal of a partner.

6

[*6] B. Benbow PS

Rachelle A. Benbow, PS (“Benbow PS”), is a professional services

corporation incorporated under the laws of the State of Washington by

Rachelle A. Benbow, who became a CRC employee in 1999.

Benbow PS purchased a 25% partnership interest in CRC from

Clark PLLC for approximately $580,000 in 2006 and was admitted to

CRC as a partner. The purchase was seller-financed by Clark PLLC,

with Benbow PS obtaining a loan from Clark PLLC for the purchase

price. The purchase price was calculated by totaling CRC’s prior

12 months of gross receipts (intended to reflect the total value of CRC’s

“book of business”) and the net value of CRC’s tangible assets. The

agreement between Benbow PS and Clark PLLC reflected that Benbow

PS purchased an indirect interest in 25% of CRC’s tangible assets and

25% of CRC’s “book of business” when it purchased a 25% partnership

interest in CRC. CRC credited Benbow PS’s capital account with an

initial balance of $580,000.

CRC employed Ms. Benbow as an accountant from 1999 until

October 2011, at which time Benbow PS ceased being a partner of CRC.

C. Town PS

John E. Town, CPA, Inc., P.S. (“Town PS”), is a professional

services corporation incorporated under the laws of the State of

Washington by John E. Town, who became a CRC employee in 2007.

Town PS did not make a direct capital contribution to CRC but instead

purchased a 25% partnership interest from Clark PLLC in 2009 and was

admitted to CRC as a partner on January 1, 2009.

The purchase was seller-financed by Clark PLLC, and Town PS

obtained a loan from Clark PLLC for the entire purchase price. 7 Clark

PLLC and Town PS calculated the purchase price for Town PS’s 25%

partnership interest by first summing the values of CRC’s tangible

7 Though the parties stipulate the fact of the loan, Town PS did not execute a

promissory note to evidence the loan from Clark PLLC. It is unclear whether Town

PS made payments on the loan to Clark PLLC in 2009 or in 2010, because Clark PLLC

reported on its 2009 and 2010 Forms 1120S, “U.S. Income Tax Return for an

S Corporation”, that it received no payments. However, Clark PLLC reported that the

outstanding principal balance of the loan decreased to $606,288 in 2009 and to

$570,347 at the end of 2010. In 2011 Town PS made a payment of $11,371 on the

balance of the loan to Clark PLLC, but it did not make any further payments after

2011.

7

[*7] assets, accounts receivable, and works-in-process, and then

subtracting the total value of CRC’s liabilities to produce an agreed-

upon total net value of CRC of $3,491,985. They then multiplied this

value by 25% to calculate the value of a 25% partnership interest in

CRC, viz., $872,996. However, before his employment at CRC, Mr. Town

had developed professional client relationships, and those clients

decided to retain CRC when Mr. Town became a CRC employee in 2007.

Clark PLLC and Town PS discounted the price to be paid for the 25%

partnership interest in CRC by the amount of revenue generated by Mr.

Town’s “book of business” in the prior year. 8 This discount reduced the

purchase price of $872,996 by $234,046, for a final purchase price of

about $639,000. CRC set Town PS’s initial capital account balance at

$639,000, the amount of the agreed-upon purchase price (and did not

adjust the balance upward to reflect the value of the book of business).

CRC employed Mr. Town as an accountant from 2007 until May 1,

2013, at which time Town PS ceased being a partner in CRC.

D. Chris Newman CPA, PLLC

Chris Newman CPA, PLLC (“Newman PLLC”), is a professional

limited liability company organized under the laws of the State of

Washington by Chris Newman, who became an employee of CRC in

2009. Newman PLLC became a partner of CRC in December 2012 and

remained a partner until May 1, 2013.

On December 22, 2012, Newman PLLC made a $200,000 cash

contribution to CRC using funds it obtained from a loan from

Washington Trust Bank (the “WTB Loan”). To obtain the loan, Newman

PLLC executed a promissory note in favor of Washington Trust Bank.

Mr. Newman, Mr. Clark, and Mrs. Clark each executed personal

guaranties with respect to the WTB Loan promissory note. CRC set

Newman PLLC’s initial capital account balance at $200,000.

8 A detailed description of the purchase price calculation appears in the record.

A note next to the “book of business” discount reads: “Agreed upon value of John’s book

brought in”.

8

[*8] CRC employed Mr. Newman as an accountant from 2009 until

May 1, 2013, at which time Newman PLLC ceased being a partner in

CRC. 9

III. CRC’s LLC agreement and restatement

CRC’s operating agreement (which it refers to as a “limited

liability company agreement”) that was applicable during the year at

issue was preceded by a prior version and by transactions that form the

context for construing the operating agreement.

A. 2009 LLC agreement

Effective January 1, 2009, through December 30, 2011, a limited

liability company agreement (the “2009 LLC Agreement”, Ex. 9–J

(Doc. 33, at 247)) governed CRC’s operation. The 2009 LLC Agreement

stipulated the partners’ agreement on the allocation of profits and losses

among partners, distributions of cash and property to partners, capital

account maintenance, partner withdrawal, and liquidation of the

company.

Regarding partner withdrawal, Section 11.1 of the 2009 LLC

Agreement provided:

In the event of a Withdrawal Event, the Withdrawing

Member [i.e., Partner] shall first have an option to receive

as a Distribution in full consideration of all of the Units of

the Member the following:

(i) Member Clients. All, or any of, the Clients of the

Withdrawing Member . . . and

9 The record does not disclose the number of CRC’s members after the

withdrawal of Town PS and Newman PLLC on May 1, 2013. If their withdrawal left

Clark PLLC as CRC’s sole member, a question would arise concerning CRC’s status as

a partnership. Cf. Treas. Reg. § 301.7701-3(f)(2). However, as explained in note 25,

infra, Tony Chang or an entity he controlled may have been a second continuing

member in CRC after the withdrawal of Town PS and Newman PLLC. Because the

parties have submitted the case on the premise that CRC was properly classified as a

partnership for federal income tax purposes throughout 2013, we have assumed that

the withdrawal of Town PS and Newman PLLC did not leave Clark PLLC as CRC’s

sole member.

9

[*9] (ii) Net Book Value. [The] Withdrawing Member’s

Percentage Interest of the Net Book Value [of

CRC].[10]

Section 8.3(b) of the 2009 LLC Agreement stated that “[i]f any Clients

[were] [d]istributed under [the] agreement, the value of such Client

[would] be the Client Value”, defined (in Section 1.19) as “the gross

revenue generated from [each respective] Client over the prior twelve-

month period.”

In lieu of taking a distribution of clients, a partner could agree to

“leave” clients at CRC and apply a portion of the value of those clients

to the partner’s outstanding loan balance incurred upon its admission

(if applicable).

Schedule 1 attached to the 2009 LLC Agreement stated that

Mr. Clark owned a 50% partnership interest in CRC, and Ms. Benbow

and Mr. Town each owned a 25% partnership interest in CRC.

B. 2011 negotiations and events preceding the 2012

restatement of the LLC agreement

In 2011 the partners of CRC were Clark PLLC, Benbow PS, and

Town PS.

1. Retirement negotiations

Mr. Clark planned to transfer ownership and management of

CRC to the remaining partners in preparation for his retirement. 11

Mr. Clark, Ms. Benbow, Mr. Town, and Mr. Newman discussed a

potential buyout of Clark PLLC’s partnership interest in CRC, and the

implementation of a new partner compensation model using a “Finders,

10The 2009 LLC Agreement defined “Clients” as “any client[s] of the firm”, and

“Net Book Value” as “the net book value of the Company, as determined by sound

accounting principles . . . [with] marketable securities, real estate, tangible property,

and other similar assets . . . valued at fair market value . . . increased by any accounts

receivables and works-in-progress . . . and . . . reduced by liabilities associated with the

collections of such accounts receivable and works-in-progress.”

11 Accounting firms generally transition ownership either externally, via

merger or acquisition, or internally, with a buy-sell agreement between the partners.

10

[*10] Minders, Grinders” (“FMG”) system 12 and an “Average Annual

Value” (“AAV”) system. 13 They also anticipated that the partners would

execute non-compete and non-solicitation agreements as part of the

proposed buyout of Clark PLLC.

Negotiations of Clark PLLC’s prospective buyout reached a

stalemate in the last quarter of 2011. At that time Messrs. Clark,

Newman, and Town agreed to continue negotiations in 2012, and CRC

operated under the terms of the 2009 LLC Agreement for the entire 2011

tax year.

2. Benbow PS’s withdrawal as partner

In October 2011 Ms. Benbow’s employment at CRC ended, and

Benbow PS ceased to be a partner of CRC. Ms. Benbow began working

for another CPA firm, and certain clients formerly engaging CRC

decided to retain the services of Ms. Benbow’s new CPA firm. Pursuant

to this transfer, Ms. Benbow, Benbow PS, and the moving clients

executed documents relating to transfer of the client files from CRC to

Ms. Benbow.

3. Capital accounts

Following Benbow PS’s withdrawal as partner and the migration

of clients to Ms. Benbow’s new CPA firm, CRC reported—pursuant to

the 2009 LLC Agreement—a property distribution to Benbow PS (and a

corresponding capital account decrease) in an amount that reduced its

12 An FMG system calculates wage compensation, profit or loss allocations, and

cash distributions to partners by applying metrics and ratios to determine the revenue

attributable to the accountant that brought the client to the firm (the finder), the

accountant who managed the client and the engagement (the minder), and the

accountant who worked the billable hours on the client’s engagement (the grinder).

13 An AAV system computes the amount payable to a departing partner for the

value of goodwill that he leaves behind at the firm. A partner’s AAV “balance” at

departure is the amount payable to the departing partner for his portion of the firm’s

goodwill. When implementing an AAV system, the partners will agree upon a value of

the firm’s total goodwill, using the prior 12 months’ revenue multiplied by an

appropriate factor, and allocate a portion of the total to each partner’s AAV balance. A

partner’s AAV balance may increase or decrease according to the formula employed by

the CPA firm to compute the individual partner’s contribution to the CPA firm’s growth

(and presumably, to its goodwill).

11

[*11] capital account to zero. 14 Benbow PS did not contest the property

distribution, but Ms. Benbow disagreed with Mr. Clark regarding the

value assigned to CRC’s departing clients and the impact to Benbow

PS’s loan from Clark PLLC. Ultimately, neither Mr. Clark, Clark PLLC,

nor CRC requested additional payment from Ms. Benbow or Benbow PS.

C. 2012 restatement of the 2009 LLC agreement and related

events

In 2012 Clark PLLC, Town PS, and Newman PLLC continued

negotiations regarding the buyout of Clark PLLC’s interest in CRC. The

parties ultimately agreed on buyout terms and memorialized their

agreement by executing a “restated” version of the 2009 LLC Agreement

on December 24, 2012 (the “2012 LLC Agreement”). The 2012 LLC

Agreement as executed did not include a form security agreement to a

form promissory note (relating to payments to be made to retiring

partners), which the parties continued negotiating and agreed to finalize

in January 2013. The 2012 LLC Agreement was effective as of

December 31, 2011.

D. 2013 LLC Agreement

As planned, the three entity partners of CRC finalized the

security agreement and included it when they reaffirmed the terms of

the 2012 LLC Agreement on January 18, 2013. (Hereinafter we refer to

the reaffirmed 2012 LLC Agreement as the “2013 LLC Agreement”,

Ex. 11–J (Doc. 33, at 352).) The 2012 terms remained unchanged in the

2013 LLC Agreement, except for minor items that are inconsequential

to the outcome of this case. The parties to this case agree that the terms

of the 2013 LLC Agreement are operative for this case.

The 2013 LLC Agreement governs many aspects of CRC’s

operation, including the rights and responsibilities of partners and

managers, admission of new partners, and transfer of partnership

interests. We discuss below only the provisions relevant to this case.

14 The distribution and capital account adjustment were made pursuant to the

2009 LLC Agreement’s provisions regarding distributions of clients, but it is unclear

whether Benbow PS received in the distribution any assets other than clients.

12

[*12] 1. Capital account maintenance

The 2013 LLC Agreement contains sophisticated partnership tax

provisions, including rules governing capital contributions and capital

account 15 maintenance for each partner.

The 2013 LLC Agreement states that “[a] separate Capital

Account will be maintained for each Member throughout the term of the

Company in accordance with the rules of Regulation Section 1.704-

1(b)(2)(iv).” It states explicitly that each partner’s capital account will

be increased by the fair market value of contributions (in cash or

property), by allocations of “net profit”, 16 and by any items of income and

gain specially allocated to the partner, and will be decreased by the fair

market value of distributions (in cash or property), by allocations of

expenditures, and by items of deduction and loss specifically allocated

to the partner.

The 2013 LLC Agreement further states that maintenance of

capital accounts under the agreement is intended to comply with “the

requirements concerning substantial economic performance [sic] under

Code Section 704(b)” and that the “[a]greement shall not be construed

as creating a deficit restoration obligation or otherwise personally

obligating any Member to make a capital contribution”.

As part of the buyout negotiations, Clark PLLC, Town PS, and

Newman PLLC agreed that, effective December 31, 2011, capital

account balances would be as follows: Town PS’s capital account balance

would be $150,000; Clark PLLC’s capital account would be $792,497;

and Newman PLLC’s capital account balance would be $200,000. 17

15 The 2013 LLC Agreement uses the terms “Capital Account,” “Net Book Value

Capital Account,” and “Tangible Net Worth Capital Account” interchangeably

throughout, and the parties have stipulated that each of these terms refers solely to

the single capital account of each partner.

16The 2013 LLC Agreement defines “Net Profit” as “an amount equal to the

Company’s taxable income or loss . . . determined in accordance with Code

Section 703(a) [regarding the computation of partnership taxable income, deductions,

and related partnership elections]”.

17 As we mention below in note 58, the fact that the partners negotiated these

capital account balances leaves open the possibility that the partners might not have

calculated them in accordance with the capital account maintenance rules under

Treasury Regulation § 1.704-1(b)(2)(iv). However, the Commissioner does not contest

the partners’ agreed upon capital account balances, and so we accept these balances

as accurate. Upon commencement of his employment by CRC, Mr. Newman did not

13

[*13] Town PS also agreed to increase its capital account over the next

five years, and accordingly made a $10,000 cash contribution to CRC

before the end of 2012, increasing its capital account balance to

$160,000.

2. Allocation of net profits and losses

Section 8.1 of the 2013 LLC Agreement allocates “Net Profit [and]

Loss” of CRC among its partners using a multi-step formula. Profit and

loss are allocated under Section 8.1 in the following order and priority:

First, income equal to “10% of the average Tangible Net Worth[18]

reflected in each Member’s Net Book Value Capital Account for the year”

is allocated to each partner. Second, Clark PLLC “receive[s] a special

allocation of taxable income with respect to the amounts collected on the

Accounts Receivable that have been reserved for non-collectability”. 19

Finally, all remaining income is allocated according to the FMG

system. 20 The 2013 LLC Agreement also allocates income, gain, loss,

and deductions according to its proportional “Net Profits [and] Loss”

allocation formula. 21

However, section 8.1 begins by noting that its allocations are

“subject to [the special allocation provisions of] Section[] 8.3”.

Section 8.3 (entitled “Special Allocations”) establishes a “Qualified

Income Offset” (“QIO”), whereby “[i]n the event that any Member

unexpectedly receives any adjustments, allocations, or distributions[,]

. . . items of Company income and gain [are] specially allocated to such

Member in an amount and in a manner sufficient to eliminate as quickly

have a “book of business”, and the initial balances of Newman PLLC’s, Town PS’s, and

Clark PLLC’s capital accounts did not include the value of any intangible assets.

18 The 2013 LLC Agreement defines “Tangible Net Worth” to be “the net book

value of the Company, . . . [including] marketable securities, real estate, tangible

personal property, and other similar assets . . . [and] in the case of [a] Withdrawal

Event other than by mutual agreement or retirement, such amount [is] reduced by

liabilities”.

19 The parties have stipulated that the “amount[] collected on the Accounts

Receivable that [was] reserved for non-collectability” in 2013 was $15,387.

20 The parties have stipulated that the remaining income under this step is

allocated 100% to Clark PLLC for 2013.

21 Section 8.7 of the 2013 LLC Agreement defines “Net Profit or Net Loss” as

“an amount equal to [CRC’s] taxable income or loss [for each fiscal year], determined

in accordance with Code Section 703(a)”.

14

[*14] as possible[] . . . the Deficit Capital Account of the Member”. 22

This QIO provision is significant in our analysis below.

3. AAV system

Articles 10 and 11 of the 2013 LLC Agreement (along with

definitions in Article 1) provide a method for computing retirement

payments for a retiring partner in a manner that takes account of,

among other things, CRC’s “goodwill”.

“Average Annual Value” is defined in Section 1.6 to mean “the

goodwill value of the Company, calculated as one times the annual

accrual basis net client fee revenue of the Company” (emphasis added);

and under Section 1.7, the “Average Annual Value Method” is “the

method pursuant to which an individual Member is allocated his portion

of the Average Annual Value”.

Article 10 of the 2013 LLC Agreement, entitled “Accumulated

Annual Value Method”, provides the method by which each partner’s

“AAV account” (a term not defined in the 2013 LLC Agreement) is

adjusted annually. Each partner’s “AAV” is adjusted up or down in

accordance with the ratio of income allocations under the FMG system

(Article 8 of the 2013 LLC Agreement). Upon a partner’s withdrawal,

the partner’s AAV is “adjusted for any changes in client relationships

that would result in a material decrease in fees billed” before any AAV

distribution to the partner. Upon voluntary withdrawal from the

company, the withdrawing partner forfeits “50% of any vested right to

AAV retirement payments”.

Article 11 of the 2013 LLC Agreement, entitled “Member

Retirement Payments”, provides the method for calculating payments to

retiring partners. 23 The retiring partner first receives a payment equal

to his capital account balance, then a payment equal to “85% of the

retiring member’s AAV account on the date of retirement”.

22 The 2013 LLC Agreement defines the “Deficit Capital Account” of any

partner as “the deficit balance, if any, in such Member’s Capital Account as of the end

of the taxable year, after giving effect to [certain] adjustments”.

23 Certain vesting requirements apply to the payments, but “[i]n order to

receive full payment of vested retirement benefits, the retiring Member must make a

best efforts commitment to actively transition the Company’s clients to the remaining

Members during [the period of transition].”

15

[*15] Clark PLLC, Town PS, and Newman PLLC agreed that the

parties’ beginning AAV balances would be: $2,650,000 for Clark PLLC;

$700,000 for Newman PLLC; and $314,200 for Town PS. Clark PLLC’s

and Town PS’s initial AAV balances were intended to reflect the value

of Clark PLLC’s goodwill in CRC and Mr. Town’s book of business.

4. Contributions

Section 7.1 of the 2013 LLC Agreement states that “[e]ach

Member shall contribute such amount as is set forth in . . . Schedule 1

(or as shown on the books of the Company) as such Member’s share of

the Members’ initial Capital Contribution.” 24 Schedule 1, entitled

“Member and Class B Unit Holder[25] Information (as of December 31,

2011)” consists of a table with each partner’s name and address, AAV

balance, capital account balance, and number of respective voting or

non-voting units, with a total for each column on the last row of the

table. The AAV balance for each partner mirrors the balances

negotiated by the partners, and Clark PLLC, Newman PLLC, and Town

PS each hold an amount of Class A units equal to their respective AAV

balances (2,650,000 units for Clark PLLC, 700,000 units for Newman

PLLC, and 314,200 units for Town PS—for a grand total of 3,664,200

units across all partners). The table shows a zero balance in each

partner’s capital account column (contrary to the partners’ agreement

regarding initial capital account balances), and the total for this column

(theoretically showing the sum of all capital accounts) likewise reflects

a zero balance.

Asterisks appear next to each partner’s name and link to

footnotes appearing below the table. The footnote corresponding with

Clark PLLC states that Clark PLLC’s initial capital contribution

consisted of “[f]ormation costs, contribution of property from predecessor

24 Under the 2013 LLC Agreement, “Capital Contribution” means any

contribution to the capital of CRC in cash, or the fair market value of property

contributed.

25 Under the 2013 LLC Agreement, a “Class B Unit Holder” is an “owner of

Class B Units”, which are “Units issued which do not have an initial Capital Account

and do not have any voting rights associated with them.” Schedule 1 lists one “Class B

Unit Holder”, “Tony Chang, CPA”. Tony H. Chang was an employee of CRC in 2013.

It is unclear from the parties’ stipulations and attached exhibits whether Mr. Chang

(or the professional limited liability company he organized, Tony H. Chang, CPA,

PLLC) was a member of CRC for state law purposes. The parties do not raise (or rebut)

the issue of whether Mr. Chang or Tony H. Chang, CPA, PLLC, was a partner for

federal income tax purposes in 2013, so we do not address that issue in this Opinion.

16

[*16] Company, and buy-out of former Members (including inventory,

business assets and equipment, goodwill and all other tangible and

intangible property) and other amounts shown on the books of the

Company”. Newman PLLC and Town PS share a single footnote stating

that their initial capital contributions consisted of “amounts as shown

on the books of the Company.”

5. Distributions

Article 9 of the 2013 LLC Agreement is entitled “Distributions

from the Company”. Cash distributions are made pursuant to

Section 9.1 (“Net Profit Distributions”) “in the Manager’s reasonable

discretion, provided that such Distributions will be consistent with the

allocations of income made pursuant to Section 8.1” (regarding

allocation of net profit and loss).

Section 9.3 provides for “Distributions In-Kind”. Section 9.3(a),

addressing “Non-cash assets”, is especially significant in our analysis

below. Section 9.3(a) states that any such assets “shall be distributed in

a manner that reflects how cash proceeds from the sale of such assets

for fair market value would [be] distributed (after any unrealized gain

or loss attributable to such noncash assets has been allocated among the

Members in accordance with Article 8)”. That is, Section 9.3(a) requires

that unrealized gain be allocated among the partners (“in accordance

with Article 8”) 26 and that non-cash assets be distributed like cash

proceeds (which, under Section 9.1, would be “in the Manager’s

reasonable discretion” but “consistent with the allocations of income

made pursuant to Section 8.1”).

Section 9.3(b) of the 2013 LLC Agreement states for the

distribution in kind of a particular non-cash asset—i.e., “Clients”—“If

any Clients are Distributed under this Agreement, the value of such

Client shall be the Client Value” (defined in Section 1.19 as the “gross

revenue as invoiced to the Client over the prior twelve-month period”). 27

26 As to allocation of income, Section 8.6(a) similarly states that “income, gain,

loss, deduction, and any other allocations not otherwise provided for shall be divided

among the Members in the same proportions as they share Net Profits or Net Losses”

(i.e., under Section 8.1). Distributions involve “the Manager’s reasonable discretion”

under Section 9.1, but income allocation is simply stated as being made pursuant to

the formula of Section 8.1.

27 This definition varies slightly from the 2009 LLC Agreement’s definition of

Client Value as the “gross revenue generated from the Client over the prior twelve-

month period”. (Emphasis added.)

17

[*17] Absent from the 2013 LLC Agreement is the 2009 LLC

Agreement’s specific provision (in Section 11.1, quoted above) that a

withdrawing partner has an “option to receive a Distribution” from CRC

consisting of “Clients”. But Section 9.3(b) of the 2013 LLC Agreement

plainly presumes that “Clients [may be] Distributed under this

Agreement”.

Upon voluntary withdrawal, a partner is entitled to a distribution

in an amount equal to his positive capital account balance, with the

exception that Town PS is not entitled to a distribution unless its

“Tangible Net Worth exceeds $150,000 [or] until Clark [PLLC] is paid in

full”. 28

In the event of a liquidation, after repayment of CRC’s creditors,

the 2013 LLC Agreement states that liquidating distributions are made

“[t]o the Members in repayment of the positive balances of their

respective Capital Accounts, as determined after taking into account all

Capital Account adjustments for the taxable year during which the

liquidation occurs”.

6. Non-solicitation agreement

The 2013 LLC Agreement contains a non-solicitation agreement

whereby the partners agree (for a period of two years) that a

withdrawing partner will not provide services to or solicit any current

or prospective 29 client of CRC, remove client files from CRC’s offices, or

hire or solicit CRC employees. Partners who violate the non-solicitation

agreement agree to pay certain financial penalties relative to the

category of violation. For example, for violations relating to clients the

violating partner must pay to CRC a penalty equal to a portion of the

28Because of the apparent omission of a conjunction, it is unclear whether the

exception carved out for Town PS imposes two limitations (i.e., that its capital account

must have a positive balance of at least $150,000 and that the loan from Clark PLLC

must be paid off entirely) or one (i.e., either of the two criteria). We assume the latter

and interpolate “or”.

29 Under the 2013 LLC Agreement, a prospective client is one with whom the

company has had direct communication within the 24 months before the partner’s

withdrawal.

18

[*18] client’s billings in the prior or subsequent year (depending on the

client’s status as current or prospective).

IV. Newman PLLC’s and Town PS’s withdrawal as partners

Effective May 1, 2013 (i.e., not quite four months after the

execution of the 2013 LLC Agreement), Newman PLLC and Town PS

withdrew as partners of CRC. Mr. Newman and Mr. Town thereafter

started their own CPA firm, practicing under the name of “Newman

Town, PLLC” (hereinafter, “NT PLLC”)

A. Book of business

Certain clients of CRC thereafter ceased engaging CRC and

retained the services of NT PLLC. That is, the withdrawing partners

took with them a “book of business”. We find (as the parties have

stipulated) that, under the terms of the 2013 LLC Agreement, the

“Client Value” of the clients that retained NT PLLC was $742,569, that

the portion of this total “Client Value” allocable to Newman PLLC was

$318,144, and that the portion allocable to Town PS was $424,425.

B. Civil litigation

The WTB Loan remained outstanding at the time Newman PLLC

withdrew from CRC. Pursuant to the guaranty that Mr. Clark signed,

Washington Trust Bank looked to Mr. Clark for repayment of the loan.

Mr. Clark thereafter filed a civil lawsuit in the King County

Superior Court of the State of Washington, suing Newman PLLC,

Mr. Newman, and Mr. Newman’s spouse, praying for relief in an

amount equal to the outstanding balance of the WTB Loan, with

interest. The parties engaged in arbitration and mediation, with

Mr. Town joining the proceedings some time thereafter.

In preparation for mediation, each party filed a “Statement of

Claims”. Among other items, Mr. Clark claimed that Messrs. Newman

and Town breached the 2013 LLC Agreement and their fiduciary duty

to CRC when they “took CRC clients . . . [and] competed against CRC”.

Mr. Clark’s statement sought relief for, among other things, the “value

of the practice grown by [Mr. Newman] at CRC”. 30 Messrs. Newman

30 Mr. Clark’s statement also requested relief for other items incident to

Newman PLLC’s and Town PS’s withdrawal from CRC that are not directly related to

the issue in this case.

19

[*19] and Town requested relief for compensation they argued was

outstanding from CRC.

C. Settlement

In October 2013, CRC, Mr. Clark, Clark PLLC, Mr. Newman,

Newman PLLC, Mr. Town, and Town PS agreed to settle the civil

lawsuit and arbitration and entered into a “Civil Rule 2A Agreement”

outlining the terms of the agreed settlement. In February 2014 they

executed a “General Release and Settlement Agreement” (“Settlement

Agreement”, 31 Ex. 33–J (Doc. 33, at 620)) to finalize the settlement

terms. 32 The Settlement Agreement acknowledged the 2013 LLC

Agreement that the parties had executed in January 2013 and settled

all claims relating to Mr. Newman’s and Mr. Town’s departure from

CRC and resolved all claims (known or unknown) that the parties

brought or could have brought in the civil lawsuit or arbitration

proceedings.

The Settlement Agreement stated that “Newman PLLC” and

“Town PS” would make the $200,000 capital contribution to CRC

(although it did not specify the denomination of capital contribution that

each entity would make—e.g., $100,000 each or otherwise).

The Settlement Agreement resolved the controversy about the

clients that Newman PLLC and Town PS had taken with them when

they withdrew from CRC. Clark PLLC had previously proposed an

“Agreement Regarding Client File Transfer Procedure”, which had

“anticipate[d] that certain clients of CRC [would] wish to have NT PLLC

provide accounting and tax service” and had set out the routine by which

31 The terms of the Settlement Agreement generally reflected the terms of the

Civil Rule 2A Agreement, but some provisions of the Settlement Agreement were more

specific. For example, the Settlement Agreement provided that “Newman, PLLC” and

“Town, PS” would make a $200,000 capital contribution to CRC, whereas the Civil Rule

2A Agreement simply stated that “Newman Town” would make such a capital

contribution.

32 The parties stipulated that all exhibits (including the Settlement

Agreement) could “be accepted as authentic . . . ; provided, however, that either party

[had] the right to object to the admission of any such . . . exhibits in evidence on the

grounds of materiality and relevancy, but not on other grounds unless expressly

reserved [therein]”. Neither party raised an objection regarding the admission of the

Settlement Agreement. Therefore, by failing to make a timely and specific objection

on the basis of Rule 408 of the Federal Rules of Evidence, CRC has waived its right to

contest the admission of the Settlement Agreement on that ground. See, e.g., Gilbrook

v. City of Westminster, 177 F.3d 839, 859 (9th Cir. 1999).

20

[*20] CRC would transfer client records, working papers, and working

files to NT PLLC. In the Settlement Agreement, NT PLLC agreed to

sign this transfer agreement and agreed not to provide accounting

services to any “current client of [CRC] for 2 years”. (Emphasis added.)

Each CRC partner-entity, former partner-entity, and their respective

individual partners signed the Settlement Agreement. As is noted

above, the parties to this case have stipulated that, under the terms of

the 2013 LLC Agreement, the “Client Value” of the clients that retained

NT PLLC was $742,569, of which $318,144 was allocable to Newman

PLLC and $424,425 was allocable to Town PS.

D. Adjustments to capital accounts

CRC made certain adjustments to the capital accounts of the

partners after the withdrawal of Newman PLLC and Town PS. CRC

first decreased Newman PLLC’s capital account by $419,043 and

decreased Town PS’s capital account by $447,437, to account for

property distributions that it reported to each of those partners. 33 It

then decreased Town PS’s capital account further by $150,000 and

increased Clark PLLC’s capital account by the same $150,000 (and later

reported this $150,000 capital account increase as a capital contribution

by Clark PLLC). 34 CRC did not adjust Newman PLLC’s or Town PS’s

capital account to reflect the allocations of any inherent gain in the

property distributions before decreasing the partners’ capital accounts

in the amounts of the distributions.

V. Realization of ordinary income

CRC realized $563,118 of ordinary business income for 2013. This

fact is not in dispute. Rather, the dispute is about how that income

should be allocated among CRC’s partners for tax purposes.

VI. CRC’s federal returns of partnership income

CRC is a calendar year taxpayer and filed as a partnership for

federal income tax purposes for 2011, 2012, and 2013. CRC was subject

to the TEFRA partnership procedures set forth in Code sections 6221–

6234 for the years 2011, 2012, and 2013. For each of these years,

See discussion infra p. 23 (regarding the reported distributions to Newman

33

PLLC and Town PS).

34 See discussion infra note 39 (regarding the reported capital contribution by

Clark PLLC).

21

[*21] Mr. Clark served as CRC’s tax return preparer, and the company

used a cash receipts and disbursements method of accounting.

A. 2011

CRC filed its 2011 Form 1065 in September 2012, and reported

that its partners were Clark PLLC, Town PS, and Benbow PS. On its

attached Schedule L, “Balance Sheets per Books”, CRC reported

$1,512,905 as its amount of intangible assets at the beginning of the

year, and zero as its amount of intangible assets at the end of the year.

22

[*22] The Schedules K–1, “Partner’s Share of Income, Deductions,

Credits, etc.”, issued to the partners reported the following information:

Clark PLLC Town PS Benbow PS

Beginning capital

$1,834,050 $466,146 $479,297

account balance

Capital

238,766 7,727 —

contributions 35

Income allocations

(net of deductions)

and other items (e.g., 665,014 129,920 148,909

nondeductible

expenses)

Distributions

Cash 549,329 102,653 113,922

Property 1,396,004 351,140 514,284

Ending capital

792,497 150,000 -0-

account balance 36

35 Neither Clark PLLC nor Town PS actually made in 2011 a capital

contribution equal to the reported contribution amounts. The upward adjustments to

Clark PLLC’s and Town PS’s capital accounts correspond to reductions in Benbow PS’s

capital account upon its withdrawal. CRC does not offer any explanation regarding

these adjustments.

36 Clark PLLC’s and Town PS’s reported ending capital account balances for

2011 resulted from the negotiation between Clark PLLC, Newman PLLC, and Town

PS. See discussion supra pp. 12–13. In computing the ending capital account balance

for each of the partners, CRC did not include the book value, fair market value, or tax

basis of any intangible assets, such as goodwill, client-based intangible assets, or

covenants not to compete.

23

[*23] B. 2012

CRC filed its 2012 Form 1065 in September 2013, and reported

that its partners were Clark PLLC, Newman PLLC, and Town PS. CRC

did not report any intangible assets on its Schedule L for 2012.

The Schedules K–1 issued to the partners reported the following

information:

Clark PLLC Town PS Newman PLLC

Beginning capital

$792,497 $150,000 —

account balance

Capital contributions — 10,000 200,000

Income allocations

(net of deductions)

and other items (e.g., 1,259,382 (1,817) (983) 37

nondeductible

expenses)

Distributions

Cash 903,585 61,545 164,045

Property 16,745 — —

Ending capital

1,131,549 96,638 34,972

account balance 38

This net figure includes, among other items, an allocation of a loss to

37

Newman PLLC in the amount of −$3,118.

38 In computing the ending capital account balance for each of the partners,

CRC did not include the book value, fair market value, or tax basis of any intangible

assets.

24

[*24] C. 2013

CRC filed its 2013 Form 1065 in September 2014, and issued

Schedules K–1 to Clark PLLC, Newman PLLC, and Town PS. CRC did

not report any intangible assets on its Schedule L for 2013.

The Schedules K–1 issued to the partners reported the following

information:

Clark PLLC Town PS Newman PLLC

Beginning capital

$1,131,549 $96,638 $34,972

account balance

Capital

150,000 100,000 100,000

contributions 39

Income allocations

(net of deductions)

and other items (e.g., 789,987 255,799 307,759

nondeductible

expenses)

Distributions

Cash 632,201 5,000 23,688

Property — 447,437 419,043

Ending capital

1,439,335 -0- -0-

account balance 40

39Clark PLLC did not in fact make a $150,000 capital contribution in 2013.

On CRC’s general ledger for the period January 1 through December 31, 2013, CRC

debited Town PS’s capital account by $150,000 and credited Clark PLLC’s capital

account by the same $150,000. CRC reported capital contributions by Newman PLLC

and Town PS in 2013 to reflect the $200,000 payment CRC received in March 2014

pursuant to the partners’ Settlement Agreement.

40 In computing the ending capital account balance for each of the partners,

CRC did not include the book value, fair market value, or tax basis of any intangible

assets.

25

[*25] VII. Newman PLLC’s and Town PS’s Forms 8082

In September 2014 Newman PLLC and Town PS each filed

Forms 8082, “Notice of Inconsistent Treatment or Administrative

Adjustment Request (AAR)”, with respect to CRC’s 2013 issued

Schedules K–1 that reported the following information: 41

Newman PLLC—Form 8082

Ordinary income Property

(loss) distributions

Schedule K–1 issued

$307,759 $419,043

to Newman PLLC

Form 8082 filed by

-0- 183,737

Newman PLLC

Town PS—Form 8082

Ordinary income Property

(loss) distributions

Schedule K–1 issued

$255,799 $447,437

to Town PS

Form 8082 filed by

5,000 -0-

Town PS

41 The Forms 8082 also reported variations in the guaranteed payments each

partner received, but neither the variations nor the guaranteed payments are

pertinent to this case. Newman PLLC’s Form 8082 reported a cash distribution

amount of $20,000 (compared to the $23,688 reported on its Schedule K–1), but the

parties have stipulated that the amount of cash distributed to Newman PLLC in 2013

was $20,000, and so we exclude that item from discussion. Newman PLLC also filed a

Form 8082 for the 2012 tax year, in which it contested CRC’s allocation of a loss of

−$3,118 to Newman PLLC. Instead, Newman PLLC reported an income allocation of

$167,872. The Commissioner contests the validity of CRC’s 2012 allocations of income

in his brief, and we address his contentions in our discussion below in note 67.

26

[*26] VIII. Proceedings before the IRS

A. CRC’s partnership-level proceeding

In response to Newman PLLC’s and Town PS’s filed Forms 8082,

the IRS conducted a partnership-level audit of CRC’s 2013 Form 1065.

On August 24, 2016, the IRS issued the Letter 1787–F, “TMP Notice of

Beginning of Administrative Proceedings”, to notify Clark PLLC that

the IRS was beginning an administrative partnership-level audit of

CRC’s 2013 Form 1065. On November 6, 2017, the IRS issued a

Letter 1827–F proposing adjustments to partnership items on CRC’s

2013 Form 1065 and notifying the TMP of its right to file a protest to

the IRS Appeals Office (“IRS Appeals”). 42

B. Notice of Final Partnership Administrative Adjustment

On December 17, 2018, IRS Appeals issued the TMP an FPAA

determining adjustments to CRC’s 2013 Form 1065.

The FPAA largely adjusted CRC’s reported property distributions

and income allocations consistently with the corrections proposed by

Newman PLLC and Town PS. 43 With regard to property distributions,

the IRS determined: (1) reported “client distributions” of $705,249 were

not distributions and should be disregarded, or, in the alternative, CRC

failed to substantiate the identities and the values of the clients

distributed (and it failed to show that CRC was capable of valuing the

clients distributed), and therefore the distributions should be

disregarded; and (2) a remaining distribution of $183,737 should be

disregarded because it was the result of a bank loan owed personally by

42 On July 10, 2017, Clark PLLC, as the TMP of CRC, signed a Form 872–P,

“Consent to Extend the Time to Assess Tax Attributable to Partnership Items”,

extending the period for assessing tax provided for in section 6229(a) to December 31,

2019, for the 2013 tax year.

43 The FPAA also determined certain adjustments to CRC’s reported ordinary

income, guaranteed payments, business deductions, and cash distributions, and that

CRC was liable for an accuracy-related penalty under section 6662(a). The parties

settled each of these issues before submitting their joint motion to submit the case

pursuant to Rule 122. See supra note 3.

27

[*27] a partner who subsequently defaulted. 44 The FPAA also

determined that

[CRC’s] reported allocation of [o]rdinary income [to

Newman PLLC and Town PS] had no substantial economic

effect, was not consistent year to year, and did not use the

allocation method described in Article 8 of the [2013 LLC

Agreement] . . . [and that] [t]he allocation of [o]rdinary

[i]ncome should be based on known amounts received by

the partners.

The FPAA determined that ordinary income should be allocated as

follows: $538,118 to Clark PLLC, $20,000 to Newman PLLC, and $5,000

to Town PS.

C. Newman PLLC’s and Town PS’s Forms 870–PT

In December 2017 Newman PLLC and Town PS executed

Forms 870–PT, “Agreement for Partnership Items and Partnership

Level Determinations as to Penalties, Additions to Tax and Additional

Amounts”, regarding CRC’s 2013 taxable year, and the IRS

countersigned in January 2018. Each Form 870–PT determined,

similarly to the FPAA, that the partner’s distributive share of ordinary

income should be allocated: $538,558 to Clark PLLC, $20,000 to Town

PS, and $5,000 to Newman PLLC. 45 (These agreements resolve the tax

consequences of the withdrawal for Town PS and Newman PLLC, so we

do not adjudicate here any claim by those entitles. Rather, at issue here

44 The FPAA also disregarded certain “silent distributions” of $80,000 reported

on the Form 1065. Although the parties do not address this item specifically in their

stipulations of settled issues, in their joint motion to submit the case pursuant to

Rule 122, the parties agree that the remaining legal issues in dispute are limited to

(1) “whether CRC made or was deemed to have made additional property distributions

to [Newman PLLC] and [Town PS (beyond the $183,737 property distribution to

Newman PLLC relating to the WTB Loan)] during 2013” and (2) “whether CRC’s

ordinary income allocations as reported on its 2013 Form 1065 had substantial

economic effect.” Therefore, we do not address whether the IRS’s determination

regarding “silent distributions” should be sustained or denied.

45 The Forms 870–PT thus stated Clark PLLC’s allocation as $538,558 rather

than $538,118 as in the FPAA, and they “swapped” the income allocation amounts for

Newman PLLC and Town PS that were determined in the FPAA—i.e., the FPAA

allocated $20,000 of income to Newman PLLC and $5,000 of income to Town PS, but

the Form 870–PT allocated $20,000 of income to Town PS and $5,000 of income to

Newman PLLC. We need not resolve these discrepancies.

28

[*28] are CRC’s income allocations that ultimately affect Clark PLLC

only.)

IX. Tax Court proceedings

CRC’s petition contesting the FPAA was timely filed in this Court

on January 30, 2019. The parties filed three stipulations of settled

issues, resolving their disagreements regarding multiple

determinations in the FPAA, and leaving the remaining issues for our

decision. The parties also filed a stipulation of facts and a supplement

to that stipulation. On January 5, 2021, the parties filed a joint motion

to submit the case pursuant to Rule 122, and we granted the motion on

January 27, 2021.

OPINION

I. Applicable legal principles

A. Jurisdiction to determine partnership items

Under the default rules of Treasury Regulation section 301.7701-

2(a) and (c)(1), noncorporate entities with more than one member (such

as LLCs) are treated as partnerships for federal tax purposes. 46 Because

CRC’s TMP filed the Petition for readjustment of partnership items

within 90 days of the Commissioner’s FPAA, we have jurisdiction under

section 6226(f) to determine all of CRC’s “partnership items” for 2013

and the proper allocation of those items among its partners.

Section 6231(a)(3) defines “partnership item” as “any item required to

be taken into account for the partnership’s taxable year under any

provision of subtitle A [sections 1–1563] to the extent regulations

prescribed by the Secretary provide that, for purposes of this subtitle,

such item is more appropriately determined at the partnership level”.

Treasury Regulation section 301.6231(a)(3)-1(a)(1)(i) provides that

partnership items include the partnership aggregate and each partner’s

share of items of income, gain, loss, deduction, or credit of the

partnership. Thus, the income allocations to partners that CRC

reported on its 2013 Form 1065 (and whether they have substantial

economic effect) are partnership items that are subject to

46 “A business entity with two or more members is classified for federal tax

purposes as either a corporation or a partnership . . . [and] [t]he term partnership

means a business entity that is not a corporation . . . and that has at least two

members.” Treas. Reg. § 301.7701-2(a), (c)(1).

29

[*29] redetermination in this partnership-level proceeding. Neither

party to this case contends otherwise.

B. Burden of proof

As a general rule, the Commissioner’s determinations in an FPAA

are presumed correct, and the taxpayer has the burden of proving them

incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933);

Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996).

The Commissioner, however, bears the burden of proof with respect to

any new matter, increase in deficiency, and affirmative defenses pleaded

in the answer. Rule 142(a). Petitioner does not allege that its burden

should shift to the Commissioner for any issue in this case, and thus,

petitioner bears the burden of proof.

C. Partnership intangible assets

Business entities may own intangible assets. See, e.g., Tomlinson

v. Commissioner, 58 T.C. 570, 580 (1972) (“We have long recognized that

these intangibles [including customer lists] are capital assets”), aff’d,

507 F.2d 723 (9th Cir. 1974); Topeka State J., Inc. v. Commissioner, 34

T.C. 205, 215, 221 (1960) (“It is well established that [subscription lists]

are an intangible asset of a newspaper [company]”). 47 Intangible assets

are generally included in the valuation of a partnership (and

partnership interest). See, e.g., Watson v. Commissioner, 35 T.C. 203,

208, 214 (1960) (holding that purchase price for partnership included

payment for tangible assets and goodwill); Tolmach v. Commissioner,

T.C. Memo 1991-538.

A “client-based intangible” asset (such as a customer list or “book

of business” 48) is one example of an intangible asset, and it may be

capable of valuation, distribution, and sale to third parties. See, e.g.,

Newark Morning Ledger Co. v. United States, 507 U.S. 546, 570 (1993)

(holding that a corporation proved that a customer list of “‘paid

47 The Code and the Treasury Regulations also anticipate that partnerships

will own intangible assets by providing an amortization deduction for the capitalized

costs of intangibles owned by the partnership (for federal income tax purposes), see

generally § 197, and requiring the inclusion of intangible assets in the valuation of a

transferred business interest (for federal gift tax purposes), see generally Treas. Reg.

§§ 1.197-2, 25.2512-3.

48 A “book of business” generally has value. See, e.g., Mitchell v. Garrison

Protective Servs., Inc., 819 F.3d 636, 641 (2d Cir. 2016) (affirming the district court’s

valuation of a book of business).

30

[*30] subscribers’ constitute[d] an intangible asset with an

ascertainable value and a limited useful life, the duration of which

[could] be ascertained with reasonable accuracy” for depreciation

purposes); JHK Enters., Inc. v. Commissioner, T.C. Memo. 2003-79, 85

T.C.M. (CCH) 1032, 1032 (“Among the assets received by [the partner]

in the liquidating distribution were client files, a client list, going

concern value (goodwill), and equipment”); Holden Fuel Oil Co. v.

Commissioner, T.C. Memo. 1972-45, 31 T.C.M. (CCH) 184, 187–89

(holding that where the taxpayer purchased customer lists from another

company it was entitled to an amortization deduction for a portion of the

amount paid), aff’d, 479 F.2d 613 (6th Cir. 1973).

The Commissioner disputes the existence of the client-based

intangible that petitioner asserts and CRC’s ability to distribute such

an asset, and we address that dispute below in Part II.A.

D. Substantial economic effect

1. General principles

Section 704(a) provides that the partnership agreement 49

generally determines a partner’s distributive share of partnership

income, gain, loss, deductions, or credits of the partnership. However,

the partners’ ability to allocate partnership items on a basis other than

the partners’ interests in the partnership (i.e., a non-pro rata “special

allocation”) is not unrestricted. Special allocations must have

substantial economic effect (as opposed to the mere avoidance of tax);

otherwise, the partners’ distributive shares of partnership items “shall

be determined in accordance with the partner’s interest in the

partnership (determined by taking into account all facts and

circumstances)”. § 704(b). The regulations under section 704(b)

describe in detail not only the circumstances in which a special

allocation will have “substantial economic effect” but also the manner of

determining a partner’s “interest in the partnership”.

The regulations provide that a special allocation of partnership

items is deemed to have economic effect if, in the event there is an

economic benefit or burden that corresponds to an allocation, the

partner to whom the special allocation is made receives a corresponding

benefit or bears a corresponding burden. See Treas. Reg.

49 The term “partnership agreement” includes all agreements among the

partners, or between one or more partners and the partnership, concerning affairs of

the partnership and responsibilities of partners. Treas. Reg. § 1.704-1(b)(2)(ii)(h).

31

[*31] § 1.704-1(b)(2)(ii)(a). A determination to this effect is made as of

the end of the partnership taxable year to which the allocation relates.

Treas. Reg. § 1.704-1(b)(2)(i). Moreover, the economic effect of the

special allocation must be substantial; this requires “a reasonable

possibility that the allocation (or allocations) will affect substantially the

dollar amounts to be received by the partners from the partnership,

independent of tax consequences.” Treas. Reg. § 1.704-1(b)(2)(iii)(a).

Determinations of substantial economic effect, as well as

determinations of a partner’s interest in the partnership, depend upon

an analysis of the partners’ capital accounts. See Treas. Reg. § 1.704-

1(b)(2)(iv)(a). Generally, a partner’s capital account represents the

partner’s equity investment in the partnership. The capital account

balance is determined by adding (1) the amount of money that the

partner contributes to the partnership, (2) the fair market value of other

property the partner contributes (net of liabilities to which the property

is subject or which are assumed by the partnership), and (3) any

allocations of partnership income or gain. Treas. Reg. § 1.704-

1(b)(2)(iv)(b). A partner’s capital account is decreased by (1) the amount

of money distributed to him by the partnership, (2) the fair market value

of property distributed to the partner (net of any liability that the

partner assumes or to which the property is subject), and (3) the

amounts of partnership losses and deductions allocated to the partner.

Id. An allocation of partnership items can have substantial economic

effect only if the partnership maintains capital accounts of the partners

in accordance with these rules. Id.

2. Tests for economic effect

The regulations governing special allocations provide three tests

for economic effect. Special allocations of items to a partner are deemed

to have economic effect if they meet the requirements of any one of these

alternative tests:

a. Basic test of economic effect

The basic test for economic effect is set forth in Treasury

Regulation section 1.704-1(b)(2)(ii)(b). The test provides, in general,

that a special allocation has economic effect if it is made pursuant to a

partnership agreement that contains provisions requiring: (1) the

determination and maintenance of partners’ capital accounts in

accordance with the rules of Treasury Regulation section 1.704-

1(b)(2)(iv); (2) upon liquidation of the partnership, the proceeds of

32

[*32] liquidation be distributed in accordance with the partners’ positive

capital account balances; and (3) upon liquidation of the partnership,

any partner with a deficit capital account balance is unconditionally

obligated to restore the amount of the deficit balance to the partnership

by the end of the taxable year (commonly referred to as a “deficit

restoration obligation” or “DRO”). Treas. Reg. § 1.704-1(b)(2)(ii)(b). This

test ensures that the economic benefits or burdens corresponding to any

given special allocation are borne by the partner receiving the allocation.

b. Alternate test of economic effect

Partnership agreements may provide for specific limits upon the

amount the limited partners are required to contribute to the

partnership. These limits on liability, however, are inconsistent with

the requirement in the basic test that each partner must agree to repay

the deficit balance (if any) in that partner’s capital account upon

liquidation. Consequently, the regulations include an “[a]lternate test

for economic effect”, which provides that special allocations of

partnership items may have economic effect even in the absence of a

deficit restoration obligation.

The alternate test begins by incorporating the first two parts of

the basic test. (That is, the partnership agreement must (1) provide for

properly maintained capital accounts and (2) provide that the proceeds

of liquidation will be distributed in accordance with the partners’

positive capital account balances.) However, instead of a negative

capital account makeup requirement, the alternate test mandates a

hypothetical reduction of the partners’ capital accounts. Specifically,

the alternate test requires that capital accounts be reduced, as of the

end of the year, for any allocation of loss or deduction or distributions

that, at that time, are reasonably expected to be made, to the extent that

such allocations or distributions exceed reasonably expected increases

to the partners’ capital account. 50 See Treas. Reg. § 1.704-1(b)(2)(ii)(d).

The alternate test also requires that the partnership agreement

provide for a QIO, i.e., a “qualified income offset”. A QIO provision

automatically allocates partnership income (including gross income and

gain) to a limited partner who has an unexpected negative capital

account, either as a result of partnership operations or as a result of

50 By requiring a prospective reduction of capital accounts, the alternate test

serves to preclude a limited partner from timing the receipt of deductible partnership

expenses in a way that would enable a partner to accumulate a negative capital

account that the partner need not repay.

33

[*33] making the adjustment for reasonably expected reductions. The

QIO must operate “in an amount and manner sufficient to eliminate

such deficit balance as quickly as possible.” Treas. Reg. § 1.704-

1(b)(2)(ii)(d) (flush text).

c. Economic equivalence test

There is a third economic effect test, referred to as the “economic

equivalence” test. Treasury Regulation section 1.704-1(b)(2)(ii)(i)

provides that, if an allocation would produce the economic equivalent of

meeting the basic test for economic effect, it will be deemed to have

economic effect even if it does not otherwise meet the formal

requirements of the basic test. We address this issue below in

Part II.B.3.

E. Partner’s interest in the partnership

Section 704(b) provides that an allocation of partnership income,

gain, loss, deductions, or credit (or item thereof) that does not have

substantial economic effect will be “determined in accordance with the

partner’s interest in the partnership”. A “partner’s interest in the

partnership” is defined as the “manner in which the partners have

agreed to share the economic benefit or burden (if any) corresponding to

the income, gain, loss, deduction, or credit (or item thereof) that is

allocated.” Treas. Reg. § 1.704-1(b)(3)(i). The partners’

sharing arrangement may or may not correspond to the

overall economic arrangement of the partners. . . . [I]n the

case of an unexpected downward adjustment to the capital

account of a partner who does not have a deficit make-up

obligation that causes such partner to have a negative

capital account, it may be necessary to allocate a

disproportionate amount of gross income of the partnership

to such partner for such year so as to bring that partner’s

capital account back up to zero.

Id. Accordingly, an examination of a partner’s interest in the

partnership “shall be made by taking into account all facts and

circumstances relating to the economic arrangement of the partners.”

Id. Among the relevant factors to be taken into account in determining

the partners’ interests in the partnership are: (1) the partners’ relative

contributions to the partnership, (2) the interests of the respective

partners in profits and losses (if different from that in taxable income or

loss), (3) the partners’ relative interests in cash flow and other non-

34

[*34] liquidating distributions, and (4) their rights to distributions of

capital upon liquidation. 51 Treas. Reg. § 1.704-1(b)(3)(ii).

We address the Commissioner’s contentions as to a “partner’s

interest in the partnership” below in Part II.C.

F. Partnership distributions

The basic capital accounting rules in Treasury Regulation

section 1.704-1(b)(2)(iv)(b) require that partners’ capital accounts be

decreased by the fair market values of property distributed to them by

the partnership. Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1). If property is in

fact distributed, then these rules must be applied even if the partners

and the partnership overlook the distribution or attempt to impose

another characterization on it. See, e.g., Seay v. Commissioner, T.C.

Memo. 1992-254, 63 T.C.M. (CCH) 2911, 2913 (holding that the taxpayer

received a distribution of partnership assets when he withdrew cash

from the partnership, despite claiming that his withdrawals were loans

from the partnership). To satisfy this requirement, the capital accounts

of the partners first must be adjusted to reflect how any unrealized52

income, gain, loss, and deduction inherent in the property (not already

reflected in the capital accounts) would be allocated among the partners

if there were a taxable disposition of the property for its fair market

value (colloquially referred to as a “book-up”). Treas. Reg. § 1.704-

1(b)(2)(iv)(e)(1).

51 “Liquidation” includes both the liquidation of the partnership and the

liquidation of the partner’s interest. Treas. Reg. § 1.704-1(b)(2)(ii)(g).

52 Gain is defined as the excess of the amount realized from a sale or other

disposition of property over the taxpayer’s adjusted basis in the property. § 1001(a).

An amount realized is the sum of money or fair market value of property received from

the sale or other disposition of the property. § 1001(b). “Realization” of these amounts

typically occurs when the transferor is in receipt of cash or property, but realization

may also occur when the last step is taken by the transferor by which he obtains the

fruition of the economic gain which has already accrued to him. Helvering v. Horst,

311 U.S. 112, 115 (1940). A taxpayer’s basis in an asset is generally its cost of acquiring

the property. § 1012. The basis of property contributed to a partnership by a partner

is the adjusted basis of the property to the contributing partner at the time of the

contribution (adjusted for any gain recognized by the contributing partner). § 723. In

the case of intangible assets, basis includes amounts that are required to be

capitalized, such as amounts paid to create or enhance an intangible asset. Treas. Reg.

§ 1.263(a)-4(b)(1), (g)(1). “Unrealized gain”, therefore, refers to the excess of the fair

market value of property over its basis (i.e., its appreciation in value) at a point before

a realization event (before it is disposed of). See, e.g., Treas. Reg. § 1.704-1(b)(5)

(example 14).

35

[*35] The fair market value assigned to property contributed to,

distributed by, or otherwise revalued by a partnership will be regarded

as correct, provided that (1) the value is reasonably agreed to among the

partners in arm’s-length negotiations and (2) the partners have

sufficiently adverse interests. Treas. Reg. § 1.704-1(b)(2)(iv)(h)(1). The

determination of fair market value is a question of fact. S. Tulsa

Pathology Lab’y, Inc. v. Commissioner, 118 T.C. 84, 101 (2002).

We address in Part II.A–C the parties’ contentions as to the

existence of “client-based intangibles”, the presence of “unrealized gain”

inherent in those intangibles, and the corresponding “book-up” of the

partners’ capital accounts.

II. Analysis

A. Distribution of client-based intangibles to Newman PLLC

and Town PS in 2013

The FPAA determined that CRC’s reported “client distributions”

were not distributions and should be disregarded. In the alternative,

the IRS determined that the “client distributions” had not been

substantiated as to the clients distributed, their overall value, or CRC’s

ability to value each client distributed. In response, petitioner argues

that “goodwill” is an asset of CRC and that when Newman PLLC and

Town PS “took clients from CRC”, they effected a distribution of goodwill

from CRC to each of them. CRC aptly cites Rudd v. Commissioner, 79

T.C. 225, 238 (1982), in which we stated:

The goodwill of a public accounting firm can

generally be described as the intangibles that attract new

clients and induce existing clients to continue using the

firm. These intangibles may include an established firm

name, a general or specific location of the firm, client files

and workpapers (including correspondence, audit

information, financial statements, tax returns, etc.), a

reputation for general or specialized services, an ongoing

working relationship between the firm’s personnel and

clients, or accounting, auditing, and tax systems used by

the firm.

The client-based component of such generalized “goodwill” is the asset

at issue here.

36

[*36] To further support its argument that goodwill was a partnership

asset, petitioner alleges that “[t]he partners agreed to transfer their

goodwill to CRC as part of a deal in which they received their interest

in the partnership and specifically, they received an AAV deferred

compensation balance.” The Commissioner rebuts this argument by

pointing to a lack of evidence that the partners contributed any

intangible assets to the partnership 53 and by arguing that CRC could not

“distribute” goodwill to Newman PLLC and Town PS when clients

decided (of their own free will) to cease engaging CRC and instead retain

the services of NT PLLC.

Taking into consideration the terminology used in the FPAA (i.e.,

“client distribution”), it is clear to us that, although both parties

intermittently refer to a contribution to and distribution of general

“goodwill” from CRC, at issue in this case is a distribution of CRC’s

clients or a client list in particular, both of which we refer to as the

“client-based intangibles”. Client lists and other client-based

intangibles have value. See, e.g., Newark Morning Ledger Co., 507 U.S.

at 570; Holden Fuel Oil Co., 31 T.C.M. (CCH) at 187–89. This value can

exist even where the client is not contractually bound to keep bringing

his business. See Aitken v. Commissioner, 35 T.C. 227, 230–31 (1960)

(holding that insurance contract “expirations”, which did not guarantee

renewal of an insurance contract, but contained client and policy

information and were analogous to customer lists, goodwill, or just

intangibles in the nature of goodwill, constituted valuable capital assets

capable of transfer); see also Holden, 31 T.C.M. at 184–85, 187

(“[Although] customers [on a customer list] were not obligated to

purchase fuel oil from [the taxpayer] . . . [i]n acquiring the list [the

taxpayer] was afforded the opportunity of contacting persons who were

known to be using fuel oil to heat their homes and who were in the need

of a new supplier; clearly providing [the taxpayer] with a valuable

asset.”). Business entities, such as limited liability companies, may own

and distribute such intangible assets. See, e.g., JHK Enters., Inc.,

8T.C.M. (CCH) at 1032. CRC could therefore hold and distribute such

assets, and although the evidence does not support that Newman PLLC

and Town PS either contributed client-based intangibles to CRC or

53 We take as true the Commissioner’s point that Town PS did not contribute

an intangible to the partnership because Town PS in fact bought its interest in CRC

not by direct contribution to CRC but rather by purchasing it from Clark PLLC (at a

discount that Clark PLLC allowed in view of the value of Town PS’s book of business).

However, this fact does not at all undermine the fact (which we have found) that Town

PS required and Clark PLLC gave compensation for the value of Town PS’s book of

business.

37

[*37] transferred client-based intangibles in exchange for their AAV

account, the evidence does support CRC’s ownership of client-based

intangible assets capable of valuation and distribution.

CRC’s dealings demonstrate that it and its partners understood

that a partner’s “book of business” consisting of current clients would be

valued upon entry of a partner and charged for upon withdrawal. For

example, when Benbow PS withdrew from CRC, its capital account was

reduced to zero to reflect the distribution of CRC clients to Benbow PS.

Similarly, when Town PS joined CRC as a partner, Clark PLLC and

Town PS calculated the price that Town PS would pay to Clark PLLC

for 25% of its interest in CRC by adding up the values of CRC’s assets,

multiplying the total by 25% (the amount of Town PS’s anticipated

partnership interest) and then subtracting from that total an amount

(i.e., $234,046) that was equal to the prior year’s revenue generated from

Mr. Town’s “book of business”. The record also contains an exhibit

entitled “John’s Buy-in Calculation” relating to the price for Town PS’s

purchase of a 25% partnership interest from Clark PLLC. This

document was contemporaneously used to determine the purchase price

of Town PS’s partnership interest in CRC, and it reflects the same

purchase price discount with the label “[a]greed upon value of John’s

book brought in”.

The 2013 LLC Agreement’s distribution provisions likewise treat

clients as a valuable partnership asset. Section 9.3(b) of the 2013 LLC

Agreement (like Section 9.3(b) of the 2012 LLC Agreement and Section

8.3(b) of the 2009 LLC Agreement) states that “[i]f any Clients are

Distributed . . . the value of such Client shall be the Client Value”,

defined as gross revenue invoiced to the client over the prior 12 months.

Although the 2013 LLC Agreement as executed in 2012 and reaffirmed

in 2013 lacks the express client distribution provision of Section

11.1(a)(i) of the 2009 LLC Agreement, the partners agreed to Section

9.3(b) when they executed the 2013 LLC Agreement, and neither party

argues we should disregard their agreement to this effect. In some

cases, we might ignore an agreed-upon valuation method where there

was evidence of collusion between the partners; but here the partners’

interests were adverse at the time they agreed to the 2013 LLC

Agreement. Plainly, the partners were negotiating at arm’s length the

terms of Clark PLLC’s buyout.

Consequently, we hold that CRC’s method for valuing client-

based intangibles upon the withdrawal of Newman PLLC and Town PS

comports with the fair market value definition of Treasury Regulation

38

[*38] section 1.704-1(b)(2)(iv)(h)(1). In the absence of any competing

valuation presented by the Commissioner, or any critique of this

valuation, we accept it as correct.

As is stated above, under the terms of the 2013 LLC Agreement,

the “Client Value” of the clients that retained NT PLLC was $742,569,

of which $318,144 was allocable to Newman PLLC and $424,425 was

allocable to Town PS. We therefore hold that petitioner has met its

burden to prove that there was a distribution of clients, and that, on the

evidence before us, 54 CRC did in fact distribute client-based intangible

assets of $318,144 to Newman PLLC and $424,425 to Town PS when

certain clients left CRC and engaged NT PLLC following Newman

PLLC’s and Town PS’s withdrawals.

Obviously, this was not a textbook instance of a partnership

distribution, labeled as such by agreement of the parties when the

partner withdrew. Rather, CRC initially contended that the taking of

property (i.e., the clients) was wrongful and was a breach of the 2013

LLC Agreement. We can imagine a circumstance in which a partner’s

taking of property from a partnership was outright robbery; and in such

a circumstance it might be treated for tax purposes not as a distribution

but as a theft, perhaps deductible on the partnership return as a theft

loss under section 165(e) and includible as ordinary income to the

partner. See James v. United States, 366 U.S. 213, 219 (1961). But here

the partners and the partnership had a disagreement about the

entitlement to the property, and before the end of the tax year, they

agreed to a settlement of their dispute under which the partners would

be entitled to keep the property they had taken. We conclude we should

accept their agreed-upon resolution of the dispute and should apply the

provisions of the Code pertinent to that characterization. Neither party

to this case argues that it should instead be treated as a theft. The

ultimately agreed-upon transfer of the client-based intangibles is best

understood as a distribution.

The Commissioner argues, in effect, that the transfer of the client-

based intangibles should be ignored as non-factual, because (he says)

the intangibles did not exist and were not transferred. For the reasons

54 We do not hold that client-based intangibles always exist in a partnership,

nor that they always have value, nor that a withdrawing partner who thereafter serves

former clients of the partnership always receives a distribution from the partnership.

But we conclude that, in this case, the evidence warrants those holdings.

39

[*39] stated above, we reject that approach. The Commissioner also

presents an alternative argument:

Having structured the economic deal that goodwill was not

a partnership asset, petitioner is bound by the treatment

the parties negotiated. A taxpayer, although free to

structure his transaction as he chooses, “once having done

so, he must accept the consequences of his choice, whether

contemplated or not . . . and may not enjoy the benefit of

some other route he might have chosen to follow but did

not.” Comm’r v. National Alfalfa Dehydrating & Milling

Co., 417 U.S. 134, 149 (1974) (citations omitted). To

disavow the LLC Agreement’s treatment of goodwill,

petitioner must present strong proof that the LLC

Agreement was wrong.

But the partners of CRC did not negotiate a deal that clients were not a

value that could be brought into the firm and taken out of it. Rather,

the partners took into account an entering partner’s book of business in

determining on what terms the partner would enter the partnership;

and Section 5.1 of the 2013 LLC Agreement acknowledges that CRC

“expended substantial time and funds in developing . . . the Company’s

clientele and their patronage”; Section 1.6 postulates a “goodwill value

of the Company” (used for calculating AAV rights); and it expressly

makes provision (in Section 9.3(b)) for “Clients [to be] Distributed under

this Agreement” and (in Section 1.19) for the “Client Value” to be

determined. When Newman PLLC and Town PS did withdraw, they

took clients with them, and the parties executed an “Agreement

Regarding Client File Transfer Procedure”.

It is true that the 2013 LLC Agreement does not make express

provision for goodwill to be contributed by a partner and included in his

capital account, but that silence does not amount to an agreement that

client-based intangibles do not exist and cannot be transferred. It is also

true that CRC failed to reflect intangible values in partners’ capital

accounts (and that is part of the reason that we hold below that CRC’s

special allocation fails the tests for economic effect, see infra Part II.B);

but a partnership’s failure to reflect an asset on its books does not make

the asset cease to exist. If a partnership fails to book its cash (to choose

an extreme instance), a distribution of that unbooked cash is still a

distribution. Treating the distribution of the client-based intangibles as

a distribution does not (in the words of the Commissioner’s brief quoted

above) require “disavow[ing] the LLC Agreement’s treatment of

40

[*40] goodwill”. Rather, it requires invoking and giving effect to the

express terms of Section 9.3(b).

B. Lack of substantial economic effect in 2013 income

allocations

Having held that CRC distributed client-based intangible assets

to Newman PLLC and Town PS upon their withdrawal as partners, we

now turn to CRC’s allocation of income to Newman PLLC and Town PS,

which the IRS determined did not have substantial economic effect.

Petitioner argues that Newman PLLC’s and Town PS’s capital

accounts, which had initial balances of $34,972 and $96,638

respectively, were driven negative by subtracting the value of the clients

distributed to them. These negative capital account balances “triggered”

the QIO provision of the 2013 LLC Agreement and required that CRC

allocate income to Newman PLLC and Town PS in 2013 in amounts

sufficient to restore their capital account balances to zero. CRC argues

that its income allocations have substantial economic effect because

they are consistent with the economic arrangement of the partners in

the 2013 LLC Agreement.

We first examine whether the income allocation at issue satisfies

any of the tests under Treasury Regulation section 1.704-1(b)(2)(ii), so

that it is deemed to have economic effect.

1. The allocation fails the basic test.

The basic test for economic effect requires (in part) that the

partnership agreement contain a deficit restoration obligation. The

2013 LLC Agreement contains no such provision and in fact explicitly

states that “this Agreement shall not be construed as creating a deficit

restoration obligation or otherwise personally obligating any Member to

make a capital contribution in excess of those required by [a section

detailing initial and additional capital contributions].” (Emphasis

added.) Without a deficit restoration obligation in the 2013 LLC

Agreement, the special allocation cannot satisfy the basic test for

economic effect. See Treas. Reg. § 1.704-1(b)(2)(ii)(b).

2. The allocation meets the criteria of the alternate test

but does not have economic effect.

The alternate test requires that the partnership agreement

provide: (1) for the determination and maintenance of partners’ capital

41

[*41] accounts in accordance with Treasury Regulation section 1.704-

1(b)(2)(iv); (2) that upon liquidation of the partnership, the proceeds of

liquidation be distributed in accordance with the partners’ positive

capital account balances; (3) that capital accounts be reduced for any

allocation of loss or deduction or distributions that, as of the end of the

year, are reasonably expected to be made, to the extent that such

allocations or distributions exceed reasonably expected increases to the

partners’ capital account; and (4) for a QIO provision. Treas. Reg.

§ 1.704-1(b)(2)(ii)(d).

The 2013 LLC Agreement does contain provisions that (1) require

maintenance of capital accounts in accordance with Treasury

Regulation section 1.704-1(b)(2)(iv), (2) require liquidation distributions

in accordance with partners’ positive capital account balances,

(3) require reductions for reasonably expected allocations or

distributions, and (4) implement a QIO. However, the special allocation

of income cannot have economic effect because, as we explain below,

CRC did not actually maintain the capital accounts of its partners in

accordance with the 2013 LLC Agreement and Treasury Regulation

section 1.704-1(b)(2)(iv) (“[A]n allocation of income, gain, loss, or

deduction will not have economic effect . . . unless the capital accounts

of the partners are determined and maintained throughout the full term

of the partnership in accordance with the capital accounting rules”

(emphasis added)).

The Commissioner asserts persuasively that CRC failed to

maintain capital accounts in accordance with Treasury Regulation

section 1.704-1(b)(2)(iv) because, before distributing those assets, CRC

did not increase the partners’ capital accounts by the value of the

unrealized gain55 inherent in the client-based intangible assets. See

Treas. Reg. § 1.704-1(b)(2)(iv)(e)(1). In response, petitioner argues that

the client-based intangibles did not have unrealized gain because the

partners transferred their “goodwill” (at fair market value) to CRC in

exchange for their AAV account balances, such that the value of that

goodwill resided in the AAV account. Petitioner further argues that the

partners’ AAV accounts control the allocation of any taxable gain on the

sale of the client-based intangibles and that, in effect, “[section] 704 and

its regulations do not apply because [the section] 704 book-up only

55 See supra note 52. With his assertion, the Commissioner necessarily

assumes that a client-based intangible asset may indeed bear unrealized gain, and we

therefore adopt his assumption.

42

[*42] applies to capital accounts and not AAV accounts (which are

deferred compensation liability accounts).”

As we have discussed, petitioner has not shown that the partners

ever actually contributed “goodwill” or client-based intangibles to CRC 56

(or exchanged client-based intangibles for an AAV account), or, if such a

contribution (or exchange) did occur, the value of the assets at that time.

Neither does it cite any authority (controlling or otherwise) to support

its position regarding the AAV accounts and the inapplicability of

section 704(b), so we cannot accept its position. Indeed, AAV accounts

(used here by CRC as a method of calculating deferred compensation

payable to retiring partners) are not capital accounts, and we are

unaware of any authority relieving CRC from its capital account

maintenance responsibilities simply because it used such a mechanism.

We must therefore examine whether the client-based intangible assets

that Town PS and Newman PLLC received contained unrealized gain,

and if so, whether CRC failed to increase the partners’ capital accounts

by such unrealized gain before the distribution to Newman PLLC and

Town PS.

The FPAA determined that the income allocation lacked

substantial economic effect, and so the burden is on Clark PLLC, as

petitioner, to prove that such allocation did have substantial economic

effect. It necessarily follows that, under an analysis of the economic

effect of the income allocation, one element of petitioner’s burden is to

prove that CRC maintained capital accounts in accordance with

Treasury Regulation section 1.704-1(b)(2)(iv). This burden includes

56 As we have mentioned, Clark PLLC discounted the purchase price of Town

PS’s partnership interest for the“[a]greed upon value of John’s book brought in”. This

discount by itself is insufficient to establish that Town PS contributed its “book of

business” or “clients” to CRC because Town PS did not make a capital contribution to

CRC to acquire its partnership interest; rather, it purchased its interest from Clark

PLLC. We interpret the discount as the value that Clark PLLC (the seller in that

transaction) must have placed on the future benefit it would realize from its

distributive share of income generated by Town PS’s book of business, and not as an

indication that Town PS was somehow contributing its clients to CRC. Our

interpretation is further supported by the fact that CRC credited Town PS’s capital

account with an initial balance equal to the discounted purchase price of its

partnership interest (i.e., Town PS’s initial capital account balance was not increased

for contribution of a “book of business”, see Treas. Reg. § 1.704-1(b)(2)(iv)(b)). That is,

when the discount reduced Town PS’s purchase price of $872,996 by $234,046, for a

final purchase price of $639,000, CRC set Town PS’s initial capital account balance not

at $872,996 (as if Town PS had contributed the cash and a client-based intangible) but

rather at $639,000 (the amount of cash only).

43

[*43] proving that CRC increased the capital accounts in accordance

with subdivision (iv)(e)(1), or, in the alternative, proving that the client-

based intangible asset lacked any unrealized gain. Petitioner does not

argue that this burden should shift to the Commissioner.

To determine whether the client-based intangible asset contained

unrealized gain, we must determine the partnership’s adjusted basis in

the asset. See § 1001(a). Petitioner made no showing of the cost to

acquire or develop the client-based intangible assets, see Treas. Reg.

§ 1.263(a)-4(g)(1), or (tangential to its argument that partners

“exchanged” or “contributed” the assets to CRC) the partners’ adjusted

bases in the client-based intangibles before their alleged contribution,

see §§ 723, 732. We hold that petitioner has failed to prove CRC’s

adjusted basis in the client-based intangibles distributed to Newman

PLLC and Town PS, and we therefore assign zero-dollar bases to these

assets. 57 Accordingly, with a collective fair market value of $742,569

and a zero-dollar basis, the unrealized gain in the distributed client-

based intangibles is $742,569. See § 1001(a).

The parties have stipulated that the partners’ opening capital

account balances in 2013 did not include the value of any intangibles

and that CRC did not increase the partners’ capital accounts by the

value of any inherent gain in the client-based intangibles. Therefore,

CRC failed to maintain the partners’ capital accounts in accordance with

Treasury Regulation section 1.704-1(b)(2)(iv), 58 and the special

allocation accordingly cannot satisfy the alternate test for economic

effect. The allocation will therefore be deemed to have economic effect

only if it is able to satisfy the third test—the economic equivalence test.

57In the absence of proof of basis by CRC (the party with the burden of proof),

we assume zero basis because that would be the finding adverse to CRC. If we found

instead that the client-based intangible assets had bases equal to their fair market

values at the time of transfer (despite the fact that CRC did not produce evidence to

support it), the assets would not have had built-in gain that CRC would have been

required to allocate among the partners’ capital accounts before distribution. In such

circumstance, it is possible that we would have held that CRC had maintained its

capital accounts in accordance with the Treasury Regulation § 1.704-1(b)(2)(iv) and,

therefore, that CRC’s allocations of income had economic effect. A holding of economic

effect would conflict with the IRS’s determination in the FPAA that the allocations

lacked substantial economic effect, and CRC has the burden to disprove that

determination.

58 The fact that the partners “agreed” to their capital account balances incident

to negotiations might suggest that CRC did not strictly adhere to the capital

accounting rules of Treasury Regulation § 1.704-1(b)(2)(iv). See supra pp. 12–13.

44

[*44] 3. The allocation does not have economic equivalence.

In some cases, despite not adhering to the formal requirements of

the economic effect tests, an allocation may produce the same income

tax results as if the allocation had satisfied the requirements of the basic

test. Treas. Reg. § 1.704-1(b)(2)(ii)(i). Petitioner has neither argued nor

demonstrated that the special allocation satisfies the economic

equivalence test. 59 Therefore, the allocations have neither economic

equivalence nor economic effect.

The substantial economic effect analysis under Treasury

Regulation section 1.704-1(b)(2)(i) has two parts: first, the allocation

must have economic effect, and second, the economic effect of the

allocation must be substantial. Because we have determined that CRC’s

allocations of income to Newman PLLC and Town PS do not have

economic effect, we do not conduct an analysis of substantiality. 60

C. Partner’s interest in the partnership

Having determined that CRC’s allocations of income to Newman

PLLC and Town PS lack substantial economic effect, we must

redetermine the allocations in accordance with “the partners’ interests

in the partnership”. Treas. Reg. § 1.704-1(b)(1)(i). In this analysis, we

must determine the “manner in which the partners have agreed to share

the economic benefit or burden (if any) corresponding to the income,

gain, loss, deduction, or credit (or item thereof) that is allocated”, taking

into account all the facts and circumstances. Treas. Reg. § 1.704-

1(b)(3)(i). To do so, the regulation calls on us to examine (1) the partners’

relative contributions to the partnership, (2) the interests of the

respective partners in profits and losses (if different from that in taxable

income or loss), (3) their relative interests in cash flow and other non-

liquidating distributions, and (4) their rights to distributions of capital

59 CRC’s failure to increase the capital accounts by the unrealized gain in the

client-based intangibles before distribution resulted in incorrect capital account

balances (before distribution) for each partner in 2013. Therefore, its income

allocations were not based on correct capital account balances and cannot have

economic equivalence because the resulting amounts of income allocated per partner

differ from those resulting from an application of the basic test for economic effect.

60 The Commissioner stated that if the Court were to find economic effect, then

he “does not dispute that the economic effect of the allocations was substantial.”

45

[*45] upon liquidation. 61 Treas. Reg. § 1.704-1(b)(3)(ii). Petitioner does

not offer any argument regarding the analysis of “the partner’s interest

in the partnership” or the individual factors set out in the regulation.

The terms of the 2013 LLC Agreement ostensibly complied with

the criteria of the alternate test for economic effect, but the special

allocation lacked substantial economic effect because the partnership

failed to correctly maintain capital accounts in accordance with those

terms and with the regulations. 62 We proceed with examining the

relevant factors, keeping in mind that our goal is to derive the “manner

in which the partners have agreed to share the economic benefit or

burden (if any) corresponding to the income, gain, loss, deduction, or

credit (or item thereof) that is allocated”, Treas. Reg. § 1.704-1(b)(3)(i)

61 Treasury Regulation § 1.704-1(b)(3)(iii) provides that if the first two

requirements of the basic test are met (i.e., that the partnership agreement provides

for (1) the determination and maintenance of the partners’ capital accounts in

accordance with the capital account rules and (2) liquidating distributions to be made

in accordance with the positive capital account balances of the partners), then “the

partners’ interests in the partnership with respect to the portion of the allocation that

lacks economic effect will be determined” with a comparative liquidation analysis. See,

e.g., Interhotel Co. v. Commissioner, T.C. Memo. 2001-151, 81 T.C.M. (CCH) 1804,

1809, supplementing T.C. Memo. 1997-449. However, neither party argues that this

comparative liquidation test should govern our analysis (in fact, the Commissioner

argues explicitly that it should not apply, and CRC does not contest the

Commissioner’s argument), so we do not address it.

62 In some of the cases that have employed a partner’s interest in the

partnership analysis, the Court has examined the actual distributions received by the

partners (and other similar items) to determine the partners’ interests in the

partnership because the partnerships lacked written partnership agreements. See,

e.g., Holdner v. Commissioner, T.C. Memo. 2010-175, 100 T.C.M. (CCH) 108, 116–17,

aff’d, 483 F. App’x 383 (9th Cir. 2012); Estate of Ballantyne v. Commissioner, T.C.

Memo. 2002-160, 83 T.C.M. (CCH) 1896, 1904–06, aff’d, 341 F.3d 802 (8th Cir. 2003).

In other cases the partnership agreement lacked the provisions for capital account

maintenance or distributions in liquidation of the partnership under Treasury

Regulation § 1.704-1(b)(2)(ii)(b)(1) and (2), or the allocations prescribed by the

partnership agreement lacked substantial economic effect, and so the Court relied

heavily on the history of the partners’ relative contributions (or the impact of the

partners’ relative contributions on prospective liquidating distributions) to determine

the partners’ interests in the partnership. See, e.g., Estate of Tobias v. Commissioner,

T.C. Memo. 2001-37, 81 T.C.M. (CCH) 1163, 1169–71; PNRC Ltd. P’ship v.

Commissioner, T.C. Memo. 1993-335, 66 T.C.M. (CCH) 265, 268, 270. In this case,

however, the partnership did have a written partnership agreement, and that written

agreement did have provisions of the sort that, in other cases, were lacking and had to

be inferred or hypothesized.

46

[*46] (emphasis added), and that the 2013 LLC Agreement is evidence

of such agreement.

1. The partners’ relative contributions to the

partnership

The record is insufficient to chronicle the entire history of the

partners’ contributions to CRC, and so we are unable to conduct a

complete evaluation of their relative contributions. 63 Town PS

purchased its interest in CRC from Clark PLLC for $639,000 in 2009

and contributed $10,000 in 2012, and Newman PLLC contributed

$200,000 in 2012, but we are lacking information regarding Clark

PLLC’s contributions. Although we lack sufficient information to

calculate overall contributions, the economic reality evidenced by the

partners’ relative ownership of membership “units” in CRC is that Clark

PLLC owned the largest percentage and therefore likely made the

largest “contribution” of his business. 64 Consistent with this economic

reality, the Commissioner reckons Clark PLLC’s “Percentage of total

capital accounts” as 69%, but he “provide[s] more weight to the other

factors”. As a proxy for partners’ contributions, he uses partners’

account balances, but this may understate Clark PLLC’s dominance.

63 The Commissioner proposes that the partners’ capital contributions are

equal to each partner’s 2012 capital account balance, following Newman PLLC’s

capital contribution of $200,000, but he offers no explanation in support of that

suggestion. We cannot understand the Commissioner’s reasoning in suggesting these

balances to represent the parties’ capital contributions and therefore do not accept his

proposal. While capital accounts are generally intended to represent a snapshot of the

partners’ equity in the partnership (adjusted to reflect the operations of the

partnership), Interhotel, 81 T.C.M. (CCH) at 1807, an analysis of the partners’ capital

contributions for the purpose of the partner’s interest in the partnership analysis

involves a comparison of the partners’ historical contributions, see, e.g., PNRC Ltd.

P’ship, 66 T.C.M. (CCH) at 270. By using a snapshot of the partners’ capital account

balances instead of a historical record of the partners’ contributions, the Commissioner

supplants actual contributions by the parties with a value that may reflect

contributions but may also reflect various distributions and other adjustments

throughout the operation of the partnership; therefore, he fails to analyze the correct

criterion for this step of the analysis.

64 See supra pp. 15–16. Clark PLLC’s initial contribution consisted of

“[f]ormation costs, contribution of property from predecessor Company, and buy-out of

former Members (including inventory, business assets and equipment, goodwill and all

other tangible and intangible property) and other amounts shown on the books of the

Company”, and Newman PLLC’s and Town PS’s initial capital contributions (beyond

the $200,000 in cash contributed by Newman PLLC) were said to consist of “amounts

as shown on the books of the Company”.

47

[*47] 2. The interests of the partners in economic profits and

losses

The 2013 LLC Agreement clearly enumerates the criteria for

allocating income to each of the partners, and we follow the 2013 LLC

Agreement to make our analysis. 65

The 2013 LLC Agreement allocates income according to a three-

step formula. The first step (in Section 8.1(a)) allocates income equal to

10% of the “Tangible Net Worth” reflected in each partner’s capital

account balance to the respective partner. On the basis of the 2013 LLC

Agreement’s definition of “Tangible Net Worth” and the partnership’s

notable exclusion of intangible assets from the partners’ capital

accounts, we understand this first step to allocate an amount of income

to each partner equal to 10% of such partner’s positive capital account

balance. The second step (in Section 8.1(b)) then allocates income to

Clark PLLC for amounts collected on accounts receivable (which the

parties have stipulated was $15,387 in 2013). Third, Section 8.1(c)

allocates the remaining income according to the FMG system, which the

parties have stipulated should be allocated fully to Clark PLLC for 2013.

The first step in the formula under Section 8.1 allocates a portion

of income to the partners’ capital accounts in accordance with their

positive capital account balances. Therefore, an income allocation

analysis necessarily begins with the capital accounts balances of the

partners, as adjusted for allocations, distributions, and other

adjustments as stipulated by the parties and as we have held in this

Opinion (in some respects different from the Commissioner’s

contentions, as we will discuss). We outline the necessary adjustments

to the capital accounts below.

65 The 2013 LLC Agreement’s income allocation provisions are not the reason

that the CRC’s special allocation of clients to Newman PLLC and Town PS lacked

substantial economic effect (rather, the reason was CRC’s failure to maintain capital

accounts in accordance with the regulations).

48

[*48] CRC reported (and the Commissioner does not contest) that the

partners had the following beginning capital account balances in 2013:

Partner Capital account balance

Clark PLLC $1,131,549

Newman PLLC 34,972

Town PS 96,638

CRC did not allocate the unrealized gain inherent in the client-

based intangible to the partners’ capital accounts before the decrease

corresponding with the distribution. We have held that the client-based

intangible held unrealized gain, and therefore, such gain must be

allocated to the partners’ capital accounts before the distribution of the

client-based intangibles. The 2013 LLC Agreement states that “all

items of Company . . . gain . . . shall be divided among the Members in

the same proportions as they share Net Profits or Net Losses”.

Therefore, the allocation of unrealized gain realized on the hypothetical

sale of the client-based intangibles follows the same tiered formula

governing income allocations, discussed above.

Following the allocation of unrealized gain, Newman PLLC’s and

Town PS’s capital accounts must be decreased by the value of the client-

based intangibles distributed to them. See Treas. Reg. § 1.704-

1(b)(2)(iv)(b). The partners’ capital accounts must also be decreased by

the distributions of cash to each partner, and Newman PLLC’s capital

account must be decreased by the value of the distribution to it on

account of the WTB Loan.

Section 8.1 of the 2013 LLC Agreement, “Allocation of Net Profit

or Loss”, allocates income according to the formula above, but “subject

to Section[] 8.3”. Section 8.3 of the 2013 LLC Agreement includes

(among other provisions that are inapplicable here) the QIO provision.

Therefore, all income allocations under Section 8.1 are subject, first, to

the QIO, which requires that, if any partner unexpectedly receives an

adjustment (i.e., following an unexpected distribution) that results in a

deficit capital account balance for that partner, items of income and gain

must be allocated to that partner to rectify the deficit capital account

balance as quickly as possible.

49

[*49] According to our calculations, the various adjustments discussed

above result in deficit capital account balances for both Newman PLLC

and Town PS at the end of 2013. Therefore, under the terms of the 2013

LLC Agreement, the triggered QIO provision allocates income to each of

them in an amount necessary to bring their capital account balances up

to zero. 66

Therefore, we hold that, for the purposes of this factor of the

partner’s interest in the partnership analysis, the partners agreed to

allocate income from the 2013 taxable year to Newman PLLC and Town

PS in amounts (yet to be precisely determined) sufficient to increase

their capital account balances to zero.

We note that the Commissioner calculates the partnership’s

allocation of income using a similar method, but he fails to adjust the

partners’ capital accounts by the various adjustments throughout the

year, in particular: (1) the allocation of unrealized gain; (2) the

distributions of client-based intangible assets to Newman PLLC and

Town PS; and (3) the property distribution to Newman PLLC on account

of the outstanding balance of the WTB Loan. 67 He then calculates the

66 The parties disagree about whether the $200,000 payment made by Newman

PLLC and Town PS (in proportions that the record does not show) incident to the

Settlement Agreement constitutes a “capital contribution” by either of them for federal

tax purposes. However, because of the stipulated value of the client-based intangibles

that we hold to have been distributed, and the corresponding decrease to the partners’

capital accounts as a result, Newman PLLC’s and Town PS’s capital accounts will be

deficit in amounts greater than CRC’s total ordinary income in 2013—whether or not

the $200,000 payment was a “capital contribution” (i.e., whether their respective

capital accounts were increased by some portion of that payment).

67 In analyzing in his brief the interests of the partners in gains and losses, the

Commissioner excludes the impact of the distribution on account of the WTB Loan

because he takes issue with CRC’s allocations of income in 2012 (i.e., not the year at

issue). In 2012 CRC had allocated a loss of −$3,118 to Newman PLLC, see supra note

37, which Newman PLLC contested in a Form 8082, see supra note 41, reporting

instead an income allocation of $167,872. The Commissioner contends that CRC’s

allocation of a loss to Newman PLLC was improper, and that instead CRC should have

allocated to Newman PLLC income of $167,872. This allocation of income, the

Commissioner contends, if taken into consideration in the calculation of the partners’

capital accounts, would sufficiently offset any decrease in Newman PLLC’s capital

account caused by the property distribution on account of the WTB Loan. He asks us

to “consider facts in the record regarding the 2012 transactions as it relates to the 2013

year at issue”, and effectively to determine the validity of CRC’s 2012 allocations of

income. Even assuming that we would otherwise have jurisdiction to make such a

determination, the issue is not properly before us: The issue is not stated in the FPAA

50

[*50] allocations of income using the formula in the 2013 LLC

Agreement on the basis of the partners’ initial capital account balances

in 2013 but concludes that 100% of income should be allocated to Clark

PLLC because “all the benefit of CRC’s 2013 business operations inured

to Clark PLLC”. While it is true that Clark PLLC received the largest

cash distribution in 2013, the Commissioner omits from his calculation

the impact of the client-based intangible distribution, and he therefore

disregards the implication of the partners’ negative account balances,

the effect of the QIO, and the income properly allocable to Newman

PLLC and Town PS as a result.

3. The interests of the partners in cash flow and other

non-liquidating distributions

The 2013 LLC Agreement states that distributions of “[c]ash may

be made to the Members at such time and amounts as determined in the

Managers’ reasonable discretion, provided that such [d]istributions will

be consistent with the allocations of income made pursuant to

Section 8.1”.

The Commissioner argues that we should look to the cash

distributions actually received by the partners in 2013 (instead of

looking to the 2013 LLC Agreement) to determine the parties’

agreement as to cash and non-liquidating distributions. He cites Estate

of Tobias, 81 T.C.M. (CCH) at 1163, and Interhotel Co., 81 T.C.M. (CCH)

at 1804, to argue that the economic burden (i.e., the tax burden) should

follow the economic benefit received by the partners. He argues that

Clark PLLC’s receipt of the largest portion ($632,201) of total cash

distributions ($660,889) is evidence of the partners’ agreement as to how

they would share the economic benefit of CRC’s income in 2013.

However, the facts of this case distinguish it substantially from

those of Interhotel and Estate of Tobias. Notably, the partnership

on which this case is founded; the Commissioner did not plead the issue in his answer

(where it would have constituted “new matter” under Rule 142(a)(1); and the parties,

in their jointly submitted motion to submit the case pursuant to Rule 122, agreed that

the remaining legal issues in dispute are limited to the distribution of the client-based

intangibles and the substantial economic effect of CRC’s income allocations in 2013.

See supra note 44. Therefore, we do not address the Commissioner’s contentions

regarding CRC’s 2012 allocations of income.

51

[*51] agreements at issue in Interhotel did not include QIOs68 (or, as far

as we can tell, the requirement that distributions follow allocations of

income), and the partnership in Estate of Tobias lacked a written

partnership agreement entirely. 69 Here, CRC has a partnership

agreement negotiated by the partners at arm’s length, and neither party

presents a reason why we should disregard its provisions. Therefore, on

the basis of the provisions of the 2013 LLC Agreement, we hold that the

partners, for the purpose of this factor of the partner’s-interest-in-the-

partnership analysis, agreed to make cash and other non-liquidating

distributions in amounts equal to the income allocations for the 2013

year.

4. The rights of the partners to distributions of capital

upon liquidation

The 2013 LLC Agreement states that, upon liquidation of the

partnership, assets will be distributed “[t]o the Members in repayment

of the positive balances of their respective Capital Accounts, as

determined after taking into account all Capital Account adjustments

for the taxable year during which the liquidation occurs”. Upon a

partner’s voluntary withdrawal (i.e., a liquidation of that partner’s

interest), a partner is entitled to a distribution amount equal to its

capital account balance. 70

On the basis of our calculations above, Clark PLLC is the only

partner that ends 2013 with a positive capital account balance after

adjustments. Therefore, under the provisions of the 2013 LLC

Agreement, if CRC liquidated at the end of 2013, Clark PLLC would

“[N]either the [taxpayer’s] Original Agreement nor the [taxpayer’s] Restated

68

Agreement contain[ed] a provision requiring capital account adjustments for

reasonably expected distributions or a ‘qualified income offset’.” Interhotel, 81 T.C.M.

(CCH) at 1808.

69 “[The partners] did not enter into a written partnership agreement and . . .

their oral agreement was merely an informal, general agreement to operate an animal

farm and did not contain any specific terms.” Estate of Tobias, 81 T.C.M. (CCH)

at 1169.

70 We recognize that whether Town PS is entitled to a distribution of its capital

account balance upon voluntary withdrawal under the 2013 LLC Agreement depends

on some combination of factors (including its capital account balance and/or payment

in full of the loan owed to Clark PLLC). See supra pp. 16–17. However, we are unable

to determine from the 2013 LLC Agreement the exact criteria of this limitation or the

outstanding balance on the loan to Clark PLLC from the record. Therefore, we do not

consider this limitation in our analysis.

52

[*52] receive the partnership’s assets in total. Similarly, given Newman

PLLC’s and Town PS’s negative capital account balances, neither

partner was likely entitled to a distribution on account of its capital

account balance. In support of this outcome, the Commissioner argues

that the terms of the parties’ Civil Rule 2A Agreement (wherein

Newman PLLC and Town PS agreed to make further contributions, and

which did not provide that either was entitled to a liquidating

distribution), and the fact that Newman PLLC and Town PS did not

receive distributions equal to their capital account balances upon their

withdrawal, are evidence that Newman PLLC’s and Town PS’s rights

upon liquidation were zero, and that all income should be allocated to

Clark PLLC.

This outcome generally comports with the observation that we

made in our contribution analysis: that Clark PLLC owned the largest

portion of CRC. Therefore, it makes intuitive sense that, in a liquidation

of CRC, Clark PLLC would receive the largest portion of distributions.

However, given that the allocation at issue is an allocation of annual

income (not in liquidation of the partnership), we believe that the

partners’ agreement as to how to allocate that income, in particular the

provisions regarding the QIO, are the most indicative of how the

partners agreed to share the economic benefits and burdens of the

partnership. We therefore afford this liquidation factor the least weight

in our consideration of the partner’s interest in the partnership.

D. “Align[ing]” distribution and income allocation in the

“book-up”

The Commissioner has another argument to resist the allocation

of income away from Clark PLLC and toward the other two partners.

He contends:

Section 9.3 [of the 2013 LLC Agreement], when read in

conjunction with . . . section 9.1 requires a matching of the

book-up and the distribution. Because section 9.3(a)

requires that non-cash distributions reflect how the cash

proceeds from the sale of such property would have been

distributed, it follows that the book-up must be allocated to

the distributee[s] – had the property been sold first, with

the proceeds distributed to Newman PLLC and Town PS,

the matching rule of section 9.1 would have required the

gain from the hypothetical sale to be allocated in a manner

that is consistent with that cash distribution from a

53

[*53] hypothetical sale. . . . If CRC would have distributed the

cash proceeds from a hypothetical sale of $419,043 and

$447,437, to Newman PLLC and Town PS, respectively,

then it follows that the book-up would have been allocated

in these same amounts to the distributee partners,

resulting in a wash to their capital accounts.

Assuming his premises, the Commissioner is partly right: He is

right that, if the unrealized gain is allocated only to the distributee

partners (Newman PLLC and Town PS) and not to Clark PLLC, then

that gain allocation would increase their capital accounts, and the

immediately subsequent distribution would reduce their capital

accounts, and the net effect would be “a wash”. Their accounts would

not be driven into negative status; the QIO would not be triggered; and

CRC’s 2013 income would not be allocated to those partners.

But we disagree with the Commissioner’s insistence that a

“matching” is required and that the unrealized gain is allocated solely

to the distributee partners. The 2013 LLC Agreement explicitly says

otherwise. Section 9.3(a) requires that, before the distribution,

unrealized gain must be allocated among the partners not in accordance

with their being distributees of the gain but rather “in accordance with

Article 8” (i.e., in accordance with their allocations of “Net Profit or Net

Loss for [the] fiscal year of the Company”). The LLC agreement could

hardly be clearer. The allocation of gain, made before any distribution

has occurred, is in accordance with Article 8.

Less clear is how to reconcile the 2013 LLC Agreement with the

distribution of client-based intangible assets to only two of the partners.

Section 9.3(a) states that “[n]oncash assets . . . shall be distributed in a

manner that reflects how cash proceeds from the sale of such assets for

fair market value would have been distributed”; and Section 9.1 states

that “Distributions of Distributable Cash may be made to the Members

as such time and amounts as determined in the Managers’ reasonable

discretion, provided that such Distributions will be consistent with the

allocations of income made pursuant to Section 8.1”. Section 9.1 thus

does state that the distributions “will be consistent with” the provisions

of Section 8.1 (providing for allocations of net profit or loss); but

Section 9.1 commits the matter to managerial discretion, so opinions

might differ about the propriety of the client distribution under the 2013

LLC Agreement.

54

[*54] However, we are adjudicating a dispute about the tax

consequences of a distribution that was in fact made; we are not

adjudicating a dispute about a partner’s claim that he was wrongly left

out of a distribution. Either dispute is resolved by the Settlement

Agreement, which compromised the parties’ disagreements about the

withdrawal of Newman PLLC and Town PS from CRC and left the

client-based intangibles in the hands of the withdrawing partners. The

Commissioner is certainly right to begin his analysis with the text of

Sections 8.1, 9.1, and 9.3 of the 2013 LLC Agreement, but ending there

without resort to the Settlement Agreement makes the puzzle seem

more difficult than it actually is. We construe the 2013 LLC Agreement

in light of the later Settlement Agreement, which superseded the LLC

agreement.

We conclude that the unrealized gain is properly allocated among

all three partners (as set out in Section 8.1) so that the capital accounts

of all three are increased, but we conclude that because the agreed-upon

distribution was made only to the withdrawing partners, only their

capital accounts are reduced. Consequently, the withdrawing partners’

capital accounts did go negative, the QIO was triggered, and considering

our analysis of the partners’ interests in the partnership (and weighing

most heavily the partners’ agreement regarding their interests in

economic profits and losses), CRC’s 2013 income should be allocated to

the withdrawing partners’ accounts to bring them up to zero. 71

We will order the parties to submit computations under Rule 155

to determine the exact amount of Newman PLLC’s and Town PS’s

capital account balance deficiencies (after applicable adjustments to

their capital accounts) and the amounts of income allocable to the

partners’ capital accounts as a result. Those computations should

account for the following capital account adjustments, beginning with

71 The Commissioner contends that all of CRC’s ordinary income for the period

of January 2013 to April 2013 is properly allocable to Clark PLLC under Section 8.1(c),

which allocates all income remaining after the allocations of Section 8.1(a) and (b)

according to the FMG system. The parties have stipulated that $15,387 of income is

allocable to Clark PLLC under Section 8.1(b) (for amounts collected on accounts

receivable) and that all remaining income is allocable to Clark PLLC under Section

8.1(c), but our analysis does not reach Section 8.1(a)–(c) of the 2013 LLC Agreement,

and therefore the parties’ stipulations regarding these allocations of income are not

helpful in this regard. Instead, the introductory text of Section 8.1 subjects the

partnership’s income allocations to Section 8.3 (regarding special allocations), and

therefore, due to the deficit capital account balances of Newman PLLC and Town PS,

the QIO provision under Section 8.3 controls the allocation of CRC’s entire amount of

income for 2013.

55

[*55] the partners’ reported opening capital account balances in 2013,

see supra p. 24: (1) the allocation of $742,569 of unrealized gain (in the

client-based intangible assets) according to Section 8.1 of the 2013 LLC

Agreement; (2) the distribution of client-based intangible assets of

$318,144 to Newman PLLC and $424,425 to Town PS; (3) the

distribution on account of the WTB Loan of $183,737, see supra note 3;

and (4) the cash distributions to the partners in the amounts stipulated

by the parties, see supra note 3. By our preliminary calculations, the

amount of CRC’s income in 2013 is insufficient to bring both Newman

PLLC’s and Town PS’s capital accounts up to zero. Therefore, the

income must be allocated between them in some proportion. In the

absence of contentions by the parties as to how to divide the total

amount of ordinary income, we hold that CRC’s income should be

allocated to each partner’s deficit capital account in an amount equal to

that partner’s pro rata “share” of the total negative balances of those

accounts, calculated by dividing the deficit balance of each partner’s

capital account by the combined deficits of both partners’ capital

accounts and then multiplying the resulting ratio for each partner by

the total amount of ordinary income to be allocated.

III. Conclusion

CRC’s special allocation of income of $307,759 to Newman PLLC

and $255,799 to Town PS in 2013 did lack substantial economic effect

(as the FPAA determined) because the partnership failed to maintain

capital accounts in accordance with the requirement of Treasury

Regulation section 1.704-1(b)(2)(iv) that CRC must allocate the

unrealized gain inherent in the client-based intangibles across the

partners’ capital accounts before decreasing Newman PLLC’s and Town

PS’s capital accounts by the value of the distribution. However, an

analysis of the partners’ interests in the partnership reveals that

although Clark PLLC was the largest percentage owner of CRC’s

“membership units”, the partners agreed to income allocations in their

partnership agreement (including a QIO) that are most indicative of how

they agreed to share the economic benefits and burdens of the

partnership, particularly in light of the unanticipated distribution of

client-based intangibles to Newman PLLC and Town PS.

Therefore, the IRS’s determinations in the FPAA disregarding

CRC’s “client distributions” and reallocating CRC’s allocations of

ordinary income in the 2013 taxable year are hereby rejected and shall

56

[*56] be redetermined in accordance with this Opinion. To give effect to

the foregoing and the parties’ concessions,

Decision will be entered under Rule 155.