The Tax Law Report

Nonreceipt of K-1 Not Reasonable Cause; Accuracy-Related Penalty Assessed

Ziegeler v. Commissioner, T.C. Summ. Op. 2010-65 (2010).

The taxpayers received income, and distributions, from a partnership but never received a K-1.  Because they did not receive the K-1, they did not report the income on their 2005 tax return.  The Tax Court holds that nonreceipt of the K-1 is not a defense to the 20% accuracy-related penalty; the taxpayers have an obligation to make a good faith attempt to obtain the K-1.

This case follows a general theme from the past few days; pass-through entities can be traps for the unwary.  For comparison with the holding in this case, see Jones v. Commissioner (posted here), where the taxpayers also did not receive a K-1, and they made no reasonable attempt to obtain one.  Consequently, the Tax Court assessed an accuracy-related penalty.

It also came out at trial that the taxpayers provided their CPA a K-1 from the partnership in 2004 with a small amount of income. (3 fn.4).  Although under no obligation under the tax code, as a matter of best practice, practitioners should make an inquiry when information provided in year 1 is missing or incomplete in year 2.  Suppose, for example, in year 1 the taxpayer provided a W-2 from XYZ, Inc., but in year 2 the taxpayer did not provide a W-2 from XYZ.  A practitioner should ask whether the taxpayer changed jobs, or if the W-2 is missing.

This point is even more important when you know the taxpayer has a p'ship interest.  The taxpayer should receive a K-1 every year until she disposes of the interest, which is itself a taxable event that has significant implications.  As applied to the Ziegelers, I do not know whether their CPA made such an inquiry, but if she had, it might have saved the Ziegelers significant time and money.  Moreover, the new AICPA Statement on Standards for Tax Services, effective Jan. 1, 2010, state that practitioners should make use of prior year returns to "avoid the omission of items" on the current year return.  Tax Executive Committee, Statement on Standards for Tax Services 17 (2009).

Respondent determined a $25,123 deficiency in petitioners’ 2005 Federal income tax and a $5,025 accuracy-related penalty under section 6662(a). Petitioners concede liability for the $25,123 deficiency. The issue remaining for decision is whether petitioners are liable for the section 6662(a) accuracy-related penalty. (2).

 

Randi Bach (Ms. Bach), a certified public accountant (C.P.A.), prepared petitioners’ 2005 Federal income tax return.

Petitioner did not provide Ms. Bach with a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., from HealthFirst or any additional information that would have enabled her to calculate his income from HealthFirst. (3).

In order to prevail on this issue, the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided all necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Associates, P.A. v. Commissioner, supra at 98-99. The ultimate responsibility for a correct return lies with the taxpayer, who must furnish the necessary information to the agent who prepares the return.  ASAT, Inc. v. Commissioner, 108 T.C. 147, 176 (1997). (6).

Petitioners have failed to meet their burden of proving that they acted with reasonable cause and in good faith. Though petitioners never received a Schedule K-1, they never requested one, nor did they make any attempt to calculate and report the income from HealthFirst. (7).

Petitioners’ contention that nonreceipt of a Schedule K-1 constitutes reasonable cause is mistaken. See Deas v. Commissioner, T.C. Memo. 2000-204 (nonreceipt of Schedule K-1 did not constitute reasonable cause where taxpayer failed to report partnership income). (7).

 

Also, the fact that a C.P.A. prepared petitioners’ tax return does not establish good faith reliance on an independent, competent professional in this case. Petitioners did not provide Ms. Bach with necessary and accurate information for her to correctly determine petitioner’s income. (7)

Ms. Bach credibly testified that had petitioner informed her of the income from HealthFirst, she would have reported it. Ms. Bach was not required to perform an audit of petitioner’s books and records. (8).

 

 

 

Disproportionate Distributions in an S-Corp; Innocent Spouse Relief

Jones v. Commissioner, T.C. Memo. 2010-112 (2010).

The issues for decision are: (1) Whether petitioner’s former husband’s distributive share of the income of two pass-through entities is includable in their joint income for the year at issue . . . .

 

Mr. Jones is a 45-percent shareholder of Hadley & Pech, Inc. (Hadley & Pech), an aviation management company that is an S corporation, and a 50-percent owner of Archipelago Aviation, LLC (Archipelago), a limited liability company that charters aircraft and is taxed as a partnership. Roger Sutton (Mr. Sutton), who was a friend of Mr. Jones’, owns the remaining 55 percent of Hadley & Pech and 50 percent of Archipelago.  (3).

 

For 2005 Hadley & Pech and Archipelago had $101,927 and $212,298 of ordinary net business income, respectively. Mr. Jones’ shares of that income, as Mr. Sutton eventually reported to the Internal Revenue Service (IRS) on the Schedules K-1, were $45,867 and $106,149, respectively. Hadley & Pech’s cash distributions for 2005 consisted of $115,000 to Mr. Sutton and $10,000 to Mr. Jones, while Archipelago did not make any distributions for 2005.  (4).

 

Although Mr. Jones received only a $10,000 cash distribution from Hadley & Pech in 2005, as a shareholder he was required to recognize his 45-percent share of the S corporation’s income even though it was not distributed. (7).

 

Archipelago reported ordinary net business income of $212,298 on its partnership return but did not make distribution to Mr. Sutton or Mr. Jones during 2005.  As a 50-percent partner, Mr. Jones is required to recognize and report $106,149, his share of the partnership income even though it was not distributed to the partners. (9).

This is an unfortunate, but correct, outcome for Mr. & Mrs. Jones.  Pass-through entities, such as partnerships and S-corporations, are double-edge swords for the unwary.  On the one hand, distributions of cash from the entity are generally not taxed.  But on the other hand, the partner's/shareholder's share of net income is taxable, EVEN IF NO DISTRIBUTIONS WERE MADE.

There were two more decisions for the court to decide: innocent spouse relief, and accuracy-related penalty.  Ms. Jones won the first and lost the second.

Divorce Decree not Controlling for Innocent Spouse Relief

Acoba v. Commissioner, T.C. Summ. Op. 2010-64 (2010)

The Tax Court held that a divorce decree allocating existing tax liabilities equally between spouses is not controlling for innocent spouse relief claims.

Petitioner and Mr. Acoba divorced on June 13, 2002. As part of the judgment of divorce, petitioner and Mr. Acoba each agreed to pay “50% of Internal Revenue Service debt for back taxes, interest, and penalties”. (3).

Petitioner argues that she should be liable for only 50 percent of the liabilities for the years at issue as provided in the divorce decree. (7).

Section 6013(d)(3) provides that if a joint return is filed, the tax is computed on the taxpayers’ aggregate income and liability for the resulting tax is joint and several. See also sec. 1.6013-4(b), Income Tax Regs. But the Internal Revenue Service (IRS) may relieve a taxpayer from joint and several liability under section 6015 in certain circumstances.  (5).

To obtain relief from joint and several liability, a spouse must qualify under section 6015(b), or, if eligible, may allocate liability under section 6015(c). In addition, if relief is not available under section 6015(b) or (c), a spouse may seek equitable relief under section 6015(f). (5).

This case does not involve a deficiency or an understatement of tax and, therefore, relief under section 6015(b) and (c) is not available to petitioner. (5).

Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297, sets forth seven threshold conditions that must be satisfied before the Commissioner will consider a request for equitable relief under section 6015(f). (7).

[A]fter weighing all the factors, the Court concludes that petitioner’s intimate involvement in the financial matters of the marriage and her knowledge of the protracted financial decline of the marriage should have put her on notice that filing a joint Federal income tax return was, for her, a poor choice. (13-14).

Unfortunately for Ms. Acoba, as the tax court points out, her divorce agreement does not defeat her "joint and several" liability for unpaid taxes.  This means the IRS can pursue either of them for 100% of the tax liability, regardless of their private agreement to share the burden equally.  If Ms. Acoba pays the entire amount, either voluntarily or involuntarily via IRS levy, the divorce decree will serve as her means for getting reimbursed by her husband.  Of course, if he has no money, she is going to have a hard time collecting.  She effectively becomes an unsecured creditor of her ex-husband, not a good place to be.